Otelco (OTEL) 10-Q 2010 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, 2010
	Or
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the transition period from                               to

Commission File Number: 1-32362

OTELCO INC.

(Exact name of registrant as specified in its charter)

Delaware	52-2126395
(State or other jurisdiction of incorporation or	(I.R.S. Employer Identification No.)
organization)
505 Third Avenue East, Oneonta, Alabama	35121
(Address of Principal Executive Offices)	(Zip Code)

(205) 625-3574

(Registrant’s telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  x No  o

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

Yes  o No  o

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

Large accelerated filer o Accelerated filer x Non-accelerated filer o Smaller reporting company o

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

Yes  o No  x

APPLICABLE ONLY TO CORPORATE ISSUERS:

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

Class	Outstanding at August 5, 2010
Class A Common Stock ($0.01 par value per share)	13,221,404
Class B Common Stock ($0.01 par value per share)	0

OTELCO INC.

FORM 10-Q

For the three month period ended June 30, 2010

TABLE OF CONTENTS

		Page
PART I  FINANCIAL INFORMATION		2
Item 1.	Financial Statements	2
	Consolidated Balance Sheets as of December 31, 2009 and June 30, 2010	2
	Consolidated Statements of Operations for the Three Months and Six Months Ended June 30, 2009 and 2010	3
	Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2009 and 2010	4
	Notes to Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	21
Item 4.	Controls and Procedures	21
PART II  OTHER INFORMATION		22
Item 6.	Exhibits	22

i

Unless the context otherwise requires, the words “we,” “us,” “our,” “the Company” and “Otelco” refer to Otelco Inc., a Delaware corporation, and its consolidated subsidiaries as of June 30, 2010.

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 tre nds, 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 I  FINANCIAL INFORMATION

Item 1. Financial Statements

OTELCO INC.

CONSOLIDATED BALANCE SHEETS

	December 31,			June 30,
	2009			2010
				(unaudited)
Assets
Current assets
Cash and cash equivalents	$	17,731,044		$	22,743,256
Accounts receivable:
Due from subscribers, net of allowance for doubtful accounts of $473,572 and $254,645, respectively		4,650,909			4,584,262
Unbilled receivables		2,444,979			2,425,742
Other		3,200,945			3,218,327
Materials and supplies		1,969,966			1,994,968
Prepaid expenses		1,342,249			968,598
Income tax receivable		389,486			-
Deferred income taxes		744,531			744,531
Total current assets		32,474,109			36,679,684
Property and equipment, net		69,028,973			65,451,303
Goodwill		188,190,078			188,190,078
Intangible assets, net		34,218,115			29,966,542
Investments		1,991,158			1,978,404
Deferred financing costs		6,964,015			6,441,873
Deferred income taxes		4,482,430			4,482,430
Other assets		179,325			127,553
Total assets	$	337,528,203		$	333,317,867
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable	$	3,145,728		$	2,191,810
Accrued expenses		6,167,023			6,680,436
Advance billings and payments		1,665,422			1,627,670
Deferred income taxes		394,850			394,850
Customer deposits		172,109			179,229
Total current liabilities		11,545,132			11,073,995
Deferred income taxes		42,239,262			42,239,262
Interest rate swaps		1,592,813			2,655,262
Advance billings and payments		698,352			677,660
Other liabilities		165,968			156,807
Long-term notes payable		273,717,301			277,757,514
Total liabilities		329,958,828			334,560,500
Class B common convertible to senior subordinated notes		4,085,033			-
Stockholders’ equity
Class A Common Stock, $.01 par value-authorized 20,000,000 shares; issued and outstanding 12,676,733 and 13,221,404 shares, respectively		126,767			132,214
Class B Common Stock, $.01 par value-authorized 800,000 shares; issued and outstanding 544,671 and 0 shares, respectively		5,447			-
Additional paid in capital		10,340,862			5,582,263
Retained deficit		(6,988,734	)		(6,957,110	)
Total stockholders’ equity		3,484,342			(1,242,633	)
Total liabilities and stockholders’ equity	$	337,528,203		$	333,317,867

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

2

OTELCO INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2009			2010			2009			2010
Revenues
Local services	$	12,063,419		$	12,286,314		$	23,918,400		$	24,524,988
Network access		8,265,063			8,603,635			16,359,196			16,588,604
Cable television		612,363			698,739			1,219,050			1,364,574
Internet		3,500,149			3,527,126			7,041,826			7,038,232
Transport services		1,355,677			1,395,130			2,758,376			2,788,755
Total revenues		25,796,671			26,510,944			51,296,848			52,305,153
Operating expenses
Cost of services and products		10,133,256			10,427,781			20,799,712			21,037,973
Selling, general and administrative expenses		3,342,855			3,236,515			6,919,529			6,467,512
Depreciation and amortization		6,604,748			5,835,311			13,396,586			11,919,602
Total operating expenses		20,080,859			19,499,607			41,115,827			39,425,087
Income from operations		5,715,812			7,011,337			10,181,021			12,880,066
Other income (expense)
Interest expense		(6,446,902	)		(6,179,470	)		(13,045,855	)		(12,168,112	)
Change in fair value of derivatives		1,289,832			(176,279	)		338,729			(1,062,449	)
Other income		12,510			24,027			238,371			382,859
Total other expense		(5,144,560	)		(6,331,722	)		(12,468,755	)		(12,847,702	)
Income (loss) before income tax		571,252			679,615			(2,287,734	)		32,364
Income tax (expense) benefit		(60,552	)		(262,339	)		964,401			(744	)
Net income (loss) available to common stockholders	$	510,700		$	417,276		$	(1,323,333	)	$	31,620
Weighted average shares outstanding:
Basic		12,676,733			12,812,901			12,676,733			12,747,540
Diluted		13,221,404			13,221,404			13,221,404			13,221,404
Basic net income (loss) per share	$	0.04		$	0.03		$	(0.10	)	$	0.00
Diluted net income (loss) per share	$	0.03		$	0.03		$	(0.11	)	$	0.00
Dividends declared per share	$	0.18		$	0.18		$	0.35		$	0.35

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

3

OTELCO INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

	Six Months Ended June 30,
	2009			2010
Cash flows from operating activities:
Net income (loss)	$	(1,323,333	)	$	31,620
Adjustments to reconcile net income to cash flows from operating activities:
Depreciation		7,176,803			6,900,218
Amortization		6,219,783			5,019,383
Interest rate caplet		699,783			-
Amortization of debt premium		(39,918	)		(44,820	)
Amortization of loan costs		675,953			677,302
Change in fair value of derivatives		(338,729	)		1,062,449
Provision for uncollectible revenue		149,765			65,581
Changes in assets and liabilities; net of assets and liabilities acquired:
Accounts receivables		86,941			53,458
Material and supplies		239,576			(25,002	)
Prepaid expenses and other assets		234,189			373,651
Income tax receivable		-			389,486
Accounts payable and accrued liabilities		(518,565	)		(428,566	)
Advance billings and payments		(46,205	)		(58,444	)
Other liabilities		(30,003	)		(2,041	)
Net cash from operating activities		13,186,040			14,014,275
Cash flows from investing activities:
Acquisition and construction of property and equipment		(3,577,514	)		(4,087,263	)
Adjustment to the purchase of the CR Companies		170,175			-
Deferred charges		-			(1,041	)
Net cash used in investing activities		(3,407,339	)		(4,088,304	)
Cash flows from financing activities:
Cash dividends paid		(4,468,548	)		(4,564,546	)
Direct cost of exchange of Class B shares for Class A shares		-			(194,053	)
Loan origination costs		-			(155,160	)
Net cash used in financing activities		(4,468,548	)		(4,913,759	)
Net increase in cash and cash equivalents		5,310,153			5,012,212
Cash and cash equivalents, beginning of period		13,542,255			17,731,044
Cash and cash equivalents, end of period	$	18,852,408		$	22,743,256
Supplemental disclosures of cash flow information:
Interest paid	$	12,018,858		$	11,535,629
Income taxes received	$	(15,342	)	$	(289,163	)

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

4

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”) and its subsidiaries, all of which are either directly or indirectly wholly owned. These include:  Otelco Telecommunications LLC (“OTC”); Otelco Telephone LLC (“OTP”); Hopper Telecommunications Company, Inc. (“HTC”); Brindlee Mountain Telephone Company (“BMTC”); Blountsville Telephone Company, Inc. (“BTC”); Mid-Missouri Holding Corp. (“MMH”) and its wholly owned subsidiary Mid-Missouri Telephone Company (“MMT”) and its wholly owned subsidiary Imagination, Inc.; Mid-Maine Telecom, Inc. (“MMTI”); Mid-Maine TelPlus (“MMTP”); The Granby Telephone & Telegraph Co. of Mass. (“GTT”); War Acquisition Corporation (“WT”); The Pine Tree Telephone and Telegraph Company (“PTT”); Saco River Telegraph and Telephone Company (“SRT”); CRC Communications of Maine, Inc. (“PTN”); and Communications Design Acquisition Corporation (“CDAC”).
	The accompanying consolidated financial statements include the accounts of the Company and all of the aforesaid subsidiaries after elimination of all material intercompany balances and transactions.  The unaudited operating results for the three months and six months ended June 30, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, 2010.
	The consolidated financial statements and notes included in this Form 10-Q should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2009.  The interim consolidated financial information herein is unaudited.  The information reflects all adjustments (which include only normal recurring adjustments), which are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations for the periods included in the report.
	Certain prior year amounts have been reclassified to conform with the current year’s presentation.
	Recently Adopted Accounting Pronouncements
	In February 2010, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) 2010-09, Amendments to Certain Recognition and Disclosure Requirements (“ASU 2010-09”), an update to Accounting Standards Codification (“ASC”) 855, Subsequent Events.  ASU 2010-09 eliminates the requirement for a Securities and Exchange Commission (“SEC”) filer to disclose a date through which subsequent events have been evaluated in both issued and revised financial statements.  Revised financial statements include financial statements revised as a result of either correction of an error or retrospective application of accounting p rinciples generally accepted in the United States.  The FASB believes these amendments remove potential conflicts with the SEC’s literature.  ASU 2010-09 is effective upon issuance except for the use of the issued date for conduit debt obligors, which is effective for interim or annual periods ending after June 15, 2010.  The adoption of this update did not have a material impact on our consolidated financial statements.
	Recent Accounting Pronouncements
	In October 2009, the FASB issued ASU 2009-13, Multiple-Deliverable Revenue Arrangements – a consensus of the FASB Emerging Issues Task Force (“ASU 2009-13”), an update to ASC 605, Revenue Recognition.  ASU 2009-13 provides application guidance on whether multiple deliverables exist, how the deliverables should be separated, and how the consideration should be allocated to one or more units of accounting.  ASU 2009-13 establishes a selling price hierarchy for determining the selling price of a deliverable.  The selling price used for each deliverable will be based on vendor-specific objective evidence, if available, third-party evidence if vendor-specific evidence is not availa ble, or estimated selling price if neither vendor-specific nor third-party evidence is available.  The Company will be required to apply this guidance prospectively for revenue arrangements entered into or materially modified for fiscal years beginning on or after June 15, 2010; however, earlier application is permitted.  The Company has not determined the impact that this update may have on its consolidated financial statements.
	In January 2010, the FASB issued ASU 2010-06, Improving Disclosures about Fair Value Measurements (“ASU 2010-06”), an update to ASC 820, Fair Value Measurements and Disclosures (“ASC 820”).  ASU 2010-06 provides more robust disclosures about (1) the different classes of assets and liabilities measured at fair value, (2) the valuation techniques and inputs used, (3) the activity in Level 3 fair value measurements, and (4) the transfers between Levels 1, 2, and 3.  The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and se ttlements in the roll forward of activity in Level 3 fair value measurements.  Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years.  The Company has not determined the impact that this update may have on its consolidated financial statements.

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2.	Commitments and Contingencies
	From time to time, we may be involved in various claims, legal actions and regulatory proceedings incidental to and in the ordinary course of business, including administrative hearings of the Alabama, Maine, Massachusetts, Missouri, New Hampshire, and West Virginia Public Service Commissions relating primarily to rate making.  Currently, none of the legal proceedings are expected to have a material adverse effect on our business.
3.	Other Accounts Receivable
	The Company reached a settlement with respect to certain contracts with FairPoint Communications, Inc. which filed for bankruptcy on October 25, 2009.  The settlement was approved by the bankruptcy court on April 27, 2010 and the contracts are in effect.
4.	Income Deposit Securities Issued
	On June 8, 2010, the Company issued 544,671 Income Deposit Securities (“IDSs”), representing an aggregate of 544,671 shares of our Class A common stock and $4,085,033 aggregate principal amount of our 13% senior subordinated notes due 2019, in exchange for all 544,671 shares of our issued and outstanding Class B common stock.  There were no proceeds to the Company from this exchange.  The $4.1 million of senior subordinated notes was reclassified from the mezzanine section of the balance sheet to long-term notes payable.  Interest on the $4.1 million of senior subordinated notes was reflected in interest expense in the statement of operations from June 8, 2010 through June 30, 2010.  The direct cost of the exchange was $349,213.
5.	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% for the three month LIBOR index 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 was considered an effective hedge for the remaining senior debt as all critical terms of the interest rate cap were identical to the underlying debt it hedged. The balance of the cap at that time was considered as an investment and adjustments were made to accumulated other comprehensive income to reflect this change. On October 31, 2 008, the Company entered into a second amended and restated credit agreement, increasing senior debt to $173.5 million in conjunction with the acquisition of three entities from Country Road Communications LLC.  The full $80 million rate cap was accounted for as an effective hedge from that date through the end of the rate cap on December 20, 2009.
	The cost of the effective portion of the interest rate cap was 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 second amended and restated credit agreement requires that the Company acquire interest rate protection for at least half of the $173.5 million senior debt through at least October 31, 2010. Accordingly, the Company has acquired two interest rate swaps with approved counterparties.  The first swap has a notional amount of $90 million with the Company paying a fixed rate of 1.85% and the counterparty paying a variable rate based upon the three month LIBOR interest rate. It is effective from February 9, 2009 through February 8, 2012. The second swap has a notional amount of $60 million with the Company paying a fixed rate of 2.0475% and the counterparty paying a variable rate based upon the three month LIBOR interest rate. It is effective from February 9, 2010 through February 8, 2012. From an accounting perspective, the do cumentation for both swaps does not meet the technical requirements of ASC 815, Derivatives and Hedging, to allow the swaps to be considered highly effective hedging instruments and therefore the swaps do not qualify for hedge accounting.  The change in fair value of the swaps is charged or credited to income as a change in fair value of derivatives.  Over the life of the swaps, the cumulative change in value will be zero.

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6.	Income (Loss) per Common Share and Potential Common Share
	Basic income 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 would occur had all of the issued and outstanding shares of Class B common stock been exchanged for IDSs at the beginning of the period.  On June 8, 2010, all of the Company’s issued and outstanding shares of Class B common stock were exchanged for IDSs on a one-for-one basis.  Each of the IDSs issued in the exchange includes a Class A common share.
	A reconciliation of the common shares for the Company’s basic and diluted income (loss) per common share calculation is as follows:

	Three Months Ended June 30,					Six Months Ended June 30,
	2009			2010		2009			2010
Weighted average common shares-basic		12,676,733			12,812,901		12,676,733			12,747,540
Effect of dilutive securities		544,671			408,503		544,671			473,864
Weighted-average common shares and potential common shares-diluted		13,221,404			13,221,404		13,221,404			13,221,404
Net income (loss) available to common stockholders	$	510,700		$	417,276	$	(1,323,333	)	$	31,620
Net income (loss) per basic share	$	0.04		$	0.03	$	(0.10	)	$	0.00
Net income (loss) available to common stockholders	$	510,700		$	417,276	$	(1,323,333	)	$	31,620
Less: Change in fair value of B share derivative		(62,882	)		-		(74,462	)		-
Net income (loss) available for diluted shares	$	447,818		$	417,276	$	(1,397,795	)	$	31,620
Net income (loss) per diluted share	$	0.03		$	0.03	$	(0.11	)	$	0.00

7.	Fair Value Measurements
	In accordance with ASC 820, the following table represents the Company’s fair value hierarchy for its financial assets and liabilities as of June 30, 2010:

	June 30, 2010
	Fair Value		Level 1 (1)		Level 2 (2)		Level 3 (3)
Assets
Cash and cash equivalents	$	22,743,256	$	22,743,256	$	-	$	-
Co-operative patronage shares		1,542,495		-		-		1,542,495
Total assets	$	24,285,751	$	22,743,256	$	-	$	1,542,495
Liabilities
Interest rate swaps	$	2,655,262	$	-	$	2,655,262	$	-
Total liabilities	$	2,655,262	$	-	$	2,655,262	$	-

(1)	Quoted prices in active markets for identical assets.
(2)	Significant other observable inputs.
(3)	Significant unobservable inputs.

The Company retains its cash and cash equivalents in short-term interest bearing instruments whose value is observable on a daily basis. Patronage shares have been issued primarily by one of our lenders which operates as a co-operative.  The Company does not pay for these shares but receives them as a non-cash dividend. The market for these shares is limited to the issuing organization and subject to uncertainty of future redemption for cash. These shares are valued at approximately 55% of their originally issued value. While the issuer and the Company expect these shares to be worth their issued value, the current valuation recognizes some uncertainty of their future redemption value.

7

	The interest rate swaps are valued at the end of the quarter by market experts in that business based on similar transactions and rates in an active financial market.
8.	Subsidiary Guarantees
	The Company has no independent assets or operations separate from its operating subsidiaries.  The guarantees of its senior subordinated notes by 12 of its 14 operating subsidiaries are full and unconditional, joint and several.  The operating subsidiaries have no independent long-term notes payable.  There are no significant restrictions on the ability of the Company to obtain funds from its operating subsidiaries by dividend or loan.  The condensed consolidated financial information is provided for the guarantor entities.
	The following tables present condensed consolidating balance sheets as of December 31, 2009 and June 30, 2010; condensed consolidating statements of operations for the three months ended June 30, 2009 and 2010; condensed consolidating statements of operations for the six months ended June 30, 2009 and 2010; and condensed consolidating statements of cash flows for the six months ended June 30, 2009 and 2010.

Otelco Inc.

Condensed Consolidating Balance Sheet

December 31, 2009

	Parent		Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Eliminations			Consolidated
ASSETS
Current assets
Cash and cash equivalents	$	-	$	17,617,266		$	113,778		$	-		$	17,731,044
Accounts receivable, net		-		9,354,246			942,587			-			10,296,833
Materials and supplies		-		938,766			1,031,200			-			1,969,966
Prepaid expenses		76,219		1,192,272			73,758			-			1,342,249
Income tax receivables		389,486		-			-			-			389,486
Deferred income taxes		744,531		-			-			-			744,531
Investment in subsidiaries		113,558,790		-			-			(113,558,790	)		-
Intercompany receivable		129,450,605		-			-			(129,450,605	)		-
Total current assets		244,219,631		29,102,550			2,161,323			(243,009,395	)		32,474,109
Property and equipment, net		-		57,762,888			11,266,085			-			69,028,973
Goodwill		-		190,126,718			(1,936,640	)		-			188,190,078
Intangible assets, net		-		31,361,923			2,856,192			-			34,218,115
Investments		1,000		1,661,027			329,131			-			1,991,158
Deferred income taxes		4,482,430		-			-			-			4,482,430
Other long-term assets		7,519,753		(376,413	)		-			-			7,143,340
Total assets	$	256,222,814	$	309,638,693		$	14,676,091		$	(243,009,395	)	$	337,528,203
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable and accrued expenses	$	2,549,577	$	5,650,086		$	1,113,088		$	-		$	9,312,751
Intercompany payables		-		123,837,610			5,612,995			(129,450,605	)		-
Other current liabilities		394,850		1,758,112			79,419			-			2,232,381
Total current liabilities		2,944,427		131,245,808			6,805,502			(129,450,605	)		11,545,132
Deferred income taxes		10,662,374		28,184,570			3,392,318			-			42,239,262
Other liabilities		1,592,813		864,320			-			-			2,457,133
Long-term notes payable		233,453,825		40,263,476			-			-			273,717,301
Class B common convertible to senior subordinated notes		4,085,033		-			-			-			4,085,033
Stockholders’ equity		3,484,342		109,080,519			4,478,271			(113,558,790	)		3,484,342
Total liabilities and stockholders’ equity	$	256,222,814	$	309,638,693		$	14,676,091		$	(243,009,395	)	$	337,528,203

8

Otelco Inc.

Condensed Consolidating Balance Sheet

June 30, 2010

	Parent			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Eliminations			Consolidated
ASSETS
Current assets
Cash and cash equivalents	$	-		$	22,599,607		$	143,649		$	-		$	22,743,256
Accounts receivable, net		-			9,419,236			809,095			-			10,228,331
Materials and supplies		-			1,022,065			972,903			-			1,994,968
Prepaid expenses		77,875			835,373			55,350			-			968,598
Deferred income taxes		744,531			-			-			-			744,531
Investment in subsidiaries		126,272,743			-			-			(126,272,743	)		-
Intercompany receivable		(118,235,194	)		-			-			118,235,194			-
Total current assets		8,859,955			33,876,281			1,980,997			(8,037,549	)		36,679,684
Property and equipment, net		-			55,335,698			10,115,605			-			65,451,303
Goodwill		239,970,317			(49,843,599	)		(1,936,640	)		-			188,190,078
Intangible assets, net		-			27,234,532			2,732,010			-			29,966,542
Investments		1,203,605			445,668			329,131			-			1,978,404
Deferred income taxes		4,482,430			-			-			-			4,482,430
Other long-term assets		6,441,873			127,553			-			-			6,569,426
Total assets	$	260,958,180		$	67,176,133		$	13,221,103		$	(8,037,549	)	$	333,317,867
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable and accrued expenses	$	1,847,763		$	5,317,532		$	1,706,951		$	-		$	8,872,246
Intercompany payables		-			(120,761,262	)		2,526,068			118,235,194			-
Other current liabilities		394,850			1,725,704			81,195			-			2,201,749
Total current liabilities		2,242,613			(113,718,026	)		4,314,214			118,235,194			11,073,995
Deferred income taxes		19,808,900			19,038,044			3,392,318			-			42,239,262
Other liabilities		2,655,262			834,467			-			-			3,489,729
Long-term notes payable		237,494,038			40,263,476			-			-			277,757,514
Stockholders’ equity		(1,242,633	)		120,758,172			5,514,571			(126,272,743	)		(1,242,633	)
Total liabilities and stockholders’ equity	$	260,958,180		$	67,176,133		$	13,221,103		$	(8,037,549	)	$	333,317,867

Otelco Inc.

Condensed Consolidating Statement of Operations

For the Three Months Ended June 30, 2009

	Parent			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Eliminations			Consolidated
Revenue	$	700,138		$	24,908,849		$	2,897,581		$	(2,709,897	)	$	25,796,671
Operating expenses		(700,138	)		(20,055,598	)		(2,035,020	)		2,709,897			(20,080,859	)
Income from operations		-			4,853,251			862,561			-			5,715,812
Other expense		(5,052,138	)		(92,411	)		(11	)		-			(5,144,560	)
Earnings from subsidiaries		5,623,390			-			-			(5,623,390	)		-
Income before income tax		571,252			4,760,840			862,550			(5,623,390	)		571,252
Income tax expense		(60,552	)		-			-			-			(60,552	)
Net income to common stockholders	$	510,700		$	4,760,840		$	862,550		$	(5,623,390	)	$	510,700

9

Otelco Inc.

Condensed Consolidating Statement of Operations

For the Three Months Ended June 30, 2010

	Parent			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Eliminations			Consolidated
Revenue	$	801,566		$	25,763,717		$	2,755,166		$	(2,809,505	)	$	26,510,944
Operating expenses		(801,566	)		(19,287,396	)		(2,220,150	)		2,809,505			(19,499,607	)
Income from operations		-			6,476,321			535,016			-			7,011,337
Other expense		(6,244,557	)		(87,131	)		(34	)		-			(6,331,722	)
Earnings from subsidiaries		6,924,172			-			-			(6,924,172	)		-
Income before income tax		679,615			6,389,190			534,982			(6,924,172	)		679,615
Income tax expense		(262,339	)		-			-			-			(262,339	)
Net income to common stockholders	$	417,276		$	6,389,190		$	534,982		$	(6,924,172	)	$	417,276

Otelco Inc.

Condensed Consolidating Statement of Operations

For the Six Months Ended June 30, 2009

	Parent			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Eliminations			Consolidated
Revenue	$	1,534,430		$	49,426,210		$	5,842,340		$	(5,506,132	)	$	51,296,848
Operating expenses		(1,534,430	)		(40,863,271	)		(4,224,258	)		5,506,132			(41,115,827	)
Income from operations		-			8,562,939			1,618,082			-			10,181,021
Other income (expense)		(12,255,217	)		(215,019	)		1,481			-			(12,468,755	)
Earnings from subsidiaries		9,967,483			-			-			(9,967,483	)		-
Income (loss) before income tax		(2,287,734	)		8,347,920			1,619,563			(9,967,483	)		(2,287,734	)
Income tax benefit		964,401			-			-			-			964,401
Net income (loss) to common stockholders	$	(1,323,333	)	$	8,347,920		$	1,619,563		$	(9,967,483	)	$	(1,323,333	)

Otelco Inc.

Condensed Consolidating Statement of Operations

For the Six Months Ended June 30, 2010

	Parent			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Eliminations			Consolidated
Revenue	$	1,621,079		$	50,767,112		$	5,551,502		$	(5,634,540	)	$	52,305,153
Operating expenses		(1,621,079	)		(38,923,398	)		(4,515,150	)		5,634,540			(39,425,087	)
Income from operations		-			11,843,714			1,036,352			-			12,880,066
Other expense		(12,681,589	)		(166,063	)		(50	)		-			(12,847,702	)
Earnings from subsidiaries		12,713,953			-			-			(12,713,953	)		-
Income before income tax		32,364			11,677,651			1,036,302			(12,713,953	)		32,364
Income tax expense		(744	)		-			-			-			(744	)
Net income to common stockholders	$	31,620		$	11,677,651		$	1,036,302		$	(12,713,953	)	$	31,620

10

Otelco Inc.

Condensed Consolidating Statement of Cash Flows

For the Six Months Ended June 30, 2009

	Parent			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Eliminations			Consolidated
Cash flows from operating activities:
Net income (loss)	$	(1,323,333	)	$	8,347,920		$	1,619,563		$	(9,967,483	)	$	(1,323,333	)
Adjustment to reconcile net income (loss) to cash flows from operating activities		997,089			11,895,013			1,651,338			-			14,543,440
Changes in assets and liabilities, net of assets and liabilities acquired		14,762,275			(12,017,282	)		(2,779,060	)		-			(34,067	)
Net cash provided by operating activities		14,436,031			8,225,651			491,841			(9,967,483	)		13,186,040
Cash flows used in investing activities		-			(2,933,420	)		(473,919	)		-			(3,407,339	)
Cash flows used in financing activities		(14,436,031	)		-			-			9,967,483			(4,468,548	)
Net increase in cash and cash equivalents		-			5,292,231			17,922			-			5,310,153
Cash and cash equivalents, beginning of period		-			13,521,138			21,117			-			13,542,255
Cash and cash equivalents, end of period	$	-		$	18,813,369		$	39,039		$	-		$	18,852,408

Otelco Inc.

Condensed Consolidating Statement of Cash Flows

For the Six Months Ended June 30, 2010

	Parent			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Eliminations			Consolidated
Cash flows from operating activities:
Net income	$	31,620		$	11,677,651		$	1,036,302		$	(12,713,953	)	$	31,620
Adjustment to reconcile net income to cash flows from operating activities		1,694,931			10,259,423			1,725,759			-			13,680,113
Changes in assets and liabilities, net of assets and liabilities acquired		15,901,162			(13,286,240	)		(2,312,380	)		-			302,542
Net cash provided by operating activities		17,627,713			8,650,834			449,681			(12,713,953	)		14,014,275
Cash flows used in investing activities		-			(3,668,494	)		(419,810	)		-			(4,088,304	)
Cash flows used in financing activities		(17,627,713	)		1			-			12,713,953			(4,913,759	)
Net increase in cash and cash equivalents		-			4,982,341			29,871			-			5,012,212
Cash and cash equivalents, beginning of period		-			17,617,266			113,778			-			17,731,044
Cash and cash equivalents, end of period	$	-		$	22,599,607		$	143,649		$	-		$	22,743,256

9.	Revenue Concentrations
	Revenues for interstate access services are based on reimbursement of costs and an allowed rate of return.  Revenues of this nature are received from the National Exchange Carrier Association in the form of monthly settlements.  Such revenues amounted to 10.3% and 9.8% of the Company’s total revenues from continuing operations for the six months ended June 30, 2009 and 2010, respectively.
	The Company has a contract through 2012 with Time Warner Cable (“TW”) for the provision of wholesale network connections to TW’s customers in Maine and New Hampshire. TW represented approximately 8.7% and 10.3% of the Company’s consolidated revenue for the six months ended June 30, 2009 and 2010, respectively.  Other unrelated telecommunications providers also pay the Company access revenue for terminating calls through it to TW’s customers.

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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 ten rural local exchange carriers (“RLECs”) serving subscribers in north central Alabama, central Maine, western Massachusetts, central Missouri and southern West Virginia. We are the sole wireline telephone services provider for many of the rural communities we serve. We also operate competitive local exchange carriers (“CLECs”) serving subscribers throughout the states of Maine and New Hampshire. Our services include local and long distance telephone services, network access, other telephone related services, cable television (in some markets) and internet access. We view, manage and evaluate the results of operations from the various telecommunications services as one company and therefore have identified one reporting segment as it relates to providing segment inform ation. As of June 30, 2010, we operated approximately 100,000 access line equivalents and supplied an additional 142,837 wholesale network connections.

Our core businesses are local and long distance telecommunications services, wholesale access to the local and long distance network, and the provision of network access to other wireline, long distance and wireless carriers for calls originated or terminated on our network. Our core businesses generated approximately 78.6% of our total revenues in the second quarter of 2010. We also provide cable and satellite television service in some markets and digital high-speed data lines and dial-up internet access in all of our markets.

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

Revenue Sources

We derive our revenues from five sources:

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

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

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

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

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

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Voice and Data Access Line Trends

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

Key Operating Statistics

	At and For the Year Ended December 31,				At and For the Three Months Ended March 31,		At and For the Three Months Ended June 30,
	2008		2009		2010		2010
Otelco access line equivalents(1)		100,043		100,356		100,522		100,126
RLEC and other services:
Voice access lines		51,530		48,215		47,552		46,788
Data access lines		18,709		20,066		20,614		20,703
Access line equivalents(1)		70,239		68,281		68,166		67,491
Cable television customers		4,082		4,195		4,239		4,205
Additional internet customers		11,864		9,116		8,528		8,048
RLEC dial-up		1,183		786		656		551
Other dial-up		9,213		6,439		5,765		5,340
Other data lines		1,468		1,891		2,107		2,157
Revenues (dollars in millions)	$	54.4	$	61.3	$	14.7	$	14.4
CLEC:
Voice access lines		26,558		28,647		28,889		29,070
Data access lines		3,246		3,428		3,467		3,565
Access line equivalents(1)		29,804		32,075		32,356		32,635
Wholesale network connections		98,187		132,324		137,318		142,837
Revenues (dollars in millions)	$	22.7	$	42.5	$	11.1	$	12.1

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

In our RLEC territories, access line equivalents decreased by 675 during the second quarter 2010, or 1.0%, compared to the quarter ended March 31, 2010. Voice access lines declined 1.6% while data access lines increased 0.4% during the period. We offer location specific bundled service packages, many including unlimited domestic calling, tailored to the telecommunications requirements of our customers.

In our Maine and New Hampshire CLEC operations, access line equivalents increased by 279 during the second quarter 2010, or 0.9%, compared to the quarter ended March 31, 2010. Voice access lines increased 0.6% while data access lines increased 2.8% during the period. Virtually all of our competitive customers are businesses, with service bundles tailored to their specific business requirements. The Company continues to be impacted by delays in processing orders by FairPoint Communications, Inc. (“FRP”), which provides the last mile connectivity for a large portion of our CLEC customers in Maine.  Wholesale network connections increased by 5,519 during second quarter 2010, or 4.0%, to 142,837 as of June 30, 2010 compared to 137,318 as of March 31, 2010.

Competitive pricing and bundling of services have led Otelco’s long distance service to be the choice of the majority of the long distance customers in the rural markets we serve. Our cable television customers decreased 0.8% from March 31, 2010 to 4,205 on June 30, 2010.  Included in this number are 154 customers who upgraded to our digital family package and 46 new IPTV customers during second quarter 2010. Additional internet customers decreased 5.6% to 8,048 on June 30, 2010 compared to 8,528 on March 31, 2010. This also includes the subscribers we service outside of our telephone service area throughout Missouri and Maine, reflecting the shift to digital high-speed internet services. In Missouri, we are expanding our data access lines for digital high-speed internet in selected areas outside of our telephone service territory.  Approximately 26.8% of the additional internet customers are served by high-speed data capability from Otelco.

13

Our Rate and Pricing Structure

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

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

Categories of Operating Expenses

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

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

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

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

Our Ability to Control Operating Expenses

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

14

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,
	2009			2010			2009			2010
Revenues
Local services		46.8	%		46.3	%		46.6	%		46.9	%
Network access		31.9			32.5			31.9			31.7
Cable television		2.4			2.6			2.4			2.6
Internet		13.6			13.3			13.7			13.5
Transport services		5.3			5.3			5.4			5.3
Total revenues		100.0	%		100.0	%		100.0	%		100.0	%
Operating expenses
Cost of services and products		39.3	%		39.4	%		40.6	%		40.2	%
Selling, general and administrative expenses		13.0			12.2			13.5			12.4
Depreciation and amortization		25.6			22.0			26.1			22.8
Total operating expenses		77.9			73.6			80.2			75.4
Income from operations		22.1			26.4			19.8			24.6
Other income (expense)
Interest expense		(25.0	)		(23.2	)		(25.4	)		(23.3	)
Change in fair value of derivatives		5.0			(0.7	)		0.6			(2.0	)
Other income		0.1			0.1			0.5			0.8
Total other expense		(19.9	)		(23.8	)		(24.3	)		(24.5	)
Income (loss) before income tax		2.2			2.6			(4.5	)		0.1
Income tax (expense) benefit		(0.2	)		(1.0	)		1.9			(0.0	)
Net income (loss) available to common stockholders		2.0	%		1.6	%		(2.6	)%		0.1	%

Three Months and Six Months Ended June 30, 2010 Compared to Three Months and Six Months Ended June 30, 2009

Total revenues.  Total revenues increased 2.8% in the three months ended June 30, 2010 to $26.5 million from $25.8 million in the three months ended June 30, 2009.   Total revenues increased 2.0% in the six months ended June 30, 2010 to $52.3 million from $51.3 million in the six months ended June 30, 2009.  The tables below provide the components of our revenues for the three months and six months ended June 30, 2010 compared to the same periods of 2009.

For the three months ended June 30, 2010 and 2009

	Three Months Ended June 30,				Change
	2009		2010		Amount		Percent
	(dollars in thousands)
Local services	$	12,064	$	12,286	$	222		1.8	%
Network access		8,265		8,604		339		4.1
Cable television		612		699		87		14.2
Internet		3,500		3,527		27		0.8
Transport services		1,356		1,395		39		2.9
Total	$	25,797	$	26,511	$	714		2.8

Local services.  Local services revenue increased 1.8% to $12.3 million in the three months ended June 30, 2010 from $12.1 million in the three months ended June 30, 2009.  The growth in CLEC revenue accounted for an increase of $0.4 million. RLEC revenue, including bundled services such as long distance, decreased $0.2 million reflecting the decline in RLEC voice revenue.

15

Network access.  Network access revenue increased 4.1% to $8.6 million in the three months ended June 30, 2010 from $8.3 million in the three months ended June 30, 2009.  CLEC growth, including wholesale network connections and bankruptcy court approval of our contracts with FRP, increased network access revenue by $0.5 million, partially offset by a decline in RLEC access revenue of $0.2 million.

Cable television.  Cable television revenue increased 14.2% to $0.7 million in the three months ended June 30, 2010 from $0.6 million in the three months ended June 30, 2009.  Growth in IPTV subscribers and the upgrade to digital family packages in Alabama accounted for the increase.

Internet.  Internet revenue remained constant at $3.5 million in the three months ended June 30, 2010 and 2009.  The growth in new digital data access lines, including related equipment rental, and Missouri fiber leases offset the decline of dial-up internet customers associated with the conversion to digital data access lines, including those customers in Maine and Missouri that are outside of our local service areas.

Transport services.  Transport services revenue remained constant at $1.4 million in the three months ended June 30, 2010 and 2009.

For the six months ended June 30, 2010 and 2009

	Six Months Ended June 30,				Change
	2009		2010		Amount			Percent
	(dollars in thousands)
Local services	$	23,919	$	24,525	$	606			2.5	%
Network access		16,359		16,589		230			1.4
Cable television		1,219		1,364		145			11.9
Internet		7,042		7,038		(4	)		(0.1	)
Transport services		2,758		2,789		31			1.1
Total	$	51,297	$	52,305	$	1,008			2.0

Local services.  Local services revenue increased 2.5% to $24.5 million in the six months ended June 30, 2010 from $23.9 million in the six months ended June 30, 2009.  The growth in CLEC revenue accounted for an increase of $1.1 million. RLEC revenue, including bundled services such as long distance, decreased $0.5 million reflecting the decline in RLEC access lines.

Network access.  Network access revenue increased 1.4% to $16.6 million in the six months ended June 30, 2010 from $16.4 million in the six months ended June 30, 2009.   CLEC growth, including wholesale network connections and bankruptcy court approval of our contracts with FRP, increased network access revenue by $1.1 million, partially offset by a decline in RLEC access revenue of $0.9 million.

Cable television.  Cable television revenue increased 11.9% to $1.4 million in the six months ended June 30, 2010 from $1.2 million in the six months ended June 30, 2009.  Growth in IPTV subscribers and the upgrade to digital family packages in Alabama accounted for the increase.

Internet.  Internet revenue remained constant at $7.0 million in the six months ended June 30, 2010 and 2009.  The growth in new digital data access lines, including related equipment rental, and Missouri fiber leases offset the decline of dial-up internet customers associated with the conversion to digital data access lines, including those customers in Maine and Missouri that are outside of our local service areas.

Transport services.  Transport services revenue remained constant at $2.8 million in the six months ended June 30, 2010 and 2009.

Operating expenses.  Operating expenses in the three months ended June 30, 2010 decreased 2.9% to $19.5 million from $20.1 million in the three months ended June 30, 2009.  Operating expenses in the six months ended June 30, 2010 decreased 4.1% to $39.4 million from $41.1 million in the six months ended June 30, 2009.  The tables below provide the components of our operating expenses for the three months and six months ended June 30, 2010 compared to the same periods of 2009.

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For the three months ended June 30, 2010 and 2009

	Three Months Ended June 30,				Change
	2009		2010		Amount			Percent
	(dollars in thousands)
Cost of services and products	$	10,133	$	10,428	$	295			2.9	%
Selling, general and administrative expenses		3,343		3,237		(106	)		(3.2	)
Depreciation and amortization		6,605		5,835		(770	)		(11.7	)
Total	$	20,081	$	19,500	$	(581	)		(2.9	)

Cost of services and products.  Cost of services and products increased 2.9% to $10.4 million in the three months ended June 30, 2010 from $10.1 million in the three months ended June 30, 2009.  The growth of $0.3 million in access expense associated with increased CLEC revenue and $0.1 million in rebranding expense in New England was partially offset by the elimination of pole rental true-up expenses in second quarter 2010 compared to $0.1 million of pole rental true-up expenses in the same quarter of 2009.

Selling, general and administrative expenses.  Selling, general and administrative expenses decreased 3.2% to $3.2 million in the three months ended June 30, 2010 from $3.3 million in the three months ended June 30, 2009. Operational synergies; lower operational taxes and insurance costs; and lower reserves for uncollectible amounts reduced expenses by $0.2 million. Increases in employee costs of $0.1 million partially offset the reductions.

Depreciation and amortization.  Depreciation and amortization decreased 11.7% to $5.8 million in the three months ended June 30, 2010 from $6.6 million in the three months ended June 30, 2009. Amortization of intangible assets associated with the acquisition of three entities from Country Road Communications LLC (the "CR Companies") decreased $0.6 million, including a covenant not to compete and contract customer base assets. The remaining decrease of $0.2 million reflected lower depreciation of plant assets in Alabama.

For the six months ended June 30, 2010 and 2009

	Six Months Ended June 30,				Change
	2009		2010		Amount			Percent
	(dollars in thousands)
Cost of services and products	$	20,800	$	21,038	$	238			1.1	%
Selling, general and administrative expenses		6,919		6,467		(452	)		(6.5	)
Depreciation and amortization		13,397		11,920		(1,477	)		(11.0	)
Total	$	41,116	$	39,425	$	(1,691	)		(4.1	)

Cost of services and products.  Cost of services and products increased 1.1% to $21.0 million in the six months ended June 30, 2010 from $20.8 million in the six months ended June 30, 2009.  The growth of $0.3 million in access expense associated with increased CLEC revenue and $0.2 million in rebranding and sales agent expense in New England was partially offset by the elimination of pole rental true-up expenses in the first six months of 2010 compared to $0.1 million of pole rental true-up expenses in the same period of 2009 and lower directory expenses of $0.2 million.

Selling, general and administrative expenses.  Selling, general and administrative expenses decreased 6.5% to $6.5 million in the six months ended June 30, 2010 from $6.9 million in the six months ended June 30, 2009. Operational synergies; lower operational taxes, legal and insurance costs; and lower reserves for uncollectible amounts reduced expenses by $0.8 million. Increases in employee costs of $0.4 million partially offset the reductions.

Depreciation and amortization.  Depreciation and amortization decreased 11.0% to $11.9 million in the six months ended June 30, 2010 from $13.4 million in the six months ended June 30, 2009. Amortization of intangible assets associated with the acquisition of the CR Companies decreased $1.2 million, including a covenant not to compete and contract customer base assets. The remaining decrease of $0.3 million reflected lower depreciation of plant assets in Alabama.

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For the three months ended June 30, 2010 and 2009

	Three Months Ended June 30,						Change
	2009			2010			Amount			Percent
	(dollars in thousands)
Interest expense	$	(6,447	)	$	(6,179	)	$	(268	)		(4.2	)%
Change in fair value of derivatives		1,290			(176	)		(1,466	)	NM
Other income		12			24			12			100.0
Income tax expense		(60	)		(262	)		(202	)	NM

Interest expense.  Interest expense decreased 4.2% to $6.2 million in the three months ended June 30, 2010 from $6.4 million in the three months ended June 30, 2009.   The interest rate caplet expense present in second quarter 2009 of $0.4 million was fully expensed during 2009. The balance reflects a reduction of $5.0 million in senior debt principal in August 2009 and higher interest costs as the second fixed rate swap took effect during first quarter 2010.

Change in fair value of derivatives.  We have two interest rate swap agreements to hedge our exposure to changes in interest rate costs associated with our senior credit facility. From an accounting perspective, the swaps do not meet the technical requirements to allow the swaps to be considered highly effective hedging instruments and therefore the swaps do not qualify for hedge accounting. These swap agreements must be considered investments and the decline in value of $0.2 million in the three months ended June 30, 2010 is reflected as a change in fair value of derivatives in the same period. Over the life of the swaps, the cumulative change in value will be zero. See — Liquidity and Capital Resources below for additional explanation.

Other income.  Other income was less than $0.1 million in the three months ended June 30, 2010 and June 30, 2009, reflecting low interest rates on overnight investments in both periods.

Income taxes.  Provision for income taxes was an expense of $0.3 million in the three months ended June 30, 2010 compared to an expense of $0.1 million in the three months ended June 30, 2009.

Net income.  As a result of the foregoing, there was net income of $0.4 million in the three months ended June 30, 2010 and net income of $0.5 million in the three months ended June 30, 2009.

For the six months ended June 30, 2010 and 2009

	Six Months Ended June 30,						Change
	2009			2010			Amount			Percent
	(dollars in thousands)
Interest expense	$	(13,046	)	$	(12,168	)	$	(878	)		(6.7	)%
Change in fair value of derivatives		339			(1,062	)		(1,401	)	NM
Other income		238			383			145			60.9
Income tax benefit		964			0			(964	)	NM

Interest expense.  Interest expense decreased 6.7% to $12.2 million in the six months ended June 30, 2010 from $13.0 million in the six months ended June 30, 2009.   The interest rate caplet expense present in the first six months of 2009 of $0.7 million was fully expensed during 2009. The balance reflects a reduction of $5.0 million in senior debt principal in August 2009 and higher interest costs as the second fixed rate swap took effect during first quarter 2010.

Change in fair value of derivatives.  We have two interest rate swap agreements to hedge our exposure to changes in interest rate costs associated with our senior credit facility. From an accounting perspective, the swaps do not meet the technical requirements to allow the swaps to be considered highly effective hedging instruments and therefore the swaps do not qualify for hedge accounting. These swap agreements must be considered investments and the decline in value of $1.1 million in the six months ended June 30, 2010 is reflected as a change in fair value of derivatives in the same period. Over the life of the swaps, the cumulative change in value will be zero. See — Liquidity and Capital Resources below for additional explanation.

Other income.  Other income increased 60.9% to $0.4 million in the six months ended June 30, 2010 from $0.2 million in the six months ended June 30, 2009. The increase was the result of increased CoBank dividends.

Income taxes.  Provision for income taxes was an expense of less than $0.1 million in the six months ended June 30, 2010 and a benefit of $1.0 million in the six months ended June 30, 2009.

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Net income (loss).  As a result of the foregoing, there was net income of less than $0.1 million in the six months ended June 30, 2010 and net loss of $1.3 million in the six months ended June 30, 2009.

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.

Historically, we satisfy our operating cash requirements from the cash generated by our business and utilize borrowings under our credit facility to facilitate acquisitions. For the six months ended June 30, 2010, we generated cash from our business to invest in additional property and equipment, pay interest on our senior debt, pay interest associated with the senior subordinated debt inherent in our Income Deposit Securities (“IDSs”), fund dividends (as declared by our board of directors) on the shares of Class A common stock that are inherent in our IDSs, and exchange IDSs for all of the issued and outstanding shares of our Class B common stock. After meeting all of these needs of our business, cash grew from $17.7 million at December 31, 2009 to $22.7 million at June 30, 2010. The Company has as its current policy to return a high percentage of its available cash to its IDS holders.

Cash flows from operating activities for the first six months of 2010 amounted to $14.0 million compared to $13.2 million for the first six months of 2009.

Cash flows used in investing activities for the first six months of 2010 were $4.1 million compared to $3.4 million for the first six months of 2009. Capital investment for property and equipment in 2010 increased $0.5 million. In 2009, there was a $0.2 million change in purchase accounting for the acquisition of the CR Companies.

Cash flows used in financing activities for the first six months of 2010 were $4.9 million compared to $4.5 million for the first six months of 2009, reflecting payments of dividends to stockholders in both periods.  Second quarter 2010 reflected dividend payments on 544,671 additional shares of Class A common stock that were issued in connection with the exchange offer for our Class B common stock.  The dividend was $0.17625 per share per quarter in both periods.  We have paid 22 consecutive dividends at this rate since the Company went public in December 2004.

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

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

On June 8, 2010, the Company issued 544,671 IDSs, representing an aggregate of 544,671 shares of our Class A common stock and $4,085,033 aggregate principal amount of our 13% senior subordinated notes due 2019, in exchange for all 544,671 shares of our issued and outstanding Class B common stock.  There were no proceeds to the Company from this exchange.  The $4.1 million of senior subordinated notes was reclassified from the mezzanine section of the balance sheet to long-term notes payable.  Interest on the $4.1 million of senior subordinated notes was reflected in interest expense in the statement of operations from June 8, 2010 through June 30, 2010.  The direct cost of the exchange was $0.3 million.

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.

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The following table discloses aggregate information about our contractual obligations as of June 30, 2010, including scheduled interest and principal for the periods in which payments are due:

	Total		Less than 1 Year		1-3 years		3-5 years		More than 5 years
Second amended and restated credit agreement
Term	$	168,500,000	$	-	$	-	$	168,500,000	$	-
Revolver (1)		-		-		-		-		-
Senior subordinated notes		107,660,531		-		-		-		107,660,531
Expected interest expense (2)		168,041,080		23,950,737		49,202,379		31,906,554		62,981,410
Total	$	444,201,611	$	23,950,737	$	49,202,379	$	200,406,554	$	170,641,941

(1)

We have a $15.0 million revolving loan facility with an October 2013 maturity available. No amounts were drawn on this facility on June 30, 2010 or during the six months ended June 30, 2010. The Company pays a commitment fee of 0.50% per annum, payable quarterly in arrears, on the unused portion of the revolving loan facility.

(2)

Expected interest payments to be made in future periods reflect anticipated interest payments related to our $168.5 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 from 1.5% to 2.7% plus a margin of 4.0%, reflecting the impacts of interest rate hedging. We have assumed in the presentation above that we will hold the senior credit facility until maturity in 2013 and the senior subordinated notes until maturity in 2019. No interest payment is included for the revolving loan facility because of the variability and timing of advances and repayments thereunder.

The following table provides a summary of the extent to which cash generated from operations is reinvested in our operations, used to pay interest on our senior debt and senior subordinated notes or distributed as dividends to our stockholders for the periods indicated.

	Six Months Ended June 30,
	2009			2010
	(dollars in thousands)
Cash generation
Revenues	$	51,297		$	52,305
Other income		238			383
Cash received from operations		51,535			52,688
Cost of services and products		20,800			21,038
Selling, general and administrative expenses		6,920			6,468
Cash consumed by operations		27,720			27,506
Cash generated from operations	$	23,815		$	25,182
Cash utilization
Capital investment in operations	$	3,578		$	4,087
Senior debt interest and fees		5,046			4,841
Interest on senior subordinated notes		6,732			6,765
Dividends		4,469			4,565
Cash utilized by the Company	$	19,825		$	20,258
Percentage of cash utilized by the Company of cash generated from operations		83.3	%		80.5	%

Recent Accounting Pronouncements

In October 2009, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) 2009-13, Multiple-Deliverable Revenue Arrangements – a consensus of the FASB Emerging Issues Task Force (“ASU 2009-13”), an update to ASC 605, Revenue Recognition.  ASU 2009-13 provides application guidance on whether multiple deliverables exist, how the deliverables should be separated, and how the consideration should be allocated to one or more units of accounting.  ASU 2009-13 establishes a selling price hierarchy for determining the selling price of a deliverable.  The selling price used for each deliverable will be based on vendor-specific objective evidence, if available, third-party evidence if vendor-specific evidence is not available, or estimated selling price if neither vendor-specific nor third-party evidence is available.  The Company will be required to apply this guidance prospectively for revenue arrangements entered into or materially modified for fiscal years beginning on or after June 15, 2010; however, earlier application is permitted.  The Company has not determined the impact that this update may have on its consolidated financial statements.

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In January 2010, the FASB issued ASU 2010-06, Improving Disclosures about Fair Value Measurements (“ASU 2010-06”), an update to ASC 820, Fair Value Measurements and Disclosures.  ASU 2010-06 provides more robust disclosures about (1) the different classes of assets and liabilities measured at fair value, (2) the valuation techniques and inputs used, (3) the activity in Level 3 fair value measurements, and (4) the transfers between Levels 1, 2, and 3.  The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll f orward of activity in Level 3 fair value measurements.  Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years.  The Company has not determined the impact that this update may have on its consolidated financial statements.

In February 2010, the FASB issued ASU 2010-09, Amendments to Certain Recognition and Disclosure Requirements (“ASU 2010-09”), an update to ASC 855, Subsequent Events.  ASU 2010-09 eliminates the requirement for a Securities and Exchange Commission (“SEC”) filer to disclose a date through which subsequent events have been evaluated in both issued and revised financial statements.  Revised financial statements include financial statements revised as a result of either correction of an error or retrospective application of accounting principles generally accepted in the United States.  The FASB believes these amendments remove potential conflicts with the SEC’s liter ature.  ASU 2010-09 is effective upon issuance except for the use of the issued date for conduit debt obligors, which is effective for interim or annual periods ending after June 15, 2010.  The adoption of this update did not have a material impact on our consolidated financial statements.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

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

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

Item 4. Controls and Procedures

With the participation of the Chief Executive Officer and the Chief Financial Officer, management has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934).  Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that our disclosure controls and procedures were effective as of June 30, 2010.

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, 2010 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 

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PART II  OTHER INFORMATION

Item 6. Exhibits

Exhibits

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 5, 2010	OTELCO INC.
	By:	/s/ Curtis L. Garner, Jr.
		Curtis L. Garner, Jr.
		Chief Financial Officer

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EXHIBIT INDEX

Exhibit No.	Description
31.1	Certificate pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934 of the Chief Executive Officer
31.2	Certificate pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934 of the Chief Financial Officer
32.1	Certificate pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of the Chief Executive Officer
32.2	Certificate pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of the Chief Financial Officer