**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

| **x**  |   | ANNUAL REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934      |
|--------|--------|-------------------------------------------------------------------------------------------------|
|   |   | For  the fiscal year ended December 31, 2006                                               |
|   |   | or                                                                                              |
| **o**  |   | TRANSITION  REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934 |

 

Commission File Number 0-556

| **SUREWEST COMMUNICATIONS**                             |
|---------------------------------------------------------|
| (Exact name of  registrant as specified in its charter) |

 

| California                                |   | 68-0365195           |
|-------------------------------------------|--------|----------------------|
| (State or other  jurisdiction             |   | (I.R.S. Employer     |
| of incorporation  or organization)        |   | Identification  No.) |
| 200  Vernon Street, Roseville, California |   | 95678                |
| (Address of  principal executive offices) |   | (Zip Code)           |

 

Registrant’s telephone number, including area code (916)772-2000

Securities registered pursuant to Section 12(b) ofthe Act:

| Title of Each Class                  |   | Name of Each  Exchange on Which Registered |
|--------------------------------------|--------|--------------------------------------------|
| Common  Stock—Without Par Value |   | The NASDAQ Stock  Market LLC               |
| Common Stock  Purchase Rights        |   | The NASDAQ Stock  Market LLC               |

 

Securitiesregistered pursuant to Section 12 (g) of the Act:  None

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.

Yes o   No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act.

Yes o   No x

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

Yes x   No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. o

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

| Large accelerated filer o |   | Accelerated filer x |   | Non-accelerated  filer o |
|---------------------------|--------|---------------------|--------|-------------------------------|

 

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

Yes o   No x

On June 30, 2006,which was the last business day of the registrant’s most recently completedsecond fiscal quarter, the registrant had 14,628,089 shares of Common Stockoutstanding and the market value of shares held by non-affiliates wasapproximately $262,221,202 (based on 13,572,526 shares of Common Stock thenheld by non-affiliates and a closing price that day of $19.32 per shareof Common Stock on The NASDAQ Stock Market LLC). The market value calculationsexclude shares held on the stated date by registrant’s employee benefit plans,directors and officers on the assumption such shares may be shares owned byaffiliates. (Exclusion from these public market value calculations does notimply affiliate status for any other purpose).

On February 27, 2007, the registrant had 14,464,612shares of Common Stock outstanding.

DOCUMENTS INCORPORATED BYREFERENCE

Incorporatedby reference into Part II, Item 5 and Part III hereof are portions ofthe registrant’s definitive proxy statement to be filed pursuant to Regulation14A within 120 days after the Registrant’s fiscal year-end of December 31,2006.

 

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**TABLEOF CONTENTS**
|                   | ** ** | ** **                                                                                                         | ** ** | **PAGE** | ** ** |
|-------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| **PART I**   |       |                                                                                                               |       |     |       |   |   |
| Item 1.           |       | Business                                                                                                           |       |     | 1          |   |   |
| Item 1A.          |       | Risk Factors                                                                                                       |       |     | 12         |   |   |
| Item 1B.          |       | Unresolved Staff Comments                                                                                          |       |     | 14         |   |   |
| Item 2.           |       | Properties                                                                                                         |       |     | 14         |   |   |
| Item 3.           |       | Legal Proceedings                                                                                                  |       |     | 15         |   |   |
| Item 4.           |       | Submission of Matters to a Vote of Security Holders                                                                |       |     | 17         |   |   |
| **PART II**  |       |                                                                                                               |       |     |       |   |   |
| Item 5.           |       | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |       |     | 18         |   |   |
| Item 6.           |       | Selected Financial Data                                                                                            |       |     | 20         |   |   |
| Item 7.           |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                        |       |     | 21         |   |   |
| Item 7A.          |       | Quantitative and Qualitative Disclosures About Market  Risk                                                        |       |     | 50         |   |   |
| Item 8.           |       | Financial Statements and Supplementary Data                                                                        |       |     | 51         |   |   |
| Item 9.           |       | Changes in and Disagreements With Accountants on  Accounting and Financial Disclosure                              |       |     | 91         |   |   |
| Item 9A.          |       | Controls and Procedures                                                                                            |       |     | 91         |   |   |
| Item  9B.         |       | Other  Information                                                                                                 |       |     | 94         |   |   |
| **PART III** |       |                                                                                                               |       |     |       |   |   |
| Item 10.          |       | Directors, Executive Officers and Corporate Governance                                                             |       |     | 95         |   |   |
| Item 11.          |       | Executive Compensation                                                                                             |       |     | 95         |   |   |
| Item 12.          |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                    |       |     | 95         |   |   |
| Item 13.          |       | Certain Relationships and Related Transactions, and  Director Independence                                         |       |     | 96         |   |   |
| Item 14.          |       | Principal Accountant Fees and Services                                                                             |       |     | 96         |   |   |
| **PART IV**  |       |                                                                                                               |       |     |       |   |   |
| Item 15.          |       | Exhibits and Financial Statement Schedules                                                                         |       |     | 97         |   |   |
| SIGNATURES        |       |                                                                                                               | 101        |     |       |

 

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**PART I**

**Item 1.**                        Business.   (Dollarsin thousands, except per share amounts)

**General Developmentof Business**

SureWest Communications (the “Company” or “we”) is aCalifornia holding company whose operating subsidiaries provide a wide range oftelecommunications, digital video, and other facilities-basedcommunication services in Northern California, primarily in the greaterSacramento region. The Company was incorporated under the laws of the State ofCalifornia in 1995, and its predecessor, Roseville Telephone Company, wasincorporated in 1914.

As of December 31, 2006, the Company’s wholly-ownedsubsidiaries included SureWest Telephone, SureWest Directories, SureWest LongDistance, SureWest Wireless, SureWest Broadband, SureWest TeleVideo andSureWest TeleVideo of Roseville (collectively, “SureWest Broadband/ResidentialServices”), SureWest Internet, and SureWest Custom Data Services (formerlyQuiknet, Inc.). As discussed in the Telecom section below, in January 2007the Company entered into a definitiveagreement to sell SureWest Directories and the transaction was consummated on February 28,2007.

The Company’s strategy is to be the first choice as anintegrated communications provider in the Sacramento region. It seeks toachieve this position by leveraging its existing advanced fiber network toextend its operations throughout Sacramento, Placer and adjacent counties, byproviding superior customer service and by integrating its systems, productsand operating functions.

No customer accounted for more than 10% of the Company’sconsolidated operating revenues during the years ended December 31, 2006,2005 and 2004.

TheCompany currently divides its business into three reportable business segments:Telecommunications (“Telecom”), Broadband and Wireless. The table that followsreflects the percentage of total operating revenues of the Company generated byeach of its three business segments for the last three fiscal years:
| ** **                 | ** ** | **% of Total Operating Revenues** | ** ** |
|----------------------------|------------|-------------------------------------------------------|------------|
| **Reporting Segment** | ** ** | **2006**                                              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Telecom                    |       | 58%                                                   |       | 61% |   | 67% |   |
| Broadband                  |       | 27%                                                   |       | 23% |   | 18% |   |
| Wireless                   |       | 15%                                                   |       | 16% |   | 15% |   |
| Total operating revenues   |       | 100%                                                  |       | 100% |   | 100% |   |

 

TheCompany’s products or services that generated 10% or more of its totaloperating revenues in any of the last three years are as follows:
| ** **             | ** ** | **Total Operating Revenues** | ** ** |
|------------------------|------------|----------------------------------------|------------|
| ** **             | ** ** | **2006**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Local service          |       | $                                      | 62,774     |   | $ | 63,522 |   | $ | 69,560 |   |
| Network access service |       | $                                      | 39,500     |   | $ | 44,214 |   | $ | 46,161 |   |
| Wireless service       |       | $                                      | 34,193     |   | $ | 34,205 |   | $ | 31,261 |   |
| Broadband data service |       | $                                      | 28,927     |   | $ | 25,780 |   | $ | 22,004 |   |

 

A summary of net operating revenues from externalcustomers, net income and assets for each of the business segments is found inNote 12 to the Consolidated Financial Statements, in Item 8, which isincorporated herein by reference. A discussion of factors potentially affectingour operations is set forth in Risk Factors in Item 1A, which is incorporatedherein by reference.

TheCompany currently generates a substantial portion of its revenues from servicesthat are subject to regulation by either or both of the California PublicUtilities Commission (“CPUC”) and the Federal 

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CommunicationsCommission (“FCC”). Revenues from services subject to comprehensive regulationinclude local service and network access service. The Company expects that theproportion of its revenues that comes from non-regulated or lightlyregulated businesses will increase in future years because of the successfulexecution of its business strategy and the impact of competition on itsexisting regulated operations. The table that follows reflects the percentageof total operating revenues of the Company contributed by various sources.
| ** **                                                  | ** ** | **Rate Regulated Revenues  as a % of Total  Operating Revenues** | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
| **Revenues**                                                | ** ** | **2006**                                                                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues from  services subject to comprehensive regulation |       | 46%                                                                                                 |       | 49% |   | 55% |   |
| Other revenues                                              |       | 54%                                                                                                 |       | 51% |   | 45% |   |
| Total operating revenues                                    |       | 100%                                                                                                |       | 100% |   | 100% |   |

 

There continues to be increased competition facingtelecommunications providers. As a result of technology change and industry,legislative and regulatory developments, the Company continues to face newcompetitive challenges. These developments, however, have also provided theCompany with significant growth opportunities. The Company believes that growthfrom its entry into newer businesses in recent years will offset flat or slowinggrowth in customers in its other businesses, and that the newer businessesprovide significant revenue opportunities not present before. Competitiveissues facing individual operating units are addressed in connection with theindividual segment discussions below.

As of December 31,2006, the Company had 864 employees, approximately 5% fewer than the number at December 31,2005. None of the Company’s employees are represented by a union. The Companyconsiders its employee relations to be positive.

**Telecom**

*General*

The Telecom segment has included SureWest Telephone,SureWest Directories and SureWest Long Distance, which provide landlinetelecommunications services, Digital Subscriber Line (“DSL”) services,directory advertising services, long distance services and certain related non-regulatedservices. The Telecom segment accounted for approximately 58%, 61% and 67% ofthe Company’s operating revenue in the years 2006, 2005, and 2004,respectively. Although revenues from this segment have decreased as apercentage of all Company revenues over the past several years, the Companyexpects this segment to continue to provide the largest proportion of itsrevenues and earnings in 2007.

SureWest Telephone operates as an Incumbent LocalExchange Carrier (“ILEC”) with a service area of approximately 83 square miles,covering Roseville and Citrus Heights, California, and adjacent areas in Placerand Sacramento Counties. The Company holds a non-exclusive perpetualfranchise granted by Section 7901 of the California Public Utilities Code.The area served by SureWest Telephone has been one of the most rapidly growingareas in California during the past two decades, but the pace of growth hasslowed in recent years as the area has become more developed. The rapid growthalso attracted new competitors to the area.

SureWest Telephone’s primary services are localtelephone service, network access services, toll services and certain verticaland non-regulated services. Toll services and access to SureWestTelephone’s network are provided through connections with other carriersserving adjacent areas, including AT&T Inc. (“AT&T”) (formerly SBCCommunications), and also through service agreements with numerousinterexchange carriers, including national interexchange carriers.

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SureWest Telephone provides services to residential,business and carrier customers, and continues to be subject to the competitiveand regulatory challenges faced by ILECs both nationally and in California. Asa result of competitive pressures, SureWest Telephone experienced a 3% decreasein total access lines from December 31, 2005 to December 31, 2006. Asof December 31, 2006, SureWest Telephone served 125,195 access lines. TheCompany believes that economic conditions in the area in 2006, expanding competition,and service substitution have impacted, and will continue to impact, the numberof access lines provided by SureWest Telephone.

The Telecom segment also has included the operationsof two other businesses, SureWest Directories and SureWest Long Distance.

SureWest Directories published and distributedSureWest Telephone’s directory, including the sale of yellow pages advertising.SureWest Directories was also engaged in the business of producing, publishingand distributing directories in other Northern California communities outsideof SureWest Telephone’s service area. The SureWest Directories’ business facedsignificant competition from national print and on-line directorypublishers and other local businesses, including AT&T. SureWest Directories’business expanded into electronic and on-line formats in 2005. Thedirectory business is not regulated by the FCC or CPUC; however, the revenuesfrom publishing rights licensed by SureWest Telephone under its contractualarrangement with SureWest Directories have been taken into account by the CPUCwith respect to SureWest Telephone’s operations.

In January 2007, the Company entered into adefinitive agreement with GateHouse Media to sell SureWest Directories, itsdirectory publishing business. The transaction was consummated on February 28,2007. Under the agreement, GateHouse Media acquired 100% of the stock ofSureWest Directories for an aggregate cash purchase price of $110,123, subjectto a post-closing working capital adjustment. Under related agreements,GateHouse Media will continue to publish SureWest Telephone’s directory. TheCompany continues to evaluate its businesses and product lines and believesthis transaction will permit the Company to focus more on the strategic growthof its core business of being a full-service integrated communicationsprovider.

SureWest Long Distance offers intrastate, interstate,and international long distance services, including calling card and 800services. SureWest Long Distance is a resale business that utilizes othernational and international carriers for wholesale transport, switching andother capabilities. SureWest Long Distance maintains agreements with SprintCommunications Company L.P. (“Sprint”) and Global Crossing Ltd. (“GlobalCrossing”) to diversify its risks related to its wholesale providers. The ratesoffered to SureWest Long Distance by these companies are competitive; however,changes in the wholesale marketplace in the recent past have provided recurringopportunities to long distance resellers to further reduce their costs. During2005, SureWest Long Distance renegotiated its agreement with Sprint, enteringinto a long-term agreement securing more favorable rates. SureWest LongDistance maintains a month-to-month agreement with Global Crossing.

As of December 31,2006 and 2005, 46% and 40%, respectively, of the customers of SureWestTelephone chose SureWest Long Distance as their presubscribed long distanceprovider.

*Competition*

In recent years, competition to serve the customers ofSureWest Telephone has increased significantly. Changes in technology have madeit possible for customers to receive services in new ways at competitive rates.To meet the competition, SureWest Telephone has responded in part byintroducing new services and service “bundles”, offering services in convenientgroupings with package discounts and billing advantages, and by investing inits network and business operations. Changing technology requires that theCompany continue to adapt its network and the manner in which it providesservice. Within its telephone service area, services are provided over anintegrated network making extensive use of optical fiber. 

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SureWest Telephone deploys fiber optic facilitiescloser to an end user’s premises than its competition to broaden the reach andcapacity of Company services requiring additional bandwidth. In some instances,fiber optics is deployed directly to a customer’s premises. Because bandwidthis limited by distance when utilizing copper facilities, the Company also isdeploying equipment throughout its service area to enable the improvedprovision of services. Certain of the Company’s facilities take advantage ofInternet protocol (“IP”), which allows for more efficient use of bandwidth.

See “Item 3–Legal Proceedings” and “Item 7–Management’sDiscussion and Analysis of Financial Condition and Results of Operations” forfurther discussion regarding SureWest Telephone’s revenues that are subject tothe competitive environment in which SureWest Telephone operates.

The Company anticipatesthat its businesses will continue to experience competition and that the natureand extent of such competition will increase. Competitors to the SureWestTelephone business include competitive local exchange carriers, interexchangecarriers (including interexchange carriers which serve customers directlywithout using facilities of local exchange carriers), traditional videoproviders expanding into voice and data services, wireless service providers(including SureWest Wireless), providers of IP-based calling services,customers which are telecommunications self-providers, and a range ofother providers that specialize in certain niche areas of telecommunications.Technology change has accelerated the pressure on established carriers,including SureWest Telephone, by virtue of software-defined businesses,and innovations related to packet switching and use of the Internet and IPcapabilities.

*Regulation*

SureWest Telephone’s revenues are influenced greatlyby the actions of the CPUC and the FCC.

All intrastate telecommunications service rates ofSureWest Telephone are subject to comprehensive regulation by the CPUC. Theprovision of access to the networks of interexchange carriers for long distancecalling is governed by access tariffs and by intercarrier agreements, which aresubject to the jurisdiction of the CPUC or FCC, or both, depending upon thenature of the transmissions. SureWest Telephone has a tariff on file with theFCC for all elements of interstate access services except carrier common linecharges, for which SureWest Telephone concurs with the tariff of the NationalExchange Carrier Association (“NECA”).

The FCC monitors SureWest Telephone’s interstateearnings through the use of annual cost separation studies prepared by SureWestTelephone, which utilize estimated cost information and projected demand usage.The FCC establishes rules that carriers must follow in the preparation ofthe annual studies. Additionally, under current FCC rules governing ratemaking, SureWest Telephone is required to establish interstate rates based onprojected demand usage for its various services and determine the actualearnings from these rates once actual volumes and costs are known.

With respect to its regulatory authority over SureWestTelephone’s rates, the CPUC also has the power, among other things, toestablish terms and conditions of service, to prescribe uniform systems ofaccounts and to regulate the mortgaging or disposition of public utilityproperties.

The characterization of traffic as interstate orintrastate, and as a telecommunications or information service has been asignificant source of dispute among carriers and others in recent years, asthose characterizations can impact the regulatory treatment of the traffic andthe payment obligations of the providers which are involved. Thecharacterization of: (i) traffic involved in intercarrier interconnection,(ii) Internet traffic, and (iii) traffic that makes use of IP andother transmission technologies are examples of issues that are currentlysubject to analysis on the state and federal levels, and that are expected tobe subject to regulatory action in the near future. Both the FCC and CPUC haveinitiated proceedings to evaluate the appropriate level of regulation forproviders of telecommunications services and for IP-enabled services. Inaddition, various proceedings at the FCC are pending that could lead tosignificant 

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alteration of the existing compensation arrangementsamong providers of telecommunications services, and that could adversely impactthe amount of the payments received by the Company from carriers and others foruse of the Company’s network.

In 1996, the CPUC issued a decision that authorizedSureWest Telephone to implement a New Regulatory Framework (“NRF”) for servicesfurnished within SureWest Telephone’s service area in order to accommodatemarket and regulatory movement toward competition and greater pricingflexibility. Under the NRF, SureWest Telephone is subject to ongoing monitoringand reporting requirements, and it was initially required to share earningswith customers through a reduction of revenues if its earned annual rate-of-returnexceeded that authorized by the CPUC.

The Company was involved in a proceeding at the CPUCthat considered the continued need for certain sharing requirements in theintrastate jurisdiction and, in connection with that review, also consideredthe issue of whether the Company overearned in the intrastate jurisdiction inrecent monitoring periods and the amount of overearnings that should be sharedwith customers. In July 2004, the Company entered into a settlementagreement (the “settlement agreement”) with the other parties in theproceeding, the Office of Ratepayer Advocates (“ORA”) and The Utility ReformNetwork (“TURN”), to resolve all issues in the proceeding. In November 2004,the CPUC approved the settlement agreement. The settlement agreement resolvedexisting intrastate sharing obligations and related earnings issues for themonitoring periods 2000 through 2004, put into place a surcredit mechanism forthe amount of the settlement, and suspended the requirement for any intrastatesharing for monitoring periods from January 1, 2005 through at least December 31,2010. The settlement agreement resulted in SureWest Telephone recognizing anincrease in local revenues of $2,948 due to a change in accounting estimate inthe fourth quarter of 2004. This increase in revenues resulted in a decrease ofthe Company’s net loss by $2,046 ($0.14 per share) during 2004.

In accordance with the settlement agreement, SureWestTelephone is returning approximately $6,500 (“Dividend A”), plus interest atthe 90-day commercial paper rate for non-financial institutions,which was 5.19% as of December 31, 2006, and an imputed rate of 3.15%, toits end users through a consumer dividend over a period of approximately fouryears, which began January 1, 2005. In addition, SureWest Telephone ispaying a one-time consumer dividend of $2,600 (“Dividend B”), which isbeing returned to the consumers to settle the monitoring periods 2000 to 2004. Theconsumer dividend is recorded as a reduction of the Company’s contractualshareable earnings obligations over approximately two years, which began January 1,2005. The consumer dividend includes an annual imputed interest rate of 3.15%(no stated contractual interest rate). At December 31, 2006, the aggregatecontractual shareable earnings obligation for these surcredits was $3,598(which is net of an unamortized discount pertaining to imputed interest of $115at that date).

Thefollowing table summarizes the amounts returned to end users through consumerdividends for the years ended December 31, 2006 and 2005:

| ** ** | ** ** | **Years Ended  December 31,** | ** ** |
|------------|------------|-----------------------------------------|------------|
| ** ** | ** ** | **2006**                                | ** ** | **2005** | ** ** |
| Dividend A |       | $                                       | 2,011      |   | $ | 1,655 |   |
| Dividend B |       | 1,177                                   |       | 1,210 |   |
| Total      |       | $                                       | 3,188      |   | $ | 2,865 |   |

 

Further, as part of the settlement agreement SureWestTelephone was to implement an additional annual consumer dividend of $1,300 on January 1,2007 to end-users receiving SureWest Telephone services subject tosharing on or after that date. However, this consumer dividend was subject toreduction based upon the results of other pending regulatory proceedings andhas subsequently been offset by a reduction in the Company’s draw from theCalifornia High Cost Fund (“CHCF”), as discussed below.

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During the fourth quarter of 2005, the Company filedan Advice Letter with the CPUC proposing an increase to the consumer dividendsin order to return the amounts entitled in accordance with the settlementagreement. The change in the consumer dividends resulted from the increase ininterest rates during 2005. The increase was effective January 1, 2006.

Prior to 2000, AT&T had been paying SureWestTelephone approximately $11,500 per year for extended area service (“EAS”)pursuant to a Settlement Transition Agreement. In November 2000, the CPUCauthorized AT&T to terminate its approximate annual EAS payments toSureWest Telephone effective November 30, 2000. The CPUC authorizedreplacement funding to SureWest Telephone on an interim basis using funds fromthe CHCF. The CHCF is a program designed by the CPUC to establish a fair andequitable local rate structure and to reduce any disparity in the rates chargedby telephone companies serving high-cost areas. The CHCF is scheduled toexpire January 1, 2009. In addition, the CPUC opened an Order InstitutingInvestigation (“OII”) for the purpose of determining whether future recovery ofall, none or a portion of the annual payments previously received from AT&Tand received currently from the CHCF, should come from SureWest Telephone’sratepayers or other regulatory recovery mechanisms.

In August 2005, the CPUC adopted a decision which(i) authorized SureWest Telephone to continue receiving $11,500 annuallyfrom the CHCF to offset its intrastate regulated operating expenses on aninterim basis, (ii) required SureWest Telephone to prepare and submit acost proxy model (which is used generally as a basis for CHCF funding) based onits current cost data, including analyses of the resulting impacts on rates, onthe Universal Lifeline Telephone Service (“ULTS”) fund, and on the CHCF fund,to be filed by SureWest Telephone within 12 months, and (iii) authorizedSureWest Telephone to file an Advice Letter with the Commission’sTelecommunications Division to implement reductions to its business access linerates. In August 2006, SureWest Telephone filed a Petition forModification proposing a series of alternatives to the preparation of the costproxy model. In conjunction with the Petition for Modification, SureWest Telephonereceived an extension of the deadline to file the cost proxy model. SureWestTelephone may be required to make its cost proxy model filing sixty days aftera decision resolving its Petition for Modification. In the Petition forModification, SureWest Telephone proposes a phased-in elimination of the$11,500 interim CHCF draw in lieu of a proceeding to evaluate the cost proxymodel. In December 2006, the CPUC issued D. 06-12-021, aninterim opinion on the Petition for Modification providing for SureWestTelephone to reduce its annual interim draw from the CHCF by $1,300 on amonthly pro rata basis to $10,200 in the aggregate from $11,500 to reflect theconsumer dividend required by D. 04-11-032 to become effective on January 1,2007 (see above). The results of this proceeding and the potential effects onSureWest Telephone could impact future funding levels through the CHCF.

These actions of the CPUC and of the FCC, as notedabove, can affect the rates charged for access and interconnection, and, as aresult, the revenues derived by the Company from access and related services.SureWest Telephone’s future operations also may be impacted by otherproceedings at the FCC and CPUC, including proceedings that address interstateaccess and other rates and charges, the nature of interconnection between ILECscarriers and others, the collection and distribution of support paymentsrequired to assure universal access to basic telephone services, and thecharges that can be assessed for new forms of service that directly orindirectly utilize carrier networks.

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Substantially all of theinterstate long distance business was detariffed in 2001. The long distancebusiness is recognized as being fully competitive, and there are many providersof long distance services. The emergence from bankruptcy reorganization proceedingsof some larger interexchange and competitive local exchange carriers hascreated new competitive pressures in the sector for both wholesale and retailproviders. Because of the level of competition, regulation of this area of thetelecommunications business is light or has been removed altogether. Where itexists, regulation is focused on specific public policy concerns, such ascustomer account slamming, rather than the rates, terms and conditions ofservice.

**Broadband**

*General*

The Broadband segment includes SureWest Broadband,SureWest Internet, SureWest Custom Data Services and SureWestBroadband/Residential Services. The Broadband segment also includes acompetitive local exchange carrier (“CLEC”), which was authorized by the CPUCin 1998 to provide telecommunications services in areas outside the telephoneservice area of SureWest Telephone. As of January 1, 2003, the Companyconsolidated the operations of SureWest Internet and SureWest Custom DataServices into the operations of SureWest Broadband for financial reportingpurposes, though they remain separate legal entities. In addition, as of January 1,2004, the Company consolidated the operations of SureWest Broadband, SureWestTeleVideo and SureWest TeleVideo of Roseville for financial reporting purposes,though they remain separate legal entities.

The Broadband segment provides various services toresidential, business and carrier customers. The services include: high-speedInternet service; digital video; voice, network access and toll telephone; andcustom data solutions, including collocation, fixed and burstable bandwidth,managed services and network monitoring services. Most of these services wereinitially offered in the greater Sacramento area, principally to customersresiding outside of SureWest Telephone’s service area. However, over time, allof SureWest Broadband’s services have been made available to customers withoutregard to service area boundaries and, commencing in December 2003,SureWest Broadband began providing digital video and high-speed Internetservices to customers within SureWest Telephone’s service area.

SureWest Broadband owns two 39-gigahertz LocalMultipoint Distribution System (“LMDS”) licenses, which provide coverage inparts of eleven different counties in the greater Sacramento area. Theselicenses allow SureWest Broadband to expand its network within these areas byusing wireless technology for extra transmission capacity backhaul. During2004, SureWest Broadband also began using these licenses to offer a fixedwireless service to customers outside of SureWest Telephone’s service area inparts of the cities of Lincoln and Rocklin, California. During 2005, SureWestBroadband further expanded its fixed wireless service by offering this serviceto customers in other areas in Sacramento and Placer Counties. In addition,SureWest Broadband will continue to use this wireless technology for backhaulin cost effective areas.

SureWest Broadband/Residential Services possess cabletelevision licenses or franchises in Sacramento and Placer counties, the citiesof Roseville and Lincoln, California and has expanded its services topreviously licensed areas of Elk Grove and Natomas, California as well as otherareas within its service area footprint. The Company is authorized to providevideo programming to substantially all of the residents in the SureWestTelephone service area.

SureWest Broadband/Residential Services procuresdigital transport capability from its affiliate, SureWest Telephone, and hasdeveloped an advanced method of delivering video services to subscribers usingIP, or IP-video capability.

The Broadband segment utilizes a digital fiber networkand is subject to continual expansion and diversification in response tobusiness growth. The Company expects that each of its segments operating in 

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Roseville and other parts of SureWest Telephone’sservice area should benefit from the Company’s offerings of telecommunications,cable television and Internet services.

The Broadband segmentaccounted for approximately 27%, 23%, and 18% of the Company’s operatingrevenues in the years 2006, 2005 and 2004, respectively. As of December 31,2006, the Broadband segment had 57,498 customers.

*Competition*

The businesses in the Broadband segment are subject toextensive competition. Competition is highly fragmented, and has growndramatically in recent years. Except for the digital video delivery business,which requires significant capital investment to serve designated serviceterritories, the barriers to entry are not high, and technology changes forcerapid competitive adjustments.

SureWest Broadband competes regularly againstAT&T, which is the ILEC in Sacramento and most of its surrounding areas,and which possesses significantly greater size and scale. The Broadband segmentalso competes against Frontier Communications in southern Sacramento County.Numerous CLECs and others offer telecommunications and related services on aflexible and highly specialized basis in the Sacramento area. The Company hasfound that it can be successful by constantly seeking out new salesopportunities in attractive segments of the market, by maintaining a highlyreliable network that is accessible to new customers, and by focusing on theprovision of excellent service to its customers. To the extent permitted by lawand regulatory requirements, the Company seeks to operate its business acrossthe Broadband segment in an integrated manner, and its network as a singleintegrated facility. The operating units in this segment benefit within theregion from the name recognition and reputation of SureWest, and from theactive participation of Company executives and employees in civic and othergroups. During 2003, the Company was able to obtain approval from theSacramento Metropolitan Cable Television Commission to activate service forcustomers in “green field” areas that were previously outside of the Company’sapproved build-out and activation schedules. It now anticipates that itwill achieve a competitive market share in the provision of telephone, digitalvideo and Internet services in many of these areas around Sacramento. It isimportant to the Company that its operations in this segment be able to deliverservices to customers in developing areas as they grow. The Company is alsoconsidering whether a modification or expansion of its service territory inSacramento County is appropriate.

The Broadband segment has assumed the responsibilityfor much of the Company’s DSL and high-speed Internet retail customerbase. The emergence of cable modems, wireless Internet access and other avenuesto reach the Internet provide significant competition. The presence of otherbroadband Internet access providers has begun to exert downward pressure onpricing in the region.

The market faced by theCompany among multichannel video providers is very competitive. The maincompetitors of SureWest Broadband/Residential Services are Comcast and varioussatellite television providers. In the Company’s opinion, Comcast possessessignificant market power in Sacramento County. However, the governingSacramento County Commission promotes competition in the provision of cableservice, and has a straightforward franchise and licensing ordinance thataccommodates other new entrants rapidly, and allows them flexibility indefining service territories. SureWest has entered the Sacramento, Rosevilleand Lincoln cable service markets as the second (or subsequent) franchisee, andwhile it will, therefore, benefit from the somewhat reduced regulation thatsuch entrants enjoy, it will nevertheless face the challenge of drawingcustomers away from the incumbent provider. The provision of cable televisionover a closed transmission path has been recognized as possessing certainmonopoly characteristics and, therefore, the ability of a second or subsequentprovider to succeed in the marketplace is not assured. Similarly, thepossession of comparative size and scale can give a competitor an advantage inboth access to and pricing of the program content needed to operate a cabletelevision business, and Comcast possesses significantly greater size and scalein Sacramento than the Company.

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*Regulation*

Like SureWest Telephone, SureWest Broadband mustcomply with various rules of the CPUC governing tariffs, access toinformation, consumer protection and similar matters for a telecommunicationservice provider. The FCC has jurisdiction over the SureWest Broadbandinterstate services, such as access service. In 2001, the FCC adopted rules thathave caused CLEC interstate switched access charges to decline over time, andthat have also caused a decline in the amount of compensation that can bederived from Internet Service Provider dial-up traffic. SureWestBroadband is only minimally affected by these actions, and has already modifiedits rates to comply with the FCC requirements.

In late 2001, the FCC began a Triennial Review of itspolicies on unbundled network elements (“UNEs”) and other regulations thataffect the nature of competition between ILECs and CLECs. The FCC concluded itsTriennial Review in early 2003, and its action was appealed by a number ofparties. The appellate court reversed the FCC and vacated significant portionsof the FCC rules in a decision that was released in early March 2004,but stayed its mandate for a short time. Subsequently, the FCC released a newdecision with modified rules. That new decision also has been appealed.SureWest Broadband does not rely to any significant degree on UNEs or otherofferings that would be affected by these appeals, and it does not relygenerally on the availability of discounted incremental cost pricing of serviceelements from the ILEC to serve retail customers. However, the position ofSureWest Broadband in the Sacramento market could be affected by a change inlaw or regulation that granted unrestricted pricing flexibility to the ILEC inSacramento or that denies competitors the ability to assure that pricingconcessions given to customers are nondiscriminatory and offered on aconsistent basis.

The cable television business is governed by federal,state and local laws and regulation, but is most substantially controlled bythe mechanisms in Title VI of the Communications Act of 1934, as amended. Whileclosely regulated in some areas, providers of cable services are generally freefrom rate regulation, and have wide leeway to select and package the contentthat they deliver. In exchange for their use of local streets and rights ofway, cable providers are required to pay franchise fees, and to deliver public,educational and governmental channels for use by the community, among otherthings.

In October 2006, theCPUC opened a proceeding to develop procedures to be followed to implementCalifornia Assembly Bill No. 2987, the Digital Infrastructure and VideoCompetition Act of 2006 (“DIVCA”), which designates the CPUC as the issuer ofstate video franchises. A decision addressing implementation of the statutoryprovisions of the DIVCA was adopted March 1, 2007, pending the outcome ofcertain procedural matters.

**Wireless**

*General*

The Wireless segment consists of the Company’ssubsidiary SureWest Wireless which was formed for the purpose of providingwireless Personal Communications Services (“PCS”). PCS is viewed generally asinvolving the capability to deliver a more advanced set of features andcapabilities than the basic form of cellular mobile service. SureWest Wirelessderives its revenue from the provision of wireless PCS, and the sale ofhandsets and related communications equipment. In addition, SureWest Wirelessgenerates revenue from long distance calls, roaming service, custom calling andother features.

SureWest Wireless has FCC licenses that allow it tooffer wireless services in four Basic Trading Areas, representing 16 countieslocated in central California. These areas include the cities of Sacramento,Stockton, Modesto and Yuba City. Each license represents 10 megahertz ofspectrum, and accommodates digital wireless technology that is capable ofproviding both voice and data transmission.

SureWest Wireless established its market share in the Sacramentomarket in large part by promoting an unlimited flat rate regional calling plan.Wireless customer acquisition has historically been most active 

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during the December holiday season, and theCompany has always been active in sales and marketing at this time. In recentyears, SureWest Wireless initiated a number of new service options forcustomers, including additional regional plans, an unlimited national plan, afamily plan and new vertical services (such as wireless data capabilities),which have attracted new customers. SureWest Wireless operates five retailstores in its service area. SureWest Wireless has been seeking to expand itsservice penetration among major accounts during 2006, while seeking to reducecustomer turnover (“churn”) and to increase revenues from its customer base.

The wireless business requires capital investment tobuild new cell sites and to deploy digital and other advanced servicecapabilities. In 2007, capital investment in SureWest Wireless will emphasizecontinued improvements in service levels rather than network expansion.

As of December 31,2006, SureWest Wireless had 52,946 subscribers. The Wireless segment accountedfor approximately 15%, 16% and 15% of the Company’s operating revenue in theyears 2006, 2005 and 2004, respectively.

*Competition*

The market for wirelessservices is highly competitive. There are numerous facilities-basedwireless providers in the Sacramento market, including all of the majornational providers, and additional wireless resellers. Most of thesecompetitors have a national presence and, therefore, have the ability toleverage national advertising budgets and name recognition. In addition, manyof the competitors have access to additional spectrum in the geographic marketsin which SureWest Wireless competes. In order for SureWest Wireless to succeedin this geographic market, it must establish innovative services, such as itsunlimited flat rate service package, and continue to leverage the SureWest nameand reputation. A trend toward consolidation in this segment has begun toemerge, with the announcement of merger agreements involving some of thelargest wireless providers. Competition in this segment is expected to remainintense.

*Regulation*

Because of their use ofvaluable spectrum resources, wireless services are subject to regulation. Theconstruction, operation, management and transfer of digital wireless systems inthe United States are regulated by the FCC and CPUC. However, regulators do notactively review price plans offered to wireless customers.

**Other SignificantEvents**

*Sale of PayTelephone Assets*

In July 2005, theCompany sold its pay telephone assets for $220 to a nationwide provider ofprivate pay telephone services. During the quarter ended June 30, 2005,the Company incurred a pretax asset impairment charge of $189, which wasrecorded in the Company’s consolidated statements of operations as depreciationand amortization expense. The asset impairment charge reduced the carryingvalue of the pay telephone assets within the Telecom segment to its fair valueof $198, which represented the expected proceeds from the sale of assets.

*WorldCom BankruptcySettlement*

Certain of the Company’s customers filed forbankruptcy protection in 2002, the most notable of which was WorldCom, Inc.(“WorldCom”), which, together with its affiliates (collectively “MCI”), filedfor bankruptcy protection in July 2002. In April 2004, MCI emergedfrom federal bankruptcy protection. In October 2005, the Company resolvedits claim filed in January 2003 related to pre-petition accounts 

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receivable, and to a conditional payment made by theCompany to MCI in connection with anticipated overearnings during the 1999-2000monitoring period.

In accordance with the MCIPlan of Reorganization, in October 2005 the Company received adistribution of cash and stock, with a combined fair value of approximately$1,400. The distribution was recognized in the Company’s 2005 consolidatedstatement of operations as an increase to network access service revenue and adecrease to general and administrative expense of $800 and $600, respectively.

**Executive Officers**

*Kirk C. Doyle; age53; Chairman of the Board of Directors*

Mr. Doyle has servedas Chairman of the Board of Directors since 2003, and has been a Director since2000. He has been a realtor with and the owner of Kirk Doyle Realty ofRoseville, California since 1982.

*Steven C. Oldham;age 56; President and Chief Executive Officer*

Mr. Oldham has servedas President and Chief Executive Officer since January 1, 2006, and as amember of the Board of Directors since 2004. He retired from Sierra PacificResources, a Nevada utility holding company in 2002 as Senior Vice President,Energy Supply, after a 26-year career during which he held variouspositions in its accounting, finance and regulatory departments. From 1999 to2001, while at Sierra Pacific Resources, he served as Senior Vice President,Corporate Development and Strategic Planning. After retiring from SierraPacific Resources, Mr. Oldham served as a consultant to The Brattle Group,which provides consulting services and expert testimony on economic, finance,regulatory and strategic issues in various industries.

*Philip A. Grybas;age 59; Senior Vice President and Chief Financial Officer*

Mr. Grybas has servedas Senior Vice President and Chief Financial Officer since he joined theCompany in 2004. Prior to joining the Company, Mr. Grybas served from 2001to 2004 as Vice President, Treasurer, and Chief Financial Officer of WarwickValley Telephone Company of Warwick, New York, a local telephone companyserving customers in New York and New Jersey. Before joining Warwick Telephonein 2001, he spent over sixteen years in the telecommunications industry atAmeritech, which is now owned by AT&T.

*Fred A. Arcuri; age54; Senior Vice President and Chief Operating Officer*

Mr. Arcuri has servedas Senior Vice President and Chief Operating Officer since January 1,2006. From 2002 to 2005, he served as Senior Vice President and Chief OperatingOfficer of SureWest Broadband, after being elected a Vice President in 2000.

*Scott K. Barber;age 46; Vice President, Network Operations*

Mr. Barber has servedas Vice President, Network Operations since 2003. From 2000 to 2003, he servedas Executive Director, Network Services.

*Bill M. DeMuth; age57; Vice President and Chief Technology Officer*

Mr. DeMuth has servedas Vice President and Chief Technology Officer since 2000.

*Peter C. Drozdoff;age 51; Vice President, Marketing*

Mr. Drozdoff hasserved as Vice President, Marketing since 2002. From 2000 to 2002, he served asExecutive Director, Corporate Marketing.

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*Thomas P. Villa;age 47; Vice President, Customer Operations*

Mr. Villa was electedVice President, Customer Operations in 2005. Prior to his election as VicePresident, he served as General Manager of SureWest Broadband from 2003 to2005. Prior to joining the Company, from 2001 to 2003 he was Director–West AreaCustomer Service for Verizon Wireless.

*L. Scott Sommers;age 49; Vice President, Treasurer*

Mr. Sommers hasserved as Vice President, Treasurer since he joined the Company in 2006. Priorto joining the Company, Mr. Sommers served from 2005 to 2006 as ManagingDirector of Investment Banking for Cantor Fitzgerald. Before joining CantorFitzgerald, Mr. Sommers served as First Vice President for MellonFinancial from 1998 to 2005.

*Darla J. Yetter;age 46; Corporate Secretary*

Ms. Yetter waselected Corporate Secretary in 2003. Since 1994, she has served as Assistant tothe President.

**AvailableInformation**

The Company’s Annual Report on Form 10-K,Quarterly Reports on Form 10-Q, Current Reports on Form 8-Kand amendments to reports filed pursuant to Sections 13(a) and15(d) of the Securities Exchange Act of 1934, as amended, are available onour website at ***www.surw.com/ir/***, as soon as reasonably practicable after those reports areelectronically filed with or furnished to the Securities and ExchangeCommission. Copies are also available free of charge upon request to SureWestCommunications, P.O. Box 969, Roseville, CA 95661, Attn: InvestorRelations Manager.

**Item 1A.**                Risk Factors.

As a result of the following factors, as well as othervariables affecting our operating results, past financial performance may notbe a reliable indicator of future performance, and historical trends should notnecessarily be used to anticipate results or trends in future periods.

Representative examples of these factors include(without limitation) the following:

*We expect to continue toface significant competition in all parts of our business and the level ofcompetition is expected to intensify.*   Thetelecommunications industry is highly competitive. We face actual or potentialcompetition from many existing and emerging companies, including otherincumbent and competitive local telephone companies, long-distancecarriers and resellers, wireless telephone companies, Internet serviceproviders, satellite companies and cable television companies. We may not beable to successfully anticipate and respond to various competitive factorsaffecting the industry, including regulatory changes that may affect ourcompetitors and us differently, new technologies and services that may beintroduced, changes in consumer preferences, demographic trends and discountpricing strategies by competitors. As the incumbent carrier in Sacramento,AT&T Inc. (formerly SBC Communications) enjoys certain business advantages,including its size, financial resources, favorable regulatory position, brandrecognition and connection to virtually all of our customers and potentialcustomers there. As the largest cable operator in Sacramento and Placer County,Comcast enjoys certain business advantages, including its size, financialresources, ownership or superior access to programming and other content, brandrecognition, and first-in-the-field advantages with acustomer base that generates positive cash flow for its operations. We faceintense competition in our markets for long-distance, Internet access andother ancillary services that are important to our business and to our growthstrategy.

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*We must adapt to rapidtechnological change.*   Technologicaldevelopments could increase our costs and cause a decline in demand for ourservices. In addition, technology changes can reduce the costs of entry forothers and give competitors significant new advantages. If we do not replace orupgrade technology and equipment that becomes obsolete, we will be unable tocompete effectively because we will not be able to meet the needs orexpectations of our customers, and we may be placed at a cost disadvantage inoffering our services. Additionally, replacing or upgrading our infrastructurein the future could result in significant capital expenditures.

*We are subject to acomplex and uncertain regulatory environment.**  *Some parts of our business are extensivelyregulated, and the nature of regulation continues to undergo fundamental changeand reinterpretation. Many businesses that compete with the Company arecomparatively less regulated. Many significant regulatory decisions have had tobe accommodated in recent years, and there are pending decisions on issuesaffecting the Company that are of great importance.

*Our operations haveundergone material changes, and our actual operating results can be expected todiffer from the results indicated in our historical financial statements.*   Asa result of our 2002 acquisition of assets, which launched our residentialbroadband business, and the subsequent expansion of our video business, our mixof operating assets differs from those operations upon which our historicalfinancial statements are based. In addition, the February 2007 sale of ourdirectories business will affect our results of operations in the future.Consequently, our historical financial statements may not be reliable as anindicator of future results.

*Our success depends uponour ability to manage our growth and expansion. If our recent acquisitions andgrowth initiatives are not successful, we could suffer an adverse effect on ourbusiness and results of operations.*   Ourgrowth strategy will continue to require us to invest significant capital infacilities and services that may not achieve the desired returns. Our futuresuccess depends, in part, upon our ability to manage our growth, including ourability to build network and related facilities to serve new customers,integrate our operations to take advantage of new capabilities and systems;attract and retain skilled personnel across the Company, effectively manage thedemands of day to day operations in new areas while attempting to execute ourbusiness strategy, and realize the projected growth and revenue targetsdeveloped by Company management.

*We receive support fromvarious funds established under federal and state law and the continued receiptof that support is not assured.*   Whilewe do not receive any support from the rural or non-rural FederalUniversal Service high cost loop fund, we do receive payments from variousother federal or state programs. These include interstate common line support,California High Cost Fund (“CHCF”) and the Lifeline, Education and Librariesprograms. These governmental programs are reviewed and amended from time totime, and are likely to change in the near future. As described in the Telecom–Regulationsection above, the Company in 2007 will receive funding of $10,200 from theCHCF, a program designed by the California Public Utilities Commission (“CPUC”)to establish a fair and equitable local rate structure and to reduce anydisparity in the rates charged by certain telephone companies serving high-costareas. The amount of this support from the CHCF is the subject of pendingregulatory proceedings, and its continuation is dependent upon many factors. Inaddition, the state legislative authorization for the CHCF is scheduled to expireJanuary 1, 2009. The outcome and impact on the Company’s operationsresulting from future changes to these governmental programs cannot bedetermined at this time.

*We could be harmed by therecent developments affecting other communications companies.*   Therehave been numerous bankruptcies and other financial difficulties experienced byother carriers and suppliers in the telecommunications and Internet sectors.Similar situations with our suppliers, some of whom provide products andservices for which there are few substitutes could cause us to 

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experience delays,service interruptions or additional expenses. Situations with carrier and othercustomers could affect our ability to collect services that have been provided.

*We depend on thirdparties, over whom we have no control, to deliver our services.*   Becauseof the interconnected nature of the telecommunications industry, we dependheavily on other local telephone companies, long-distance carriers, andnumerous other third parties to deliver our services. In addition, we aredependent on easements, franchises and licenses from various private partiessuch as established telephone companies and other utilities, railroads, long-distancecompanies, and from state highway authorities, local governments and transitauthorities for access to aerial pole space, underground conduits and otherrights-of-way in order to construct and operate our networks. Thefailure to maintain in effect the necessary third party arrangements onacceptable terms would have an adverse effect on our ability to conduct ourbusiness.

*We are subject to corporate governance and internalcontrol reporting requirements, and our failure to comply with existing andfuture requirements could adversely affect our business.*   Pursuantto Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”)and related SEC rules, we have issued a report of management’s assessment ofthe effectiveness of our internal controls at December 31, 2006. Inaddition, our Independent Registered Public Accounting Firm audited andreported on management’s assessment. Management concluded that the Company’sinternal control over financial reporting was effective at December 31,2006. If we are unable to maintain effective internal controls or if futuredeficiencies are not adequately addressed, we could experience accountingerrors that could result in misstatements of our financial position and resultsof operations, potential restatements of our financial statements or otherwiseadversely affect our business, reputation and results of operations. Inferiorinternal controls could also cause investors to lose confidence in our reportedfinancial information, which could have a negative effect on the trading priceof our securities.

**Item 1B.**               Unresolved StaffComments.

None.

**Item 2.**                        Properties.

The Company owns and leases office facilities andrelated equipment for executive headquarters, administrative personnel, centraloffice buildings, and operations in Roseville, Citrus Heights, Granite Bay, andother locations in Sacramento and Placer Counties. The Company’s executiveheadquarters, principal business and administrative office, and operationsfacility, which are located in Roseville, consist of 266,670 square feet. TheCompany leases a 213,871 square foot facility in McClellan Park (SacramentoCounty), which is used by all of its segments. The Company has appropriateeasements, rights of way and other arrangements for the accommodation of itspole lines, underground conduits, aerial and underground cables and wires, andwireless towers and antennas. See Note 8 in the Notes to Consolidated FinancialStatements and “Item 7–Management’s Discussion and Analysis of FinancialCondition and Results of Operations” for information regarding the Company’slease obligations.

In addition to land and structures, the Company’sproperty consists of equipment necessary for the provision of communicationservices. This includes central office equipment, customer premises equipmentand connections, radio and wireless antennas, towers, pole lines, video head-end,remote terminals, aerial and underground cable and wire facilities, vehicles,furniture and fixtures, computers and other equipment. The Company also ownscertain other communications equipment held as inventory for sale or lease.

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In addition to plant andequipment that it wholly-owns, the Company utilizes poles, towers andcable and conduit systems jointly-owned with other entities, and leasesspace on facilities to other entities. These arrangements are in accordancewith written agreements customary in the industry.

**Item 3.**                        LegalProceedings.   (Dollars in thousands)

Except for the proceedings described below, theCompany is not aware of any material pending legal proceedings, other thanordinary routine litigation incidental to its business, to which it is a partyor to which any of its property is subject.

Prior to 2000, AT&T Inc. (“AT&T”) (formerlySBC Communications) had been paying SureWest Telephone approximately $11,500per year for extended area service (“EAS”) pursuant to a Settlement TransitionAgreement. In November 2000, the California Public Utilities Commission (“CPUC”)authorized AT&T to terminate its annual EAS payments to SureWest Telephoneeffective November 30, 2000. The CPUC authorized replacement funding toSureWest Telephone on an interim basis using funds from the California HighCost Fund (“CHCF”). The CHCF is a program designed by the CPUC to establish afair and equitable local rate structure and to reduce any disparity in therates charged by telephone companies serving high-cost areas. The CHCF isscheduled to expire January 1, 2009. In addition, the CPUC opened an OrderInstituting Investigation (“OII”) for the purpose of determining whether futurerecovery of all, none, or a portion of the approximate $11,500 annual paymentspreviously received from AT&T should come from SureWest Telephone’sratepayers or other regulatory recovery mechanisms.

In August 2005, the CPUC adopted a decision which(i) authorized SureWest Telephone to continue receiving $11,500 annuallyfrom the CHCF to offset its intrastate regulated operating expenses on aninterim basis, (ii) required SureWest Telephone to prepare and submitwithin twelve months a cost proxy model (which is used generally as a basis forCHCF funding) based on its current cost data, including analyses of theresulting impacts on rates, on the Universal Lifeline Telephone Service (“ULTS”)fund, and on the CHCF fund and (iii) authorized SureWest Telephone to filean advice letter with the Commission’s Telecommunications Division to implementreductions to its business access line rates. In August 2006, SureWestTelephone filed a Petition for Modification proposing a series of alternativesto the preparation of the cost proxy model. In conjunction with the Petitionfor Modification, SureWest Telephone received an extension of the deadline tofile the cost proxy model. SureWest Telephone may be required to make its costproxy model filing sixty days after a decision resolving its Petition forModification. In the Petition for Modification, SureWest Telephone proposes aphased-in elimination of the $11,500 interim CHCF draw in lieu of aproceeding to evaluate the cost proxy model. In December 2006, the CPUCissued D. 06-12-021, an interim opinion on the Petition forModification providing for SureWest Telephone to reduce its annual interim drawfrom the CHCF by $1,300 on a monthly pro rata basis to $10,200 in the aggregatefrom $11,500 to reflect the consumer dividend required by D. 04-11-032to become effective on January 1, 2007 (see above). The results of thisproceeding and the potential effects on SureWest Telephone could impact futurefunding levels through the CHCF.

In 1996, the CPUC issued a decision that authorizedSureWest Telephone to implement a New Regulatory Framework (“NRF”) for servicesfurnished within SureWest Telephone’s service area in order to accommodatemarket and regulatory movement toward competition and greater pricingflexibility. Under the NRF, SureWest Telephone is subject to ongoing monitoringand reporting requirements, and it was initially required to share earningswith customers through a reduction of revenues if its earned annual rate-of-returnexceeds that authorized by the CPUC.

In accordance with the requirements of its generalrate case order, SureWest Telephone filed an application for review of its NRFin 1999. In connection with this proceeding, the CPUC’s Office of RatepayerAdvocates (“ORA”) undertook a verification audit of SureWest Telephone’s non-regulatedand 

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affiliated transactions pursuant to the general ratecase and other CPUC orders. In June 2001, the CPUC adopted its decision inthis matter (the “NRF Decision”). The NRF Decision did not suspend the sharingmechanism as SureWest Telephone had requested, and further provided thatSureWest Telephone must change the method used to allocate costs for servicesprovided by SureWest Telephone to its affiliates, the treatment of certaindirectory revenues and the treatment of internal-use software costs.Additionally, in accordance with the provisions of the NRF Decision, theCompany recorded certain liabilities and reductions of revenues relating toestimated intrastate shareable earnings obligations.

In April 2005, the CPUC opened a rulemakingproceeding to assess and revise the regulation of telecommunications utilitiesto develop a uniform regulatory framework (“URF”) to apply to most providers ofregulated telecommunications services, to the extent that it is feasible and inthe public interest to do so. In August 2006, the CPUC adopted Decision 06-08-030(the “URF Decision”) which revises the regulations of telecommunicationsutilities, such as SureWest Telephone, which were previously subject to theNRF. The URF Decision grants carriers broad pricing freedoms in the provisionof telecommunications services, bundles of services, promotions and contracts. TheURF Decision, among other things:  (i) freezesthe Company’s basic residential and lifeline rates until at least January 1,2009 in order to address the subsidy levels supporting these services, subjectto review in the CHCF review and public policy programs proceedings, (ii) eliminatesprice regulation and allows full pricing flexibility for all new and retailservices except lifeline and basic residential services, (iii) allowsbundles and promotional packages on any telecommunication service, (iv) allocatesall gains and losses from the sale of assets to shareholders and (v) eliminatesprice caps, the annual price cap filing, the productivity factor, and allresidual elements of rate of return regulation, including the calculation of shareableearnings. In accordance with the URF Decision, the CPUC ordered a separatebriefing cycle to consider whether to detariff altogether telecommunicationsservices other than basic residential service.

In December 2006, the CPUC adopted D. 06-12-044,an order clarifying the URF Decision and granting limited rehearing of the URFDecision with respect to the elimination of all asymmetric requirementsconcerning marketing, disclosure, or administrative processes with theexception of conditions relating to basic residential rates. Pending theoutcome of this limited rehearing, the rules adopted with respect to theelimination of asymmetric regulations are suspended.

Pursuant to the URF Decision, further proceedings inthis matter will be held during 2007 to address detariffing of telephoneservice other than basic exchange service, the pricing of retail special accessservices, determination of the extent to which the Commission requiresmonitoring reports in addition to, or different from, the reports carriersroutinely file with the Federal Communications Commission (“FCC”), and issuesrelating to the implementation of the URF Phase I decision. In addition,pursuant to an assigned commissioner’s ruling issued in December 2006 inaccordance with D. 06-12-044, these further proceedings will alsoexamine customer disclosure rules and the rules adopted governingelimination of asymmetric administrative processes.

Also, in January 2007, The Utility Reform Networkfiled a petition for writ of review in the Court of Appeal of the State ofCalifornia challenging the URF Decision and seeking an order that the CPUC’sdecision be set aside. The ultimate results of this proceeding and thepotential effects on SureWest Telephone cannot yet be determined.

In September 2006, the Governor of Californiasigned into law Assembly Bill No. 2987, which enacted the DigitalInfrastructure and Video Competition Act of 2006 (“DIVCA”). This new lawprovides an alternative to the local franchise process and establishes aprocedure for the issuance of state franchises for the provision of videoservice, and promotes a more rapid entry by telephone companies into the videobusiness and new competition for cable and Direct Broadcast Satellite providers.Existing cable providers will be able to abrogate their local franchises andopt into the state franchise process beginning in January 2008. Specifically,the Company will be able to exit its current local franchise agreements and 

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operate under a state-issued franchise if any ofthe following events occur:  (i) theexpiration, prior to any renewal or extension, of the Company’s localfranchise; (ii) mutual agreement between the local franchising entity andthe Company; or (iii) at the time a new video service provider initiatesvideo service in all or part of the area within the local municipality’sfranchise area. This new law also prohibits ILECs that provide video serviceunder a state-issued franchise from increasing**basic residential telephone service rates until January 1,2009. In October 2006, the CPUC opened a proceeding to develop proceduresto be followed to implement DIVCA, which designates the CPUC as the issuer ofstate video franchises. A decision addressing implementation of the statutoryprovisions of DIVCA was adopted March 1, 2007, pending the outcome ofcertain procedural matters.

SureWest Telephone’s operations may also be impactedby the Telecommunications Act of 1996 (the “Act”). The Act significantlychanged the regulatory environment for telecommunications companies. Beginningin 1996, the FCC conducted proceedings and adopted orders implementing the Act’sprovisions to open local exchange service markets, such as the market ofSureWest Telephone, to competition. These proceedings and orders address theregulation of competing telecommunications companies, interconnection, accesscharges and universal service.

Given the ongoing activities of the FCC to promulgate rules andregulations on competition, interconnection, access charges, and universalservice reform, and the various on-going legal challenges considering thevalidity of these FCC orders, it is not yet possible to determine fully theimpact of the Act and related FCC regulations on SureWest Telephone’soperations.

There are a number of other regulatory proceedingsoccurring at the federal and state levels that may have a material impact onSureWest Telephone. These regulatory proceedings include, but are not limitedto, consideration of changes to the jurisdictional separations process, theinterstate universal service fund, intercarrier compensation access chargereform and the regulation of local exchange carriers and their competitors,including providers of Internet protocol-enabled services. The outcomesand impact on SureWest Telephone’s operations of these proceedings and relatedcourt matters cannot be determined at this time.

The regulatory proceedingsoccurring at the state and federal levels described above may also broaden thescope of competition in the provision of regulated services and change therates and rate structure for regulated services furnished by SureWestTelephone, the effects of which on SureWest Telephone cannot yet be determined.

**Item 4.**                        Submissionof Matters to a Vote of Security Holders.

No matters were submitted to a vote of securityholders during the fourth quarter of 2006.

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**PART II**

**Item 5.**                        Market forRegistrant’s Common Equity, Related Stockholder Matters and Issuer Purchases ofEquity Securities.

SureWestCommunications (the “Company”) common stock is traded on The Nasdaq Stock Market LLC (“NASDAQ”)under the symbol “SURW.” As of February 26, 2007, there were approximately10,944 beneficial owners based on the number of record holders of the Company’scommon stock. The following table indicates the range of stock closing pricesof the Company’s common stock as reported on the NASDAQ, for each of thequarters ending on the dates indicated:
| ** **              | ** ** | **NASDAQ National Market** | ** ** |
|-------------------------|------------|--------------------------------------|------------|
| ** **              | ** ** | **High**                             | ** ** | **Low** | ** ** |
| March 31, 2005     |       | $                                    | 28.15      |   | $ | 22.26 |   |
| June 30, 2005      |       | $                                    | 25.95      |   | $ | 19.63 |   |
| September 30, 2005 |       | $                                    | 29.23      |   | $ | 24.01 |   |
| December 31, 2005  |       | $                                    | 29.39      |   | $ | 24.02 |   |
| March 31, 2006     |       | $                                    | 28.40      |   | $ | 23.60 |   |
| June 30, 2006      |       | $                                    | 24.46      |   | $ | 17.32 |   |
| September 30, 2006 |       | $                                    | 20.48      |   | $ | 16.51 |   |
| December 31, 2006  |       | $                                    | 28.40      |   | $ | 19.33 |   |

 

The Company paid cash dividends on its common stock of$0.25 per share for each quarter of 2006 and 2005.****See “Part II, Item 7–Management’s Discussion andAnalysis of Financial Condition and Results of Operations–Liquidity and CapitalResources” for a discussion regarding restrictions on the payment of dividends.Additional information concerning dividends may be found in “Selected FinancialData” in Item 6, and in Item 8, which are incorporated herein by reference.

During the year ended December 31,2006, no equity securities of the Company were sold by the Company, which werenot registered under the Securities Act of 1933, as amended.

**Share Repurchases**

Thefollowing table summarizes the Company’s common stock repurchase activityduring the quarter ended December 31, 2006:
| **Period**                                                  | ** ** | **(a)Total Number  of Shares  Purchased** | ** ** | **(b) Average  Price Paid  per Share** | ** ** | **(c)Total Number of Shares  Purchased as Part of  Publicly Announced Plan** | ** **                                        | **(d)Shares Available  for Repurchase  under the Plan** | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------------------------|------------|-------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------|---------------------------------------------------|-----------------------------------------------------------------------------|------------|
| October  1,  2006,–October 31, 2006 (1) |       |                                                | 13,317     |                                                  |       |                                                                                                                 | $                                                 | 19.27                                                                       |       |   |   | 1,227,993 |   |   |   | 272,007 |   |   |
| November 1,  2006–November 30, 2006 (2)      |       |                                                | –     |                                                  |       |                                                                                                                 | $   –     |                                                                        |       |   | – |   |   |   | 1,272,007 |   |   |
| December 1, 2006–December 31, 2006      |       |                                                | –     |                                                  |       |                                                                                                                 | $   –     |                                                                        |       |   | – |   |   |   | 1,272,007 |   |   |

 

(1)          Shares purchased in October 2006include a reversal of 5,765 shares from a trade made in September 2006that was not completed.

(2)          Asdiscussed in Part II, Item 7–Management’s Discussion and Analysis ofFinancial Condition and Results of Operations”, in November 2006 theCompany’s Board of Directors authorized the repurchase of up to an additionalone million shares, supplementing a prior repurchase approval.

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**Performance Graph**

The following graph showsa five-year comparison of cumulative total shareholder return of theCompany’s Common Stock (assuming dividend reinvestment) with the Dow Jones USTelecommunications Index (a published index which includes 20 telecommunicationscompanies) and the Russell 2000(R) Index. The comparison of total returnon investment (change in year-end stock price plus reinvested dividends)for each of the periods assumes that $100 was invested on December 31,2001 respectively in each of SureWest Communications, the Dow Jones USTelecommunications Index and the Russell 2000(R) Index. The stockperformance shown on the graphs below is not necessarily indicative of futureprice performance.

**COMPARISON OF 5YEAR CUMULATIVE TOTAL RETURN*Among SureWest Communications, Russell 2000(R)and DJ US Telecommunications**

*$100invested on 12/31/01 in stock or index-including reinvestment of dividends.

Fiscal year endingDecember 31.
| ** **                      | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| SureWest Communications         |       | $        | 100        |     |       | $        | 78         |     |       | $        | 87         |     | $          | 63 |   | $ | 61 |   | $ | 67 |   |
| Russell  2000(R) Index     |       | $        | 100        |     |       | $        | 80         |     |       | $        | 117        |     | $          | 139 |   | $ | 145 |   | $ | 171 |   |
| DJ US Telecommunications  Index |       | $        | 100        |     |       | $        | 65         |     |       | $        | 70         |     | $          | 83 |   | $ | 80 |   | $ | 110 |   |

 

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**Item6.**                        SelectedFinancial Data. 
| ** **                                       | ** ** | **2006**                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| ** **                                       | ** ** | **(Dollars in  thousands, except per share amounts)** | ** ** |
| Total operating  revenues (3)                    |       | $                                                     | 222,745    |     | $          | 218,588  |       | $        | 211,763    |     | $          | 195,121 |   | $ | 185,849 |   |
| Net income (loss)  (3)(4)(5)                     |       | $                                                     | 5,738      |     | $          | 6,378    |       | $        | (1,128     | )        | $          | 645 |   | $ | 11,249 |   |
| Basic and diluted  earnings (loss) per share (1) |       | $                                                     | 0.39       |     | $          | 0.44     |       | $        | (.08       | )        | $          | 0.04 |   | $ | 0.76 |   |
| Cash dividends  per share (2)                    |       | $                                                     | 1.00       |     | $          | 1.00     |       | $        | 1.00       |     | $          | 1.00 |   | $ | 1.00 |   |
| Property, plant  and equipment, at cost          |       | $                                                     | 832,028    |     | $          | 781,579  |       | $        | 715,718    |     | $          | 646,740 |   | $ | 576,579 |   |
| Total assets                                     |       | $                                                     | 445,750    |     | $          | 459,029  |       | $        | 448,903    |     | $          | 439,347 |   | $ | 401,390 |   |
| Long-term  obligations                           |       | $                                                     | 123,722    |     | $          | 89,168   |       | $        | 95,345     |     | $          | 93,135 |   | $ | 52,252 |   |
| Shares of common  stock used to calculate:       |       |                                                  |       |     |       |     |       |     |       |     |       |
| Basic earnings (loss) per share (1)              |       | 14,531                                                |       | 14,552   |       | 14,531   |       | 14,522   |       | 14,728   |       |
| Diluted earnings  (loss) per share (1)           |       | 14,615                                                |       | 14,631   |       | 14,531   |       | 14,539   |       | 14,795   |       |

 

(1)          Shares used in thecomputation of basic earnings (loss) per share are based on the weightedaverage number of common shares and restricted common stock units (“RSUs”)outstanding, excluding unvested restricted common shares and unvested RSUs.Shares used in the computation of diluted earnings per share are based on theweighted average number of common shares, restricted common shares and RSUsoutstanding, along with other potentially dilutive securities outstanding ineach period. Shares used in the computation of diluted loss per share are basedon the weighted average number of vested common shares and vested RSUs andexclude potential dilutive common shares, unvested restricted common shares andunvested RSUs outstanding, as the effect is antidilutive.

(2)          Cash dividends per shareare based on the actual dividends per share, as declared by the Company’s Boardof Directors. On each date that the Company pays a cash dividend to the holdersof the Company’s common stock, the Company credits to the holders of RSUs anadditional number of RSUs equal to the total number of whole RSUs andadditional RSUs previously credited to the holders multiplied by the dollaramount of the cash dividend per share of common stock. Any fractional RSUsresulting from such calculation are included in the additional RSUs.

(3)          In January 2007,the Company entered into a definitive agreement with GateHouse Media to sellSureWest Directories, its directory publishing business. The transaction wasconsummated on February 28, 2007. Under the agreement, GateHouse Mediaacquired 100% of the stock of SureWest Directories for an aggregate cashpurchase price of $110,123, subject toa post-closing working capital adjustment. The sale by the Companyof its directory publishing business will have various effects on the Company’sfinancial statements and results of operations in 2007 and beyond. For a moredetailed discussion see the Consolidated Overview section below, in Item 7–Management’sDiscussion and Analysis of Financial Condition and Results of Operations.

(4)          During the Company’sfinancial statement closing process for the year ended December 31, 2003,certain matters were identified related to prior financial reporting periodsthat necessitated the recording of adjustments to the Company’s consolidatedfinancial statements. Such adjustments pertained principally to property, plantand equipment. The prospective correction of the aforementioned amountsrelating to prior periods reduced the Company’s 2003 consolidated net income by$1,603, or $0.11 per basic and diluted share.

(5)          In December 2003,the Company discovered certain irregular bank transactions and deposits in aroutine investigation following the abrupt resignation of the Company’sTreasury Analyst. An investigation revealed concealed illegal transfers inviolation of the Company’s investment and cash management policies. The Companyconcluded that the irregularities were limited to the 2003 

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calendar year and nearlyall of the funds had been recovered; however, approximately $1,828 remainedoutstanding as of December 31, 2003. During 2004, the Company received aninsurance recovery in the amount of $1,803, which was reflected as a non-operatinggain in the Company’s 2004 consolidated financial statements.

 

**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations.

*(Amountsin thousands, except selected operating metrics and share and per shareamounts)*

Certain information included in this 2006 AnnualReport on Form 10-K of SureWest Communications (the “Company”),including that which relates to the impact on future revenue sources andpotential sharing obligations of pending and future regulatory orders,continued expansion of the telecommunications network and expected changes inthe sources of the Company’s revenue and its cost structure resulting from itsentrance into new communications markets, are forward looking statements andare made pursuant to the safe harbor provisions of the Securities LitigationReform Act of 1995. Such forward looking statements are subject to a number ofrisks, assumptions and uncertainties that could cause the Company’s actualresults to differ from those projected in such forward looking statements.

Important factors thatcould cause actual results to differ from those set forth in the forwardlooking statements include, but are not limited to:  advances in telecommunications technology,changes in the telecommunications regulatory environment, changes in thefinancial stability of other telecommunications providers who are customers ofthe Company, changes in competition in markets in which the Company operates,adverse circumstances affecting the economy in California in general, and inthe Sacramento, California Metropolitan area in particular, the availability offuture financing, changes in the demand for services and products, new productand service development and introductions, pending and future litigation, andunanticipated changes in the growth of the Company’s emerging businesses,including the wireless and broadband business segments.

**Corporate Structure**

The Company is a holding company with wholly-ownedsubsidiaries operating in the Telecommunications (“Telecom”), Broadband andWireless segments.

The Telecom segment has included SureWest Telephone,SureWest Directories, and SureWest Long Distance, which provide landlinetelecommunications services, directory advertising, Digital Subscriber Line(“DSL”) service, long distance services and certain non-regulatedservices. SureWest Telephone, which is the principal operating subsidiary ofthe Telecom segment, provides local services, toll telephone services, networkaccess services and certain non-regulated services. SureWest Directoriespublished and distributed SureWest Telephone’s directory, including the sale ofyellow pages advertising. SureWest Directories was also engaged in thebusiness of producing, publishing and distributing directories in otherNorthern California communities outside of SureWest Telephone’s service area.SureWest Long Distance is a reseller of long distance services.

In January 2007, the Company entered into adefinitive agreement with GateHouse Media to sell SureWest Directories, itsdirectory publishing business. The transaction was consummated onFebruary 28, 2007. Under the agreement, GateHouse Media acquired 100% ofthe stock of SureWest Directories for an aggregate cash purchase price of$110,123, subject to a post-closing working capital adjustment. Underrelated agreements, GateHouse Media will continue to publish SureWestTelephone’s directory. The Company continues to evaluate its businesses andproduct lines and believes this transaction will permit the Company to focusmore on the strategic growth of its core business of being a full-serviceintegrated communications provider.

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The Broadband segment includes the Company’ssubsidiaries SureWest Broadband, SureWest TeleVideo and SureWest TeleVideo ofRoseville (collectively referred to as “SureWest Broadband/Residential Services”)and SureWest Broadband Business Services, which is comprised, in part, of adivision of SureWest Telephone operating as a Competitive Local ExchangeCarrier (“CLEC”). The Broadband segment provides various services, includinghigh-speed and dial-up Internet, digital video, voice, networkaccess, long distance and managed services in the greater Sacramento area,principally to customers residing outside of SureWest Telephone’s service area.

The Wireless segment consists of the Company’ssubsidiary SureWest Wireless, which provides wireless services. Wirelessrevenues include wireless voice services, sales of handsets and relatedaccessories, long distance, roaming service and custom calling features.Wireless services are provided on a month-to-month basis and aregenerally billed in advance for non-contract subscribers and in arrearsfor contract subscribers.

The Company expects thatthe sources of its revenues and its cost structure may be different in futureperiods, both as a result of its entry into new communications markets andcompetitive forces in each of the markets in which the Company has operations.

**Results ofOperations**

**ConsolidatedOverview**

The tables below reflectcertain financial data (on a consolidated and segment basis) and selectedoperating metrics for each reportable business segment as of and for the yearsended December 31, 2006, 2005 and 2004.

**FinancialData**
| ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **% Change**       | ** ** |
|------------------------------------|------------|------------|------------|------------|------------|------------|------------|-------------------------|------------|
| ** **                         | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2006 vs.  2005** | ** ** | **2005 vs.  2004** | ** ** |
| **Operating  revenues**(1)         |       |       |       |       |       |       |       |                    |       |   |   |   |   |   |   |
| Telecom                            |       | $          | 128,758    |       | $          | 134,468    |       | $                       | 141,086    |   |   | (4 | )% |   |   | (5 | )% |   |
| Broadband                          |       | 59,794     |       | 49,915     |       | 39,416     |       |                    | 20         |   |   |   | 27 |   |   |
| Wireless                           |       | 34,193     |       | 34,205     |       | 31,261     |       |                    | –     |   |   |   | 9 |   |   |
| Total operating revenues           |       | 222,745    |       | 218,588    |       | 211,763    |       |                    | 2          |   |   |   | 3 |   |   |
| **Income  (loss) from operations** |       |       |       |       |       |       |       |                    |       |   |   |   |   |   |   |
| Telecom                            |       | 57,833     |       | 53,593     |       | 49,937     |       |                    | 8          |   |   |   | 7 |   |   |
| Broadband                          |       | (26,337    | )          | (24,785    | )          | (31,340    | )          |                    | (6         | ) |   |   | 21 |   |   |
| Wireless                           |       | (14,837    | )          | (12,878    | )          | (17,278    | )          |                    | (15        | ) |   |   | 25 |   |   |
| Total operating income (loss)      |       | 16,659     |       | 15,930     |       | 1,319      |       |                    | 5          |   |   |   | 1,108 |   |   |
| **Net  income (loss)**             |       |       |       |       |       |       |       |                    |       |   |   |   |   |   |   |
| Telecom                            |       | 34,022     |       | 30,033     |       | 28,322     |       |                    | 13         |   |   |   | 6 |   |   |
| Broadband                          |       | (18,597    | )          | (15,438    | )          | (18,627    | )          |                    | (20        | ) |   |   | 17 |   |   |
| Wireless                           |       | (9,687     | )          | (8,217     | )          | (10,823    | )          |                    | (18        | ) |   |   | 24 | % |   |
| Total net income  (loss)           |       | $          | 5,738      |       | $          | 6,378      |       | $                       | (1,128     | ) |   | (10 | )% |   |   | NA |   |   |

 

(1)          External customers only

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**Selected OperatingMetrics**
| ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **% Change**       | ** ** |
|-----------------------------------------------|------------|------------|------------|------------|------------|------------|------------|-------------------------|------------|
| ** **                                    | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2006 vs.  2005** | ** ** | **2005 vs.  2004** | ** ** |
| **Telecom**                                   |       |       |       |       |       |       |       |                    |       |   |   |   |   |   |   |
| Incumbent Local Exchange Carrier access lines |       | 125,195    |       | 129,291    |       | 131,905    |       |                    | (3         | )% |   |   | (2 | )% |   |
| Long Distance lines                           |       | 57,605     |       | 52,288     |       | 47,512     |       |                    | 10         |   |   |   | 10 |   |   |
| **Broadband**                                 |       |       |       |       |       |       |       |                    |       |   |   |   |   |   |   |
| Total Subscribers (1)                         |       | 57,498     |       | 49,743     |       | 41,970     |       |                    | 16         |   |   |   | 19 |   |   |
| Broadband Revenue-generating units (2)        |       |       |       |       |       |       |       |                    |       |   |   |   |   |   |   |
| Data                                          |       | 55,095     |       | 47,093     |       | 39,158     |       |                    | 17         |   |   |   | 20 |   |   |
| Video                                         |       | 19,657     |       | 16,138     |       | 12,998     |       |                    | 22         |   |   |   | 24 |   |   |
| Voice                                         |       | 18,721     |       | 15,526     |       | 11,373     |       |                    | 21         |   |   |   | 37 |   |   |
| Business Voice-grade equivalents (3)          |       | 741,900    |       | 685,600    |       | 449,439    |       |                    | 8          |   |   |   | 53 |   |   |
| **Wireless**                                  |       |       |       |       |       |       |       |                    |       |   |   |   |   |   |   |
| Subscribers                                   |       | 52,946     |       | 53,858     |       | 52,657     |       |                    | (2         | )% |   |   | 2 | % |   |

 

(1)          Total subscribers arecustomers who receive data, video or voice services from SureWest Broadband.

(2)          The Broadband segmentcan deliver multiple services to a customer. Accordingly, the Company maintainsstatistical data regarding Revenue-generating units for digital video,voice and data, in addition to the number of subscribers. For example, a singlecustomer who purchases digital video, voice and data services would bereflected as three Revenue-generating units.

(3)          Business Voice-gradeequivalents (“VGEs”) are calculated by dividing the capacity of all circuits inuse by 64 kilobits (bandwidth representing a voice access line). DSL VGEs arecounted as two 64 kbps channels.

Operating revenues from external customers in theTelecom segment decreased $5,710 in 2006 as compared to 2005. SureWestTelephone continues to experience decreases in local and network accessrevenues as a result of competition from wireless (including SureWest Wireless)and wireline competitors, which has resulted in an approximate 3% decline inaccess lines. In addition, network access revenues were impacted by a declinein the rate base, which affects the interstate pool settlements from theNational Exchange Carrier Association (“NECA”) (see *RegulatoryMatters* within the *Telecom Segment Results ofOperations*and*Critical AccountingPolicies and Estimates*sections below). SureWest Telephone’srevenues are also impacted by shareable earnings obligations, which are alsodiscussed below in the *Telecom Segment Results ofOperations*.

While the Telecom segment steadily continues togenerate a majority of the Company’s revenues, cash flows and net income, theCompany believes that the results of the Telecom segment in recent years(reflected in declining revenues and access lines) support, in part, theCompany’s efforts to continue to develop its other business segments. Asdiscussed above, on February 28, 2007 the Company completed a transactionto sell its directory publishing business, SureWest Directories, which was acomponent of the Telecom Segment. During 2006, the directories businessgenerated operating revenues and net income of $17,849 and $5,791, respectively.

Broadband operating revenues increased $9,879 and$10,499 in 2006 and 2005, respectively, as compared to each prior year period,primarily as a result of the continued expansion of the broadband network andgrowth in the demand for data and video services. At December 31, 2006,the Broadband segment experienced a 16% annual increase in total subscribers.In addition, broadband business services realized an 8% annual increase inVGEs. While continuing to produce significant revenue increases, the expansionof the broadband residential services has and will continue to require ongoingcapital and expense commitments.

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The Wireless segment reported a slight decline inoperating revenues of $12 in 2006 as compared to 2005. As the Companydeemphasizes the prepaid market and migrates toward contract subscribers, thenumber of wireless subscribers decreased to 52,946 at December 31, 2006, a2% decline from December 31, 2005. Access and roaming revenues decreasedfrom the prior year as a result of the decline in subscribers, a reduction inroaming rates and the implementation of new Travel Plans during 2006, whichprovide subscribers with competitive roaming packages and lower priced callingoptions. Despite the decline in access and roaming revenues, average revenueper subscriber remained relatively consistent with the prior year primarily dueto an increase in feature revenues as a result of new features introduced in2006.

The Company’s consolidated operating expenses,excluding depreciation and amortization, decreased $2,580 in 2006 as comparedto the prior year in large part to savings of approximately $6,800 in employeecompensation and benefits.

During 2005, the Company implemented a strategy fordriving efficiency and long-term growth through cost reduction andworkforce consolidation. This strategic plan entailed a reduction of operatingexpenses through a realignment of organizational structure in order to focus onprimary customer segments. The corporate restructuring resulted in areorganization of stand-alone segment functions in order to gainoperating efficiencies through a consolidated organizational structure.

In addition, based on revised actuarial calculations,during 2006 the costs related to the Company’s defined benefit pension plan(the “Pension Plan”) and Postretirement Welfare Plan (“Other Benefits”)declined by approximately $1,400. The decline in the cost of the Pension Planand Other Benefits was offset in part by the curtailment loss of $574 recordedin 2006 associated with the freeze of the Pension Plan, Supplemental ExecutiveRetirement Plan (“SERP”), and Other Benefits (collectively “the Plans”), asdiscussed below.

In January 2007, the Company’s Board of Directorsauthorized amendments to the Plans. As a result of these amendments, effectiveas of April 1, 2007, the Company will freeze the Pension Plan so that noperson will become eligible to participate in the Plans on or following theeffective date and all future benefit accruals under the Plans shall cease. Theamendments to the Plans have been accounted for as plan curtailments, resultingin the recognition of a $574 non-cash pretax curtailment loss ($0.04 pershare) reflected in operating expenses in the Company’s consolidated statementof operations for the year ended December 31, 2006.

The SERP is an unfunded plan which providessupplemental retirement benefits to certain retired executives of the Companyto partially offset the reduction in amounts that would have been payable underthe pension Plan if it were not for limitations imposed by federal income taxregulations. The Other Benefits relates to certain post-retirementbenefits other than pensions available to substantially all employees,including life insurance benefits and a stated reimbursement for Medicare supplementalinsurance.

In late 2004, the Company initiated a voluntaryenhanced early retirement program (the “REWARD program”). The REWARD programwas offered to certain eligible employees across all business units. Inaddition to retirement benefits, eligible employees receive enhanced medicalbenefits for a specified period of time. As of December 31, 2004, 59employees had accepted the REWARD program and the Company recorded operatingexpenses of $3,768 related to the REWARD program during the fourth quarter of2004. During the quarter ended March 31, 2005, the Company recorded $791in operating expenses attributed to 13 employees that accepted the REWARDprogram in 2005.

Cost of services and products expense (exclusive ofdepreciation and amortization) increased $52 primarily due to an increase in (i) videolicense fees as the number of subscribers within the Broadband segmentcontinued to grow and (ii) cost of equipment sales due to increases in theaverage cost and quantity of wireless handsets sold, but were largely offset bya decline in expenses for network operations as a result of the cost reductionand workforce consolidation.

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Customer operations andselling expense increased $1,506 in 2006 compared to 2005 due primarily to anincrease in sales and advertising costs to promote subscriber growth and newproduct offerings within the Broadband segment. General and administrativeexpenses decreased $4,138 primarily as a result of (i) a reduction inlabor costs and benefits, (ii) a decline in consulting and audit fees dueto the completion of Sarbanes-Oxley Act implementation and complianceefforts in the prior year and (iii) a decrease in annual insurancepremiums.

The Company’s consolidateddepreciation and amortization expense increased $6,008 in 2006 compared to theprior year. This increase was primarily due to the continued network build-outand success-based capital projects undertaken within the residentialbroadband service territories.

In July 2005, theCompany sold its pay telephone assets for $220 to a nationwide provider ofprivate pay telephone services. The Company had experienced a decline in thepay telephone business due to the rapid growth of wireless alternatives andjoined other telephone companies in transitioning the assets to an enterprisespecializing in that business. Divesting these assets represents the Company’scontinued effort to drive efficiency and long-term growth. During thequarter ended June 30, 2005, the Company incurred a pretax assetimpairment charge of $189, which was recorded in the Company’s consolidatedstatements of operations as depreciation and amortization expense. The assetimpairment charge reduced the carrying value of the pay telephone assets withinthe Telecom segment to its fair value of $198, which represented the expectedproceeds from the sale of assets.

*Reclassification*

Certain amounts in theCompany’s 2005 and 2004 consolidated financial statements have beenreclassified to conform to the presentation of the Company’s 2006 consolidatedfinancial statements.

*Effects of Corporate Actions*

The sale by the Company ofits directory publishing business, and the decision to freeze the Pension Plan,both announced in the first quarter of 2007, will have various effects on theCompany’s financial statements and results of operations in 2007 and beyond.

In recent years, including2006, the Company’s Telecom segment has benefited from the directoriesbusiness, including operating revenues and net income from that business of$17,849, or 14%, and $5,791, or 17%, respectively in 2006. The operatingresults of the directories business represented approximately 8% and 59% of theCompany’s consolidated revenues and consolidated income from operations,respectively, and substantially all of the Company’s consolidated net income in2006. In 2007, the Company’s consolidated results of operations will includetwo months (for the period from January 1, 2007 through the February 28,2007 closing date of the transaction) of operating revenues from thedirectories business of approximately $3,000, which will be reflected in theCompany’s consolidated statement of income in net income from discontinuedoperations. However, the Company’s annual results in 2007 should also reflect areduction in corresponding expenses resulting from the transfer of theemployees and other costs to the purchaser of the business. The Companyreceived pre-tax proceeds of approximately $110,123. Accordingly, in theperiod following the closing of the transaction the Company will experiencelower interest expense or increased interest income, or a combination,resulting from the application of the sales proceeds. In the longer term, theCompany will be looking to utilize its available capital, including thatgenerated from the sale of the directories business, to focus more on thestrategic growth of its core business of being a full-service integratedcommunications provider.

The Pension Plan freezewill also affect the Company’s financial statements and results of operationsbeginning in 2007. The freeze, effective April 1, 2007, will reduce boththe Company’s operating expenses and cash requirements. Although the futureimpact of the freeze has not been determined, for the fiscal 

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years 2003 through 2006,cash contributions to the Pension Plan ranged from $3,000 to $9,000, and annualservice cost averaged approximately $5,000 over the same time period.

*Nonmonetary Transactions*

In the normal course ofbusiness, the Company entered into certain nonmonetary transactions that arenot material, either individually or in the aggregate, to the Company’sconsolidated financial statements.

**2006versus 2005**

**Segment Results of Operations**

**Telecom**
| ** **                                        | ** ** | **2006** | ** ** | **2005** | ** ** | **$Change** | ** ** | **%Change** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|-------------|------------|-------------|------------|
| Local service                                     |       | $        | 62,774     |     | $          | 63,522      |       | $           | (748       | ) |   | (1 | )% |   |
| Network access  service                           |       | 39,500   |       | 44,214   |       | (4,714      | )          |        | (11        | ) |   |
| Directory  advertising                            |       | 17,971   |       | 17,383   |       | 588         |       |        | 3          |   |   |
| Long distance  service                            |       | 5,546    |       | 6,016    |       | (470        | )          |        | (8         | ) |   |
| Other                                             |       | 2,967    |       | 3,333    |       | (366        | )          |        | (11        | ) |   |
| Total operating  revenues from external customers |       | 128,758  |       | 134,468  |       | (5,710      | )          |        | (4         | ) |   |
| Intersegment  revenues                            |       | 29,484   |       | 30,056   |       | (572        | )          |        | (2         | ) |   |
| Operating  expenses*                              |       | 75,368   |       | 85,503   |       | (10,135     | )          |        | (12        | ) |   |
| Depreciation and  amortization                    |       | 25,041   |       | 25,428   |       | (387        | )          |        | (2         | ) |   |
| Income from  operations                           |       | 57,833   |       | 53,593   |       | 4,240       |       |        | 8          |   |   |
| Net income                                        |       | $        | 34,022     |     | $          | 30,033      |       | $           | 3,989      |   |   | 13 | % |   |

*Exclusive of depreciationand amortization

*Operating Revenues*

Operating revenues fromexternal customers in the Telecom segment decreased $5,710 compared to 2005.SureWest Telephone continues to experience decreases in local and networkaccess revenues as a result of competition from wireless (including SureWestWireless) and wireline competitors, which has resulted in an approximate 3%decline in access lines. In addition, network access revenues decreased due toa decline in the rate base, which affects the interstate pool settlements fromNECA (see *Regulatory Matters* and *Critical Accounting Policies and Estimates* sections below).

The decrease in local andnetwork access revenues was offset in part by revenue growth of $588 inDirectory advertising revenues primarily due to increases in advertising rates.Revenues within the Telecom segment are also affected by SureWest Telephone’sshareable earnings obligations. During the years ended December 31, 2006and 2005, Surewest Telephone changed its estimates for a portion of itsinterstate shareable earning obligations and certain NECA accounts receivablebalances, related to prior year monitoring periods; resulting in an increase torevenues of $145 and $916, respectively, as described in more detail in the *Regulatory Matters* section below.

*Operating Expenses*

Operating expenses for theTelecom segment decreased $10,135 in 2006 from 2005. The decrease in operatingexpenses was due in large part to savings in employee compensation and benefitsrealized through the cost containment and workforce consolidation plan, thedecline in costs related to the Pension Plan and the inclusion during the firstquarter of 2005 of approximately $640 related to the REWARD program, asdescribed in the *Consolidated Overview* sectionabove. Total headcount in the Telecom segment decreased 15% from December 2005to December 2006. The change in operating expenses also reflected therecognition in 2006 of a $295 non-cash pretax curtailment loss resultingfrom the amendments to the Company’s Pension Plan, as described in the *Consolidated Overview* section above.

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Cost of services and products (exclusive ofdepreciation and amortization) decreased $5,078 in 2006 compared to 2005. Theyear-over-year decrease is attributable to decreases in networkoperations and support expenses as a result of reductions in the number ofemployees. The decrease was also impacted by revised estimated costs for 2006related to the Pension Plan and employee compensation incentives, and theinclusion in 2005 of costs related to the REWARD program. These decreases wereoffset in part by increases in long distance access expense as a result of theInfinitAccessä bundle program andan increase in minutes of use.

Customer operations and selling expense decreased$1,382 in 2006 compared to 2005, due primarily to decreases in labor costs forproduct management and customer and operator services as a result of areduction in the number of employees and internal efficiencies resulting fromintegrated customer support systems and productivity gains.

General and administrative expense decreased $3,675 in2006 compared to 2005. The decrease was due primarily to a reduction inheadcount and associated labor costs, as well as lower audit fees andconsulting fees related to Sarbanes-Oxley Act implementation andcompliance. The revised estimated costs for 2006 related to the Pension Planand employee compensation incentives resulted in additional decreases.

Depreciation and amortization decreased $387 in 2006compared to 2005 due primarily to a significant portion of computer softwarebecoming fully depreciated during 2006.

Certain of the Company’s customers filed forbankruptcy protection in 2002, the most notable of which was WorldCom, Inc.(“WorldCom”), which, together with its affiliates (collectively “MCI”), filedfor bankruptcy protection in July 2002. In April 2004, MCI emergedfrom federal bankruptcy protection. In October 2005, the Company resolvedits claim filed in January 2003 related to pre-petition accountsreceivable, and to a conditional payment made by the Company to MCI inconnection with anticipated overearnings during the 1999-2000 monitoringperiod.

In accordance with the MCIPlan of Reorganization, in October 2005 the Company received adistribution of cash and stock, with a combined fair value of approximately$1,400. The distribution was recognized in the Company’s 2005 consolidatedstatement of operations as an increase to network access service revenue and adecrease to general and administrative expense of $800 and $600, respectively.In October 2005, MCI shareholders approved a merger with VerizonCommunications Inc. (“Verizon”), which was completed in January 2006. As aresult of the merger, the Company received 17,970 shares of Verizon commonstock and an $86 cash distribution in exchange for the 31,292 shares of MCIcommon stock previously held. As of December 31, 2006, the Company held17,970 shares of Verizon common stock with an aggregate carrying value ofapproximately $669. The Company’s investment in Verizon common stock isclassified as an available-for-sale, short-term investment inthe consolidated balance sheet.

*Regulatory Matters*

Revenues fromservices subject to regulation constituted approximately 46% and 49% of theCompany’s total operating revenues in 2006 and 2005, respectively. Thoserevenues, which include local service, network access service and toll service,are derived from various sources, including:

·       business and residentialsubscribers, for basic exchange services;

·       surcharges, mandated by theCalifornia Public Utilities Commission (“CPUC”);

·       long distance carriers, fornetwork access service;

·       competitive accessproviders and subscribers, for network access services;

·       interstate poolsettlements, from NECA;

·       support payments fromfederal or state programs, and

·       supportpayments from the California High Cost Fund (“CHCF”), recovering costs ofservices including extended area service (“EAS”).

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Revenues from certain telephone services are affectedby rates authorized by various regulatory agencies. Intrastate service ratesare subject to regulation by the CPUC. With respect to toll calls initiated byinterexchange carriers’ customers, the interexchange carriers are assessedaccess charges based on tariffs filed by SureWest Telephone. Interstate accessrates and resultant earnings are subject to regulation by the FederalCommunications Commission (“FCC”). With respect to interstate services,SureWest Telephone has filed its own tariff with the FCC for all elements ofaccess services except carrier common line charges, for which SureWestTelephone concurs with tariffs filed by NECA.

The FCC monitors SureWest Telephone’s interstateearnings through the use of annual cost separation studies prepared by SureWestTelephone, which utilize estimated cost information and projected demand usage.The FCC establishes rules that carriers must follow in the preparation ofthe annual studies. Additionally, under current FCC rules governing ratemaking, SureWest Telephone is required to establish interstate rates based onprojected demand usage for its various services and determine the actualearnings from these rates once actual volumes and costs are known. Based onpreliminary cost studies, the Company recognized liabilities relating toSureWest Telephone’s estimated interstate shareable earnings obligations of$157 for the year ended December 31, 2005 through reductions of revenues. TheCompany did not identify any interstate shareable earrings obligations atSureWest Telephone during the years ended December 31, 2006 or 2004.

As a result of periodic cost separation studies, SureWestTelephone changed its estimates for a portion of its interstate shareableearnings obligations and certain NECA interstate common line (“CL”) accountsreceivable balances related to prior year monitoring periods during the yearsended December 31, 2006, 2005 and 2004. For the years ended December 31,2006 and 2005 these changes in estimates increased the Company’s consolidatedrevenues by $145 and $791, respectively, and net income by $86 ($0.01 pershare) and $482 ($0.03 per share), respectively. For the year ended December 31,2004, similar changes in accounting estimates, including a change in estimateto the Company’s intrastate shareable earnings obligations, increased theCompany’s consolidated revenues by $1,258 and decreased the net loss by $873($0.06 per share).

During September 2005, SureWest Telephone made apayment of $100 to a certain carrier customer in full settlement of aninterstate overearnings dispute for the monitoring period 2001-2002. Thelimitations period applicable to this monitoring period expired. Therefore,SureWest Telephone released all other amounts reserved in connection with thepotential overearnings claims for 2001-2002 monitoring period, whichincreased the Company’s revenues and net income for the year ended December 31,2005 by $125 and $78 ($0.01 per share), respectively.

The FCC has a pending rulemaking proceeding to re-examineall regulated forms of intercarrier compensation and develop a more unifiedmechanism to govern the payment flows among telecommunications carriers. Intercarriercompensation is the regulated fees that service providers charge each other tocarry and terminate traffic. Reform has been suggested due to the changingnature of the industry with increasing competition from new technologies, suchas Internet and Internet-based services and wireless services. Variousplans have been submitted to the FCC with divergent approaches to handleintercarrier compensation that may reduce per-minute access andreciprocal compensation charges and replace these revenues with a combinationof increases to the subscriber line charge and revenues obtained from a newrestructure mechanism. The ultimate results of this proceeding and thepotential effects on SureWest Telephone cannot yet be determined.

The Company was involved in a proceeding at the CPUCthat considered the continued need for certain sharing requirements in theintrastate jurisdiction and, in connection with that review, also consideredthe issue of whether the Company overearned in the intrastate jurisdiction inrecent monitoring periods and the amount of overearnings that should be sharedwith customers. In July 2004, the Company entered into a settlementagreement (the “settlement agreement”) with the other parties in theproceeding, the 

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Division of Ratepayer Advocates (“DRA”) (formerlyOffice of Ratepayer Advocates) (“ORA”), and The Utility Reform Network (“TURN”),to resolve all issues in the proceeding. In November 2004, the CPUCapproved the settlement agreement. The settlement agreement resolved existingintrastate sharing obligations and related earnings issues for the monitoringperiods 2000 through 2004, put into place a surcredit mechanism for the amountof the settlement, and suspended the requirement for any intrastate sharing formonitoring periods from January 1, 2005 through at least December 31,2010. The settlement agreement resulted in SureWest Telephone recognizing anincrease in local revenues of $2,948 due to a change in accounting estimateduring the fourth quarter of 2004. This increase in revenues decreased theCompany’s net loss by $2,046 ($0.14 per share) during 2004.

In accordance with the settlement agreement, SureWestTelephone is returning approximately $6,500 (“Dividend A”), plus interest atthe 90-day commercial paper rate for non-financial institutions,which was 5.19% as of December 31, 2006, and an imputed rate of 3.15%, toits end users through a consumer dividend over a period of approximately fouryears, which began January 1, 2005. In addition, SureWest Telephone ispaying a one-time consumer dividend of $2,600 (“Dividend B”), which isbeing returned to the consumers to settle the monitoring periods 2000 through2004. The consumer dividend is recorded as a reduction of the Company’scontractual shareable earnings obligations over approximately two years, whichbegan January 1, 2005. The consumer dividend includes an annual imputedinterest rate of 3.15% (no stated contractual interest rate). At December 31,2006, the aggregate contractual shareable earnings obligation for thesesurcredits was $3,598 (which is net of an unamortized discount pertaining toimputed interest of $115 at that date). Future payments for these obligationsare $1,857 and $1,856 in 2007 and 2008, respectively.

Thefollowing table summarizes the amounts returned to end users through consumerdividends for the years ended December 31, 2006 and 2005:

| ** ** | ** ** | **Years Ended December 31,** | ** ** |
|------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| Dividend A |       | $                                           | 2,011      |   | $ | 1,655 |   |
| Dividend B |       | 1,177                                       |       | 1,210 |   |
| Total      |       | $                                           | 3,188      |   | $ | 2,865 |   |

 

Further, as part of the settlement agreement SureWestTelephone was to implement an additional annual consumer dividend of $1,300 on January 1,2007 to end-users receiving SureWest Telephone services subject tosharing on or after that date. However, this consumer dividend was subject toreduction based upon the results of other pending regulatory proceedings and in2007 has been offset by a reduction in the Company’s draw from the CHCF, asdiscussed below.

During the fourth quarter of 2005, the Company filedan Advice Letter with the CPUC proposing an increase to the consumer dividendsin order to return the amounts entitled in accordance with the settlementagreement. The change in the consumer dividends resulted from the increase ininterest rates during 2005. The increase was effective January 1, 2006.

Prior to 2000, AT&T Inc. (“AT&T”) (formerlySBC Communications), had been paying SureWest Telephone approximately $11,500per year for EAS pursuant to a Settlement Transition Agreement. In November 2000,the CPUC authorized AT&T to terminate its annual EAS payments to SureWestTelephone effective November 30, 2000. The CPUC authorized replacementfunding to SureWest Telephone on an interim basis using funds from the CHCF.The CHCF is a program designed by the CPUC to establish a fair and equitablelocal rate structure and to reduce any disparity in the rates charged bytelephone companies serving high-cost areas. The CHCF is scheduled toexpire January 1, 2009. In addition, the CPUC opened an Order InstitutingInvestigation (“OII”) for the purpose of determining 

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whether future recovery of all, none, or a portion ofthe annual payments received from the CHCF should come from SureWest Telephone’sratepayers or other regulatory recovery mechanisms.

In August 2005, the CPUC adopted a decision which(i) authorized SureWest Telephone to continue receiving $11,500 annuallyfrom the CHCF to offset its intrastate regulated operating expenses on aninterim basis, (ii) required SureWest Telephone to prepare and submitwithin twelve months a cost proxy model (which is used generally as a basis forCHCF funding) based on its current cost data, including analyses of theresulting impacts on rates, the Universal Lifeline Telephone Service (“ULTS”)fund and the CHCF fund and (iii) authorized SureWest Telephone to file anadvice letter with the Commission’s Telecommunications Division to implementreductions to its business access line rates.

In August 2006, the Company filed a petition formodification (the “petition”) of the decision that reviewed SureWest Telephone’srevenue requirement, which seeks CPUC authorization for a graduated phase-downof its $11,500 interim draw from the CHCF over a period of time that isintended to assure the continued maintenance of good service to SureWest Telephonecustomers while avoiding precipitous rate increases. The Company’s petitionproposed a transitional phase-down over a five-to-ten yearperiod and requested elimination of the requirement to file its cost proxymodel. The Company will seek to recover the eliminated revenues through rateincreases and/or operating efficiencies. In August 2006, the DRA filedopposition to the Company’s petition and instead proposed the Companyimmediately discontinue receipt of CHCF funds. In October 2006, theCompany filed a request for an interim decision on its petition by which theCompany proposed to reduce its annual interim CHCF draw by a $1,300 consumerdividend required by the settlement agreement, as described above. In December 2006,the CPUC issued an interim decision approving the Company’s proposal to offsetits draw from the CHCF by the $1,300 consumer dividend. The results of thisproceeding and the potential effects on SureWest Telephone could impact futurefunding levels through the CHCF.

In June 2006, the CPUC instituted a rulemakingproceeding to review the CHCF program. The goals of this review include, butare not limited to, adjusting universal service rate support payments toreflect updated operating costs, evaluating whether CHCF support levels can bereduced and made more predictable while still meeting the goals of the program,ensuring it is competitively neutral, reducing rate disparity in residentialbasic service between urban and rural areas in the state, and making thecurrent administration of the program more efficient. In addition, the CHCFrulemaking requested comments as to whether SureWest Telephone should continuereceiving the annual payments from the CHCF and the advisability and impacts ofphasing out the EAS payments gradually over a period of approximately 5 years. Theresults of this proceeding and the potential effects on SureWest Telephonecould impact future funding levels through the CHCF.

In 1996, the CPUC issued a decision that authorizedSureWest Telephone to implement a New Regulatory Framework (“NRF”) for servicesfurnished within SureWest Telephone’s service area in order to accommodatemarket and regulatory movement toward competition and greater pricingflexibility. Under the NRF, SureWest Telephone is subject to ongoing monitoringand reporting requirements, and it was initially required to share earningswith customers through a reduction of revenues if its earned annual rate-of-returnexceeds that authorized by the CPUC.

In April 2005, the CPUC opened a rulemaking proceedingto assess and revise the regulation of telecommunications utilities to developa uniform regulatory framework (“URF”) to apply to most providers of regulatedtelecommunications services, to the extent that it is feasible and in thepublic interest to do so. In August 2006, the CPUC adopted Decision 06-08-030(the “URF Decision”) which revises the regulations of telecommunicationsutilities, such as SureWest Telephone, which were previously subject to theNRF. The URF Decision grants carriers broad pricing freedoms in the provisionof telecommunications services, bundles of services, promotions and contracts. TheURF Decision, among other things:  (i) freezesthe Company’s basic residential and lifeline rates until at least January 1,2009 in 

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order to address the subsidy levels supporting theseservices, subject to review in the CHCF review and public policy programsproceedings, (ii) eliminates price regulation and allows full pricingflexibility for all new and retail services except lifeline and basicresidential services, (iii) allows bundles and promotional packages on anytelecommunication service, (iv) allocates all gains and losses from thesale of assets to shareholders and (v) eliminates price caps, the annualprice cap filing, the productivity factor, and all residual elements of rate ofreturn regulation, including the calculation of shareable earnings. Inaccordance with the URF Decision, the CPUC ordered a separate briefing cycle toconsider whether to detariff altogether telecommunications services other thanbasic residential service.

In December 2006, the CPUC adopted D. 06-12-044,an order clarifying the decision and granting limited rehearing of the URFDecision with respect to the elimination of all asymmetric requirementsconcerning marketing, disclosure, or administrative processes with theexception of conditions relating to basic residential rates. Pending theoutcome of this limited rehearing, the rules adopted with respect to theelimination of asymmetric regulations are suspended.

Pursuant to the URF Decision, further proceedings inthis matter will be held during 2007 to address detariffing of telephoneservice other than basic exchange service; the pricing of retail special accessservices, determination of the extent to which the Commission requiresmonitoring reports in addition to, or different from, the reports carriersroutinely file with the FCC, and issues relating to the implementation of theURF Phase I decision. In addition, pursuant to an assigned commissioner’s rulingissued in December 2006 in accordance with D. 06-12-044, thesefurther proceedings will also examine customer disclosure rules and the rules adoptedgoverning elimination of asymmetric administrative processes.

Also, in January 2007, TURN filed a petition forwrit of review in the Court of Appeal of the State of California challengingthe URF Decision and seeking an order that the CPUC’s decision be set aside. Theultimate results of this proceeding and the potential effects on SureWestTelephone cannot yet be determined.

In April 2006, the CPUC released a decision in aproceeding investigating the continued need for the transport interconnectioncharge (“TIC”), which is an access charge element. An earlier draft decisionrequired all ILECs operating within California to eliminate the TIC element andauthorized recovery of lost revenue through end users, specifically through anincrease in their local rate surcharge, and use of the CHCF-A for thesmall companies. If SureWest Telephone did not recover any lost revenues fromend users, the decision could ultimately result in a loss of revenues of up to$4,200, on a prospective basis. The Company sought modification of the draftdecision on the basis that the CPUC had indicated that it was prepared to actonly with respect to larger ILECs, and thus denied SureWest Telephone dueprocess. In the final decision, the CPUC deferred the elimination of the TICelement for SureWest to the next phase of the proceeding, which began in May 2006.The Company filed testimony in May 2006 supporting that the CPUC shouldnot eliminate the TIC for small and mid-sized ILECs due to an impendingfederal intercarrier compensation restructure proceeding at the FCC. OnMarch 13, 2007, the CPUC released a proposed decision which eliminates theTIC and allows SureWest to impose a surcharge and increase other rates torecover any loss in access revenue. The ultimate results of this proceeding andthe potential effects on SureWest Telephone cannot yet be determined.

In September 2006, the Governor of Californiasigned into law Assembly Bill No. 2987, which enacted the DigitalInfrastructure and Video Competition Act of 2006 (“DIVCA”). This new lawprovides an alternative to the local franchise process and establishes aprocedure for the issuance of state franchises for the provision of videoservice, and promotes a more rapid entry by telephone companies into the videobusiness and new competition for cable and DBS providers. Existing cableproviders will be able to abrogate their local franchises and opt into thestate franchise process beginning in January 2008. Specifically, theCompany will be able to exit its current local franchise agreements and operateunder a 

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state-issued franchise if any of the followingevents occur:  (i) the expiration,prior to any renewal or extension, of the Company’s local franchise; (ii) mutualagreement between the local franchising entity and the Company; or (iii) atthe time a new video service provider initiates video service in all or part ofthe area within the local municipality’s franchise area. This new law alsoprohibits ILECs that provide video service under a state-issued franchisefrom increasing basic residential telephone service rates until January 1,2009. In October 2006, the CPUC opened a proceeding to develop proceduresto be followed to implement DIVCA, which designates the CPUC as the issuer ofstate video franchises. A decision addressing implementation of the statutoryprovisions of DIVCA was adopted March 1, 2007, pending the outcome ofcertain procedural matters.

As of December 31,2006, the Company’s consolidated balance sheet reflected aggregate liabilitiesof $73 relating to SureWest Telephone’s estimated interstate shareable earningsobligations. The calculations supporting these liabilities are very complex andinvolve a variety of estimates prior to the ultimate settlement of suchobligations. In addition, SureWest Telephone’s interstate shareable earningsobligations lapse over time if SureWest Telephone’s interexchange carrier andother customers do not claim the amounts ascribed to them. Accordingly, it isreasonably possible that management’s estimates of the Company’s liabilitiesfor interstate shareable earnings obligations could change in the near term,and the amounts involved could be material.

**Broadband**
| ** **                                        | ** ** | **2006** | ** ** | **2005** | ** ** | **$Change** | ** ** | **%Change** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|-------------|------------|-------------|------------|
| Data                                              |       | $        | 28,927     |     | $          | 25,780      |       | $           | 3,147      |   |   | 12 | % |   |
| Video                                             |       | 12,398   |       | 9,609    |       | 2,789       |       |        | 29         |   |   |
| Voice                                             |       | 7,506    |       | 5,792    |       | 1,714       |       |        | 30         |   |   |
| Network access                                    |       | 8,962    |       | 6,598    |       | 2,364       |       |        | 36         |   |   |
| Other                                             |       | 2,001    |       | 2,136    |       | (135        | )          |        | (6         | ) |   |
| Total operating  revenues from external customers |       | 59,794   |       | 49,915   |       | 9,879       |       |        | 20         |   |   |
| Intersegment  revenues                            |       | 1,507    |       | 1,693    |       | (186        | )          |        | (11        | ) |   |
| Operating  expenses*                              |       | 64,811   |       | 59,942   |       | 4,869       |       |        | 8          |   |   |
| Depreciation and  amortization                    |       | 22,827   |       | 16,451   |       | 6,376       |       |        | 39         |   |   |
| Loss from  operations                             |       | (26,337  | )          | (24,785  | )          | (1,552      | )          |        | (6         | ) |   |
| Net loss                                          |       | $        | (18,597    | )        | $          | (15,438     | )          | $           | (3,159     | ) |   | (20 | )% |   |

*Exclusive of depreciationand amortization

*Operating Revenues*

Operating revenues fromexternal customers in the Broadband segment increased $9,879 in 2006 comparedto 2005. The increase in Broadband revenues was due to the combined effects of (i) a19% increase in Revenue-generating units of broadband services and (ii) an8% increase in business voice grade equivalents, which is a result of thecontinued expansion of the Broadband Business services.

*Operating Expenses*

Total operating expenses in the Broadband segmentincreased $4,869 in 2006 compared to 2005. Cost of services and products(exclusive of depreciation and amortization) increased $2,885 during 2006compared to 2005, due primarily to (i) an increase in programming andtransport costs related to the growth in Broadband subscribers and Revenue-generatingunits, (ii) an increase in network and general support costs correspondingto the increased subscriber count, as well as the expanded network footprintand (iii) an increase in property taxes predominantly due to the increasein property, plant and equipment as the network is expanded. These increaseswere offset in part by a decrease in contract labor expenses.

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Customer operations expense increased $2,188 in 2006compared to 2005. The year-over-year increase was attributable toincreased advertising efforts to promote existing and new products and plans.

General and administrative expense decreased $204 in2006 compared to 2005 due primarily to (i) a reduction in labor costs andbenefits and (ii) a decline in audit and consulting fees due to thecompletion of Sarbanes-Oxley Act implementation and compliance efforts inthe prior year.

Depreciation and amortization increased $6,376 in 2006compared to 2005 primarily due to continued network build-out within theresidential broadband service territories.

The change in operating expenses also reflected therecognition in 2006 of a $222 non-cash pretax curtailment loss resultingfrom the amendments to the Company’s Pension Plans, as described in the *Consolidated Overview* section above.

**Wireless**
| ** **                                 | ** ** | **2006** | ** ** | **2005** | ** ** | **$Change** | ** ** | **%Change** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|-------------|------------|-------------|------------|
| Wireless revenues from  external customers |       | $        | 34,193     |     | $          | 34,205      |       | $           | (12        | ) |   | – | % |   |
| Intersegment revenues                      |       | 2,864    |       | 2,592    |       | 272         |       |        | 10         |   |   |
| Operating expenses*                        |       | 39,984   |       | 37,784   |       | 2,200       |       |        | 6          |   |   |
| Depreciation and  amortization             |       | 11,910   |       | 11,891   |       | 19          |       |        | –     |   |   |
| Loss from operations                       |       | (14,837  | )          | (12,878  | )          | (1,959      | )          |        | (15        | ) |   |
| Net loss                                   |       | $        | (9,687     | )        | $          | (8,217      | )          | $           | (1,470     | ) |   | (18 | )% |   |

*Exclusive of depreciationand amortization

*Operating Revenues*

Operating revenues fromexternal customers in the Wireless segment decreased $12 in 2006 compared to2005. The nominal decrease was due primarily to (i) a 2% decline insubscribers due in part to a de-emphasis on the prepaid market, (ii) adecline in access and roaming revenues primarily as result of a reduction inroaming rates and the implementation of Travel Plans, which provide subscriberswith flat-rate roaming packages and lower priced calling options and (iii) adecline in directory assistance revenues due primarily to a reduction in callvolume resulting from the transition to an outsourced vendor offset by (a) increasesin feature revenues as a result of new features introduced in 2006 and (b) increasesin equipment revenues resulting from an increase in the quantity of handsetssold.

*Operating Expenses*

Total operating expenses for the Wireless segmentincreased $2,200 in 2006 compared to 2005. Cost of services and products(exclusive of depreciation and amortization) increased $1,701 in 2006 comparedto 2005 primarily due to increases in (i) the average cost and quantity ofhandsets sold, (ii) costs associated with additional features introducedin 2006 and (iii) long distance expense due to an increase in the minutesof use. These increases were partially offset by decreases in (i) laborcosts in network operations through the corporate restructuring, (ii) directoryassistance as a result of the transition to an outsourced vendor at reduced costsin addition to a reduction in call volume and (iii) roaming costs as aresult of a reduction in contracted rates.

Customer operations expense increased $796 in 2006compared to 2005 due primarily to an increase in sales and advertising costs asa result of increased promotional campaigns.

General and administrative expense decreased $297 in2006 compared to 2005 primarily due to decreased labor costs resulting fromefficiencies gained through the corporate restructuring and a decline in auditand consulting fees related to the completion in prior years of Sarbanes-OxleyAct implementation and compliance efforts.

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The change in operatingexpenses also reflected the recognition in 2006 of a $57 non-cash pretaxcurtailment loss resulting from the amendments to the Company’s Pension Plans,as described in the *Consolidated Overview*section above.

**Non-OperatingItems**

*Other Income andExpense, Net*

Consolidated interestexpense increased $1,207, or 21%, compared to 2005. The rise in interestexpense was due both to an increase in long-term debt and a correspondingincrease in the weighted average cost of debt in the current year. Consolidatedinvestment income increased $59, or 13%, during 2006 as compared to 2005primarily as a result of an increase in the average invested balances andhigher average interest rates during 2006, offset by a decrease in dividendincome related to the Company’s available-for-sale securities.

*Income Taxes*

Income taxes increased $22 in 2006 compared to 2005due to an increase in the effective tax rate. The effective federal and stateincome tax rates were 40.7% and 38.0% for the years ended 2006 and 2005,respectively. The change in the effective federal and state income tax rate isprimarily due to permanent differences, including meals and entertainment andcertain non-deductible contributions.

As of December 31,2006, the Company had net operating loss carryforwards for federal income taxpurposes of approximately $5,489, which will expire in the years 2018 through2024, if not utilized. As of December 31, 2006, the Company also had netoperating loss carryforwards for state income tax purposes of approximately$218, which will expire in the years 2007 through 2014, if not utilized. Thenet operating loss carryforwards for both federal and state decreased from theprior year due to the reversal of deferred tax liabilities, primarilydepreciation expense-related, and other taxable income. The Companycurrently has a net state deferred asset of $3,223 and expects to generatefuture state taxable income in excess of the approximately $36,463 required torealize the net deferred asset. As of December 31, 2006, the Company alsohad research and development tax credit carryforwards of approximately $100 forfederal income tax purposes. The federal credit will expire in 2022 if it isnot utilized. The Company has an Alternative Minimum Tax carryforward of $930for federal and $324 for state, which do not expire.

**2005 versus 2004**

**Segment Results ofOperations**

**Telecom**
| ** **                                        | ** ** | **2005** | ** ** | **2004** | ** ** | **$Change** | ** ** | **%Change** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|-------------|------------|-------------|------------|
| Local service                                     |       | $        | 63,522     |     | $          | 69,560      |       | $           | (6,038     | ) |   | (9 | )% |   |
| Network access  service                           |       | 44,214   |       | 46,161   |       | (1,947      | )          |        | (4         | ) |   |
| Directory  advertising                            |       | 17,383   |       | 16,283   |       | 1,100       |       |        | 7          |   |   |
| Long distance  service                            |       | 6,016    |       | 5,184    |       | 832         |       |        | 16         |   |   |
| Other                                             |       | 3,333    |       | 3,898    |       | (565        | )          |        | (14        | ) |   |
| Total operating  revenues from external customers |       | 134,468  |       | 141,086  |       | (6,618      | )          |        | (5         | ) |   |
| Intersegment  revenues                            |       | 30,056   |       | 25,814   |       | 4,242       |       |        | 16         |   |   |
| Operating  expenses*                              |       | 85,503   |       | 91,736   |       | (6,233      | )          |        | (7         | ) |   |
| Depreciation and  amortization                    |       | 25,428   |       | 25,227   |       | 201         |       |        | 1          |   |   |
| Income from  operations                           |       | 53,593   |       | 49,937   |       | 3,656       |       |        | 7          |   |   |
| Net income                                        |       | $        | 30,033     |     | $          | 28,322      |       | $           | 1,711      |   |   | 6 | % |   |

*Exclusive of depreciationand amortization

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*Operating Revenues*

Operating revenues from external customers in theTelecom segment decreased $6,618 compared to 2004. SureWest Telephone continuedto experience decreases in local and network access revenues as a result ofcompetition from wireless (including SureWest Wireless) and wirelinecompetitors and an approximate 2% decline in access lines.

The decrease in the local and network access revenueswas offset in part by revenue growth of $832 in SureWest Long Distanceresulting from an increase in minutes of use and the effects of theInfinitAccessä bundle program. Inaddition, Directory advertising revenues increased $1,100 in 2005 compared to2004 primarily due to increases in advertising rates.

Revenues within theTelecom segment were also affected by SureWest Telephone’s shareable earningsobligations. During the years ended December 31, 2005 and 2004, SurewestTelephone changed its estimates for a portion of its interstate shareableearning obligations and certain National Exchange Carrier balances related toprior year monitoring periods resulting in an increase to revenues of $916 and$1,258, respectively, as described in more detail in the *Regulatory Matters* section above.

*Operating Expenses*

Operating expenses for the Telecom segment decreased$6,233 in 2005 compared to 2004. As described in more detail in the *Consolidated Overview* section above, thedecrease in operating expenses was due in large part to labor savings realizedthrough the cost containment and workforce consolidation plan and the REWARDprogram offered to certain eligible employees during the fourth quarter of2004. These savings were partially offset by operating expenses ofapproximately $640 related to certain eligible employee’s who accepted theREWARD program during the quarter ended March 31, 2005, also described inthe *Consolidated Overview* sectionabove.

Cost of services and products (exclusive ofdepreciation and amortization) decreased $1,556 in 2005 compared to 2004. Theyear-over-year decrease was attributable to decreases in outsideplant and network operations as a result of reductions in the number ofemployees as well as the additional expenses incurred in 2004 as a result ofproviding video over the existing in-territory network. The decreaseswere offset in part by increases in long distance access expense as a result ofthe InfinitAccessä bundle program andan increase in minutes of use and directory production and distribution costs.

Customer operations and selling expense decreased$1,812 in 2005 compared to 2004, due primarily to decreases in labor costs forproduct management and customer and operator services as a result of areduction in the number of employees and internal efficiencies resulting fromintegrated customer support systems and productivity gains. These decreaseswere partially offset by increased billing expenses associated with theincrease in long distance access line usage.

General and administrative expense decreased $2,865 in2005 compared to 2004. The decrease was due primarily to the incurrence in 2004of Sarbanes-Oxley implementation and compliance costs and professionaland legal fees related to the treasury investigation, as described below.

Depreciation and amortization increased $201 in 2005compared to 2004 due primarily to the incurrence of a pretax asset impairmentcharge of $189 associated with the sale of the Company’s pay telephone assets,as described above in the *ConsolidatedOverview* section.

Certain of the Company’s customers filed forbankruptcy protection in 2002, the most notable of which was MCI, filed forbankruptcy protection in July 2002. In April 2004, MCI emerged fromfederal bankruptcy protection. In October 2005, the Company resolved itsclaim filed in January 2003 related to pre-petition accountsreceivable, and to a conditional payment made by the Company to MCI inconnection with anticipated overearnings during the 1999-2000 monitoringperiod.

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In accordance with the MCIPlan of Reorganization, the Company received in October 2005 adistribution of cash and stock, with a combined fair value of approximately$1,400. The distribution was recognized in the Company’s consolidated statementof operations as an increase to network access service revenue and a decreaseto general and administrative expense of $800 and $600, respectively. As of December 31,2005, the Company held 31,292 shares of MCI common stock with an aggregatecarrying value of approximately $617. The Company’s investment in MCI commonstock is classified as an available-for-sale, short-terminvestment in the consolidated balance sheet. In October 2005, MCIshareholders approved a merger with Verizon. The merger was completed in January 2006.

**Broadband**
| ** **                                        | ** ** | **2005** | ** ** | **2004** | ** ** | **$Change** | ** ** | **%Change** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|-------------|------------|-------------|------------|
| Data                                              |       | $        | 25,780     |     | $          | 22,004      |       | $           | 3,776      |   |   | 17 | % |   |
| Video                                             |       | 9,609    |       | 7,000    |       | 2,609       |       |        | 37         |   |   |
| Voice                                             |       | 5,792    |       | 4,038    |       | 1,754       |       |        | 43         |   |   |
| Network Access                                    |       | 6,598    |       | 4,576    |       | 2,022       |       |        | 44         |   |   |
| Other                                             |       | 2,136    |       | 1,798    |       | 338         |       |        | 19         |   |   |
| Total operating  revenues from external customers |       | 49,915   |       | 39,416   |       | 10,499      |       |        | 27         |   |   |
| Intersegment  revenues                            |       | 1,693    |       | 1,784    |       | (91         | )          |        | (5         | ) |   |
| Operating  expenses*                              |       | 59,942   |       | 61,143   |       | (1,201      | )          |        | (2         | ) |   |
| Depreciation and  amortization                    |       | 16,451   |       | 11,397   |       | 5,054       |       |        | 44         |   |   |
| Loss from  operations                             |       | (24,785  | )          | (31,340  | )          | 6,555       |       |        | 21         |   |   |
| Net loss                                          |       | $        | (15,438    | )        | $          | (18,627     | )          | $           | 3,189      |   |   | 17 | % |   |

*Exclusive of depreciationand amortization

*Operating Revenues*

Operating revenues fromexternal customers in the Broadband segment increased $10,499 in 2005 comparedto 2004. The increase in Broadband revenues was due to the combined effects of (i) a24% increase in Revenue-generating units of broadband services and (ii) thecontinued expansion of the Business Broadband services, resulting in a 53%increase in business voice grade equivalents.

*Operating Expenses*

Total operating expenses in the Broadband segmentdecreased $1,201 in 2005 compared to 2004. As described in more detail in the *Consolidated Overview* section above, thisdecrease in operating expenses was due in large part to labor savings realizedthrough the cost containment and workforce consolidation plan and the REWARDprogram offered to certain eligible employees during the fourth quarter of 2004.These savings were partially offset by operating expenses of approximately $119related to certain eligible employees who accepted the REWARD program duringthe quarter ended March 31, 2005, also described in the *Consolidated Overview* section above.

Cost of services and products (exclusive ofdepreciation and amortization) increased $1,039 during 2005 compared to 2004,due primarily to (i) an increase in programming and transport costsrelated to the growth in Broadband subscribers and Residential BroadbandRevenue-generating units, (ii) an increase in network and generalsupport costs corresponding to the increased subscriber count, as well as theexpanded network footprint and (iii) an increase in property taxespredominantly due to the increase in property, plant and equipment as thenetwork is expanded. These increases were offset in part by a decrease inrepair and maintenance costs.

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Customer operations expense increased $668 in 2005compared to 2004. The year-over-year increase was attributable toan increase in customer service costs resulting from increased call volumecaused by the Residential Broadband subscriber growth.

General and administrative expense decreased $2,908 in2005 compared to 2004 due primarily to (i) the incurrence in 2004 of Sarbanes-Oxleyimplementation and compliance costs and professional and legal fees related tothe treasury investigation, as described below, and (ii) a decrease ininformation management expenses due to a consolidation of billing systems and areduction of maintenance and service agreements.

Depreciation and amortization increased $5,054 in 2005compared to 2004 primarily due to continued network build-out within theresidential broadband service territories.

**Wireless**
| ** **                                 | ** ** | **2005** | ** ** | **2004** | ** ** | **$Change** | ** ** | **%Change** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|-------------|------------|-------------|------------|
| Wireless revenues from  external customers |       | $        | 34,205     |     | $          | 31,261      |       |        | $          | 2,944 |   |   |   | 9 | % |   |
| Intersegment revenues                      |       | 2,592    |       | 1,699    |       |        | 893        |        |       |   | 53 |   |   |
| Operating expenses*                        |       | 37,784   |       | 38,266   |       |        | (482       | )           |       |   | (1 | ) |   |
| Depreciation and  amortization             |       | 11,891   |       | 11,972   |       |        | (81        | )           |       |   | (1 | ) |   |
| Loss from operations                       |       | (12,878  | )          | (17,278  | )          |        | 4,400      |        |       |   | 25 |   |   |
| Net loss                                   |       | $        | (8,217     | )        | $          | (10,823     | )          |        | $          | 2,606 |   |   |   | 24 | % |   |

*Exclusive of depreciationand amortization

*Operating Revenues*

Operating revenues fromexternal customers in the Wireless segment increased $2,944 in 2005 compared to2004 due primarily to (i) a 2% increase in Wireless subscriber base, (ii) anincrease in feature revenues, including voicemail and text and picturemessaging, (iii) an increase in equipment revenue due to an increase insubscribers and average handset price and (iv) an increase in local numberportability recovery fees, which were implemented during the second quarter of2004.

*Operating Expenses*

Total operating expenses for the Wireless segmentdecreased $482 in 2005 compared to 2004. The Wireless segment experienced anoverall annual decrease in operating expenses primarily due to the efficienciesgained through the corporate restructuring, as described in the *Consolidated Overview* section above.

Cost of services and products (exclusive ofdepreciation and amortization) increased $1,573 in 2005 compared to 2004primarily due to increases in (i) long distance expense due to an increasein the minutes of use and the introduction of additional unlimited callingplans and (ii) tower rent expense.

Customer operations expense decreased $1,427 in 2005compared to 2004 due primarily to a decrease in (i) sales and advertisingexpense as a result of reduced promotional campaigns and (ii) dealercommissions due to a decline in sales executed through dealer channels.

General and administrativeexpense decreased $628 in 2005 compared to 2004 due primarily to the incurrencein 2004 of Sarbanes-Oxley implementation and compliance costs andprofessional and legal fees related to the treasury investigation, as describedbelow.

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**Non-OperatingItems**

*Other InterestIncome and Expense, Net*

Consolidated investmentincome increased $244, or 121%, compared to 2004. The Company received dividendincome of $175 during 2005 as a result of the receipt of the shares of MCIcommon stock through the MCI Plan of Reorganization, as discussed above in the *Telecom Segment Results of Operations*section.In addition, interest income increased due to higher average interest ratesduring 2005. Consolidated interest expense increased $1,170, or 26%, during2005 as compared to 2004 due to an increase in short-term borrowings anda decrease in capitalized interest. An increase in the turnover rate ofconstruction projects contributed to lower capitalized interest costs.

*Corporate TreasuryLoss Recovery*

In December 2003, theCompany discovered certain irregular bank transactions and deposits in aroutine investigation following the abrupt resignation of the Company’sTreasury Analyst. An investigation revealed concealed illegal transfers inviolation of the Company’s investment and cash management policies. The Companyconcluded that the irregularities were limited to the 2003 calendar year andnearly all of the funds had been recovered; however, approximately $1,828remained outstanding as of December 31, 2003. During 2004, the Companyreceived an insurance recovery in the amount of $1,803, which was reflected asa non-operating gain in the Company’s 2004 consolidated financialstatements.

*Income Taxes*

Income taxes increased $4,406 in 2005 compared to 2004due to a corresponding increase in income subject to tax. The effective federaland state income tax rates were 38.0% and 30.6% for the years ended 2005 and2004, respectively. The change in the effective federal and state income taxrates was primarily due to an increase in income before income taxes for 2005.

As of December 31,2005, the Company had net operating loss carryforwards for federal income taxpurposes of approximately $33,385, which will expire in the years 2018 through2024, if not utilized. As of December 31, 2005, the Company also had netoperating loss carryforwards for state income tax purposes of approximately$355, which will expire in the years 2006 through 2014, if not utilized. TheCompany had a net state deferred asset of $2,175 and expects to generate futurestate taxable income in excess of the approximately $24,601 required to realizethe net deferred asset. As of December 31, 2005, the Company also hadresearch and development tax credit carryforwards of approximately $100 forfederal income tax purposes. The federal credit will expire in 2022 if it isnot utilized. The Company has an Alternative Minimum Tax carry forward of $322for federal and $343 for state, which do not expire.

**Liquidity andCapital Resources**

As reflected in the Consolidated Statements of CashFlows, net cash provided by operating activities was $65,695, $57,441 and$56,070 in 2006, 2005 and 2004, respectively. Net cash provided by operatingactivities during 2006 was due primarily to (i) net income of $5,738, (ii) non-cashcharges of $59,778 consisting primarily of depreciation and amortization due tocapital investments principally in the Broadband segment and (iii) anincrease in the change of the provision for deferred income taxes of $4,162.Cash provided by operating activities was offset in part by an approximate$3,249 decrease in the Company’s estimated and contractual shareable earningsobligations due primarily to payments in the form of a surcredit to end usersresulting from the November 2004 intrastate settlement agreement (see *Regulatory Matters* within the Telecom Segment Results ofOperations).

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Net cash used in investing activities was $55,041,$69,344 and $68,257 for 2006, 2005 and 2004, respectively. In all three yearsthe primary use of cash was capital expenditures for property, plant andequipment amounting to $55,393, $69,768 and $70,833 for 2006, 2005 and 2004,respectively.

Net cash used in financing activities was $11,916 and$8,702 in 2006 and 2004, respectively. Net cash provided by financingactivities was $1,417 in 2005. For all years, the Company’s primary use of cashwas for the payment of dividends and principal payments to retire long-termdebt. In addition, in 2006, $3,678 was used for the repurchase of the Company’scommon stock, offset by a $10,000 net increase in short and long-termborrowings.

The Company had working capital of $6,510 at December 31,2006. The increase in working capital during the twelve months ended December 31,2006 was due primarily to the retirement of short-term borrowings. Inaddition, as a result of the adoption of SFAS No. 158, as discussed below,working capital (i) increased due to the reclassification of accruedpension benefits from current to non-current liabilities and (ii) decreasedas a result of a change in the deferred income tax asset. As discussed below,the Company believes that its working capital position, the proceeds from thesale of SureWest Directories, and operating cash flows and borrowing capacityare sufficient to satisfy its liquidity requirements in the next twelve months.

The Company’s most significant use of funds in 2007 isexpected to be for (i) budgeted capital expenditures of approximately$55,000, (ii) scheduled payments of long-term debt of $3,636 and (iii) supportof the operations of SureWest Wireless up to an anticipated $1,350. Inaddition, during 2006 the payment of dividends, which is at the discretion ofthe Company’s Board of Directors, could be as much as $14,400 based on theCompany’s most recent dividend payments. A substantial portion of the 2007budgeted capital expenditures is at the discretion of the Company, anddependent upon the Company’s working capital position, operating cash flows andability to borrow, as described below. The Company is required to comply withits cable franchise agreements to continue its build-out in the franchiseareas.

The Company contributes to its defined benefit PensionPlan and Other Benefits Plans, which provide retirement benefits to allemployees. During 2006, the Company made contributions of $3,202 and $1,617 tothe Pension and Other Benefits Plans, respectively. Contributions are intendedto provide for benefits attributed to service to date. The Company’s fundingpolicy is to contribute annually an actuarially determined amount consistentwith applicable federal income tax regulations. As discussed in the *Consolidated Overview* section above, in January 2007the Company approved plan amendments which provide that benefits under thePlans will stop accruing for active participants effective April 1, 2007. TheCompany believes that future funding requirements will decrease significantlyas a result of the freeze of the Plans. The Company will continue to evaluatethe future funding requirements of the Plans and fund them as deemed necessary.The Company does not expect to make any contributions to the Pension or OtherBenefits Plans during 2007. See Note 7 of the Notes to the ConsolidatedFinancial Statements for a more detailed discussion on the Company’s Pensionand Other Post-retirement Plans.

As discussed more fully in the *RegulatoryMatters* section above, the CPUC instituted a rulemaking whichrequests comments as to whether SureWest Telephone should continue receivingthe $11,500 annually from the CHCF and the advisability and impacts of phasingout the EAS payments gradually over a period of approximately 5 years. In August 2006,the Company filed a Petition for Modification of D.05-08-004, whichseeks CPUC authorization for a graduated phase-down of its $11,500interim draw from the CHCF over a period of time that is intended to assure thecontinued maintenance of good service to SureWest Telephone customers whileavoiding precipitous rate increases. The Company’s Petition for Modificationproposes a transitional phase-down over a five-to-ten yearperiod and requests elimination of the requirement to file its cost proxy model.In December 2006, the CPUC issued an interim opinion providing for theCompany to reduce its annual draw from the CHCF by $1,300 on a monthly proratedbasis, to $10,200 in the aggregate from $11,500, to reflect a “consumerdividend” required in another regulatory 

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proceeding to be effective January 1, 2007. TheCompany will seek to recover the eliminated revenues through rate increasesand/or operating efficiencies. For a more detailed discussion, see *Regulatory Matters* within the TelecomSegment Results of Operations.

On May 1, 2006, the Company completed anunsecured Credit Agreement for a Term Loan facility and a Revolving Loanfacility (collectively “Loan Facilities”) in principal amounts up to $75,000and $25,000, respectively. Interest on the Loan Facilities is payable quarterlyand based on a LIBOR, variable interest rate, or a fixed interest rate pricingformula, or a combination, as defined in the Credit Agreement. Principalpayments on the outstanding amounts borrowed under the Term Loan facility as ofDecember 31, 2007 are due in equal quarterly installments commencing March 31,2008 through June 30, 2016. The Revolving Loan facility has an expirationdate of June 30, 2013. As of December 31, 2006, $40,000 wasoutstanding under the Term Loan Facility and no amounts were outstanding underthe Revolving Loan facility.

The Company had a business loan agreement with a bankfor a $50,000 unsecured line of credit, which was originally due to expire July 1,2006. As of December 31, 2005 there was $30,000 under this credit facilityat a weighted average interest rate of 5.75%, which was based on a LIBOR-basedpricing formula. As a result of the availability of the Loan Facilities theCompany terminated its business loan agreement effective May 1, 2006.

In November 2006, the Company’s Board ofDirectors increased the number of shares of the Company’s common stockauthorized for repurchase from 1.5 million shares to 2.5 million shares. Sharesare purchased from time to time in the open market or through privatelynegotiated transactions, subject to overall financial and market conditions.Through December 31, 2006, approximately 1.2 million shares of commonstock had been repurchased. The Company has remaining authorization from theBoard of Directors to repurchase an approximate 1.3 million additionaloutstanding shares. The purchase of common shares did not have a substantiveeffect on the average number of common shares outstanding or the calculation ofbasic and diluted earnings per share for the years ended 2006 and 2005 or thecalculation of loss per share for the year ended 2004.

The Company had cash and cash equivalents at December 31,2006, of $6,371. Subsequently, on February 28, 2007, the Company receivedthe pre-tax proceeds from the sale of its Directories business ofapproximately $110,123, as described above. Accordingly, the Company believesthat its working capital position, the proceeds from the sale of theDirectories business, operating cash flows and borrowing capacity aresufficient to satisfy its liquidity requirements for the next twelve months.This includes capital expenditures as required by the Company’s cable franchiseagreements, while maintaining adequate cash and cash equivalents. The Companybelieves, given its financial position and debt-to-equity position,it has substantial additional short-and long-term borrowingcapacity. As indicated above, a substantial portion of the Company’s 2007budgeted capital expenditures and cash dividend payments is at the discretionof the Company. Accordingly, the Company believes that it can modify itsplanned construction and commitments and cash dividend payments if the resultsof operations or available capital so require.

As of December 31,2006, the Company’s contractual obligations were as follows:
| ** **                                  | ** ** | **2007** | ** ** | **2008-2009** | ** ** | **2010-2011** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|----------|------------|---------------|------------|---------------|------------|----------------|------------|-----------|------------|
| Long-term  debt                             |       | $        | 3,636      |          |       | $             | 28,684     |           |       |      | $          | 40,684 |   |   |   | $ | 52,450 |   |   | $ | 125,454 |   |
| Capital leases                              |       | 6        |       |          | 13         |          |       |           | –     |      |       |   | – |   |   | 19 |   |
| Contractual  shareable earnings obligations |       | 1,857    |       |          | 1,856      |          |       |           | –     |      |       |   | – |   |   | 3,713 |   |
| Operating leases                            |       | 5,335    |       |          | 10,888     |          |       |           | 9,520      |      |       |   | 18,893 |   |   | 44,636 |   |
| Unconditional purchase  obligations         |       | 2,400    |       |          | 50         |          |       |           | –     |      |       |   | – |   |   | 2,450 |   |
|                                             |            |          |            |               |            |               |            |                |            |           |            |  |  |  |  |  |  |  |  |  |  |  |

 

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Dividends are declared atthe discretion of the Company’s Board of Directors. However, the Note PurchaseAgreement under which the Company issued its Series A and Series BSenior Notes, and the Credit Agreement contain financial and operatingcovenants that restrict, among other things, the payment of cash dividends, therepurchase of the Company’s capital stock, the making of certain otherrestricted payments and the incurrence of additional indebtedness. In addition,the Company is required to maintain certain financial ratios and minimum levelsof tangible net worth. At December 31, 2006, retained earnings ofapproximately $65,776 were available for the payments described immediatelyabove, under the Company’s Note Purchase Agreement and the Credit Agreement.

**Critical AccountingPolicies and Estimates**

Below is a summaryof the Company’s critical accounting policies and estimates, which are morefully described in the referenced Notes to the Company’s Consolidated FinancialStatements. Management has discussed development and selection of criticalaccounting policies and estimates with the Company’s Audit Committee.

·      As discussed more fully in Note 1, inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 142,*Goodwill and Other Intangible Assets,*goodwill and wireless licenses are reviewed for impairment annually or morefrequently if an event occurs or circumstances change that would reduce thefair value below its carrying value. The impairment test for goodwill requiresthe Company to estimate the fair value at the reporting unit level. Todetermine the fair value in 2006, the Company obtained an independent valuationof the Company’s goodwill using a discounted cash flow model. Assumptions usedin this model include the following:

·      cash flow assumptionsregarding investment in network facilities, distribution channels and customerbase (the assumptions underlying these inputs are based upon a combination ofhistorical results and trends, new industry developments and the Company’s businessplans);

·      a15% weighted average cost of capital based on industry weighted averaged costof capital; and

·      noterminal growth rate.

The carrying value of the Company’s goodwill was$2,171 as of December 31, 2006. The fair value of the Company’s goodwillis based on the value associated with the telephone reporting unit, whichbenefits from the goodwill. The telephone reporting unit includes SureWestTelephone and certain related non-regulated services. When determiningthe fair value, the use of different estimates or assumptions within thediscounted cash flow model could result in a different fair value. For example,the Company used a discount rate of 15.0% and no terminal growth rate in itsassessment of fair value in 2006. At November 30, 2006 the fair value ofthe telephone reporting unit was $199,900 and the associated carrying value was$22,800. If the discount rate were to increase 2%, the fair value of thetelephone reporting unit would decrease by approximately $24,000, but would notresult in an impairment of goodwill.

The Company’s wireless licenses include PersonalCommunications Services (“PCS”) and Local Multipoint Distribution System (“LMDS”)licenses. The carrying value at December 31, 2006 of the PCS and LMDSlicenses was $8,925 and $4,641, respectively. In assessing the recoverabilityof the Company’s PCS licenses, the Company obtained an independent valuation in2006, which reviewed transactions involving sales of comparable wirelesslicenses in the aftermarket, using characteristics of the license and therelated market, including geographic location, market size and megahertzfrequency.

In assessing the recoverability of the Company’s LMDSlicenses, the Company obtained an independent valuation, as comparable licensesales data was not available. The independent valuation 

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estimates fair value of the Company’s LMDS licensesusing a discounted cash flow model. Assumptions used in this model include thefollowing:

·      cashflow assumptions regarding investment in network facilities, distributionchannels and customer base (the assumptions underlying these inputs are basedupon a combination of historical results and trends, new industry developmentsand the Company’s business plans);

·      a20% weighted average cost of capital based on industry weighted averaged costof capital adjusted to reflect the inherent risks associated with theintroduction of a new service offering; and

·      a5% terminal value growth rate.

The use of different estimates or assumptions withinthe discounted cash flow model when determining fair value of the Company’sLMDS licenses could result in different values for these licenses. For example,the Company used a discount rate of 20% and a terminal growth rate of 5% in itsassessment of fair value in 2006. If the discount rate were to increase 1%, thefair value of the LMDS licenses would decrease by $1,000, which would result inan impairment charge of approximately $242 based on the carrying value of theLMDS licenses as of December 31, 2006. In addition, the Company’s LMDSlicenses may be impaired in the future if the estimates and assumptions used inthe 2006 LMDS license discounted cash flow model are not met.

If the estimated fair value is less than the carryingvalue, then the carrying value is written down to the fair value. As a resultof the Company’s annual test for 2006, no impairment of either goodwill or PCSor LMDS licenses was indicated. During 2006, the Company was unaware of anyevents or changes in circumstance that would require a test of impairment thatmay potentially reduce the fair value below the carrying value.

·      As discussed more fully inNote 3, total revenues from telephone services are affected by rates authorizedby various regulatory agencies. The FCC monitors SureWest Telephone’sinterstate earnings through the use of annual cost separation studies preparedby SureWest Telephone. The FCC establishes rules that carriers must followin the preparation of the annual studies. Based on these rules, the Company isrequired to prospectively set its annual interstate rates based on theaforementioned cost separation studies. These cost studies include estimatesand assumptions regarding various financial data including operating expenses,taxes and investment in property, plant and equipment. Non-financial dataestimates are also utilized in the preparation of these cost studies, includingprojected demand usage and detailed network information. The Company must alsomake estimates of the jurisdictional separation of this data to assign currentfinancial and operating data to the interstate or intrastate jurisdiction.These estimates are finalized in future periods as actual data becomesavailable to complete the separation studies. The Company also participates inthe NECA pool for certain interstate revenues. In addition to the estimatesnoted above, the Company’s earned rate-of-return from itsparticipation in the NECA pool can also be impacted by the earnings and data ofother carriers who participate in the pool.

In accordance with the NRF, SureWest Telephone issubject to ongoing monitoring and reporting requirements by the CPUC, and itwas initially required to share earnings with customers based on its earnedannual rate-of-return. The Company utilizes models, which rely onestimates regarding the jurisdictional separation of financial data andoperational data into the interstate jurisdictions as discussed previously forthe purposes of calculating its earned annual rate-of-return.However, as discussed more fully in Note 3, SureWest Telephone has entered intoa settlement agreement, which was approved by the CPUC in November 2004,to cease intrastate sharing requirements beginning January 1, 2005 throughat least December 31, 2010. The settlement agreement also resolvesexisting sharing obligations and related earnings issues for the monitoringperiods 2000-2004.

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As a result of these estimates and assumptions, it isreasonably possible that management’s estimates of SureWest Telephone’sshareable earnings obligations could change in the near term, and the amountsinvolved could be material. For example, the CPUC approved a settlementagreement on November 19, 2004 that resolved the Company’s intrastateshareable earnings for the years 2000 through 2004. In accordance with thissettlement agreement, the Company recorded $2,948 in local revenues due to achange in accounting estimate in the fourth quarter of 2004. This increase inrevenue resulted in a decrease of the Company’s net loss by $2,046 ($0.14 pershare). See Note 3 for a more detailed discussion regarding the settlementagreement.

·      As discussed more fully inNote 2, the Company recognizes revenue when (i) persuasive evidence of anarrangement between the Company and the customer exists, (ii) delivery ofthe product to the customer has occurred or service has been provided to thecustomer, (iii) the price to the customer is fixed or determinable and (iv) collectibilityof the sales price is reasonably assured. Revenues based on a flat fee, derivedprincipally from local telephone, dedicated network access, datacommunications, Internet access service, residential/business broadband serviceand non-contract wireless services, are billed in advance and recognizedin subsequent periods when the services are provided. Contract wirelessservices are billed in arrears. Revenues based on usage, derived primarily fromnetwork access, roaming and long distance services, are recognized monthly asservices are provided. Incremental direct costs of telecommunications serviceactivation are charged to expense in the period in which they are incurred.

Directory advertising revenues and costs related topublishing and distributing directories are recognized using the “circulationperiod” method, under which revenues and related costs are recognized ratablyover the expected useful life of the directory, generally one year from thedate of publication. For all other operations, revenue is recognized whenproducts are delivered or services are rendered to customers.

The Company applies the Financial Accounting StandardsBoard’s (“FASB”) Emerging Issues Task Force (“EITF”) Issue No. 00-21,*Revenue Arrangements with Multiple Deliverables,*to all wireless handset sales below cost, which approximates fair value in theabsence of an activation “subsidy”, when receiving an up-front fee of anykind (e.g., a service activation fee). The application of EITF Issue No. 00-21results in the immediate recognition of all or a portion of such up-frontfees as equipment sales revenue. Additionally, when the Company activateswireless service for a customer, but does not concurrently provide the customerwith a handset, any up-front fees received continue to be deferred andamortized over the expected term of the customer relationship. The Companyprovides a general right of return within the first 30 days of service for afull refund of the handset price. The estimated equipment return allowanceassociated with this right of return is estimated based on historicalexperience.

·      As discussed more fully inNote 1, the Company maintains allowances for doubtful accounts for estimatedlosses resulting from the potential inability of its customers to make requiredpayments. In evaluating the collectibility of its accounts receivable, theCompany assesses a number of factors including a specific customer’s or carrier’sability to meet its financial obligations to the Company, the length of timethe receivable has been past due and historical and future expectations ofconditions that may impact the Company’s ability to collect its accountsreceivable. If circumstances change or economic conditions worsen such that theCompany’s past collection experience is no longer relevant, the Company’sestimate of the recoverability of its accounts receivable could be furtherreduced from the levels reflected in the Company’s consolidated balance sheet.If uncollectibility of the Company’s billed revenue changes by 1%, the Companywould expect an increase in uncollectible expense of approximately $2,270. Asof December 31, 2006, the Company had three customers that accounted for14% of consolidated accounts receivable, net of allowances. Although managementbelieves that these customers are creditworthy, a severe adverse impact ontheir business operations could have a 

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correspondingmaterial effect on their ability to pay timely and, therefore, on the Company’sresults of operations, cash flows and financial condition. In addition, certainrevenues are subject to refund if the customer terminates services or returnsequipment within a stipulated time period, or if certain performance criteriaare not met. Accordingly, the Company maintains accounts receivable allowancesand recognizes certain customer refund liabilities, through charges torevenues, based on the Company’s best estimates of the resolution of thesecontingencies, which are based on historical experience.

·      As discussed more fully inNote 1, the Company states its inventories held for sale at lower of cost ormarket. In assessing the ultimate recoverability of inventories, the Company isrequired to make estimates regarding future customer demand and technologicaladvances of equipment.

·      As discussed more fully inNote 1, property, plant and equipment are recorded at cost. Retirements andother reductions of regulated telephone plant and equipment are charged againstaccumulated depreciation with no gain or loss recognized in accordance with thecomposite group remaining life methodology utilized for telephone plant assets.When property applicable to non-telephone operations is sold or retired,the asset and related accumulated depreciation are removed from the accountsand the associated gain or loss is recognized. Property, plant and equipment isdepreciated or amortized using the straight-line method over theirestimated economic lives. The economic lives are estimated at the time theassets are acquired and are based on historical experience with similar assets,as well as anticipated technological or other changes. If technological changeswere to occur more rapidly than anticipated or differently than anticipated,the economic lives assigned to these assets may need to be shortened, resultingin the recognition of increased depreciation and amortization expense in futureperiods. Likewise, if the anticipated technological or other changes occur moreslowly than anticipated, the life of the asset group could be extended based onthe life assigned to new assets added to the group. This could result in areduction of depreciation and amortization expense in future periods. TheCompany reviews the estimated useful lives of its property, plant and equipmentonce every three years, or when events or circumstances indicate that thecarrying amount may not be recoverable over the remaining lives of the assets.In assessing the recoverability of the Company’s property, plant and equipment,the Company must make assumptions regarding estimated future cash flows andother factors to determine the fair value of the respective assets.

·      As discussed more fully inNote 1, the Company accounts for asset retirement obligations in accordancewith SFAS No. 143, *Accounting for AssetRetirement Obligations*and FASB Interpretation (“FIN”) No. 47, *Accounting for Conditional Retirement Obligations*,which requires the Company to recognize a retirement obligation when a legalobligation exists to remove an asset at some point in the future or iflegislation exists that requires special disposal procedures of the asset. TheCompany believes it may have potential retirement obligations relating to itswireless cell sites and disposal obligations relating to certain buildingmaterials containing asbestos. Based on terms outlined in its tower leases, theCompany is obligated to return the land or facilities to their originalcondition at the end of the cell site lease term, should the lease beterminated. Based on the Company’s estimates it believes that the disposalrequirement relating to certain building materials containing asbestos is theexpected retirement date of the underlying assets. The Company has used aprobability-weighted cash flow approach in estimating its potentialretirement obligations. The Company calculates the net present value of theretirement obligation assuming an inflation rate of 3%, a discount rate of 7%and a market risk premium of 4%. The Company has also assumed the settlementdate for its wireless towers to be 25 years from the date the asset is placedinto service. The Company has estimated that the expected retirement date ofits buildings that contain asbestos is 2025. The Company has also used aprobability-weighted assessment to address the uncertainty regarding thetiming of future cash flows to settle the potential liability. The Companybelieves that utilizing probabilities for its wireless towers 

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of less than 100%is appropriate because the Company believes the likelihood of incurringmaterial asset retirement expenditures is remote. The Company used a 100%probability factor of its building materials containing asbestos. The Companymonitors the estimates and assumptions used in determining its potential assetretirement obligations for its cell sites and buildings containing asbestos.However, the Company believes it is remote that any future adjustment to its assetretirement liability for obligations existing as of December 31, 2006 willbe material to the Company’s consolidated financial statements.

·      As discussed more fully inNotes 1 and 6, the Company accounts for income taxes using the liabilitymethod. Under this method, deferred tax assets and liabilities are determinedbased on differences between the financial reporting and tax bases of assetsand liabilities and are measured using the enacted tax rates and laws that areexpected to be in effect when the differences are expected to reverse. TheCompany does not have a valuation allowance on its deferred tax asset as of December 31,2006 or 2005 because it believes it is more likely than not that such deferredtax asset will be realized. Should the Company determine that it would not beable to realize all or part of its deferred tax asset in the future, anadjustment to the deferred tax asset would be charged to income in the periodin which the determination was made.

·      As discussed more fully inNote 7, the Company has pension and post-retirement benefit costs andobligations. The Company’s pension and post-retirement benefitobligations are actuarially determined based on estimates of discount rates,long-term rates of return on plan assets and increases in futurecompensation levels. Changes in these estimates and other factors couldsignificantly impact the Company’s pension and post-retirement benefitcosts and obligations. Assumed health care cost trend rates have a significanteffect on the amounts reported for the health care plans. A one-percentage-pointchange in assumed health care cost trend rates would have the followingeffects:
| ** **                                                                 | ** ** | **1-Percentage-  Point Increase** | ** ** | **1-Percentage-  Point Decrease** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|
| Effect on total  2006 post-retirement service and interest cost            |       |                                   | $          | 72                                     |       |   |   | $ | (63 | ) |   |
| Effect on post-retirement  benefit obligation as of December 31, 2006 |       |                                   | $          | 137                                    |       |   |   | $ | (130 | ) |   |

 

For 2006, the discount rates used for the Company’spension and post-retirement benefit obligations were 6.00% and 5.50%,respectively. The discount rates were determined based on current yields onhigh quality corporate fixed-income investments with maturitiescorresponding to the expected duration of the benefit obligations. The rateused for the post-retirement benefit obligation reflects heavierweighting for retired participants of shorter durations.

The expected return on assets (“EROA”) rate isdetermined based on the current and projected investment portfolio mix andestimated long-term investment returns for each asset class. In 2005, theCompany used an EROA of 8.5%. The Company evaluated the appropriateness of theEROA rate for 2006 by analyzing the long-term returns for domestic andinternational equities, as well as domestic fixed income instruments. Based onthe evaluation the Company decreased the EROA for 2006 to 8.0% to betterreflect the current economic environment. The 0.5% decrease in the EROA rateincreased the Company’s 2006 pension expense approximately $550, or 9.0%.

The Company’s decision to freeze the Pension Plan willalso affect the Company’s financial statements and results of operationsbeginning in 2007. The freeze, effective April 1, 2007, will reduce boththe Company’s operating expenses and cash requirements. Although the futureimpact of the freeze has not been determined, for the fiscal years 2003 through2006, cash contributions to the Pension Plan 

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ranged from $3,000 to $9,000, and annual service costaveraged approximately $5,000 over the same time period.

·      As discussed more fully inNotes 3 and 8, the Company is a party to a variety of litigation, regulatoryproceedings and other contingencies that arise in the ordinary course ofbusiness. The Company is required to assess the likelihood of any adversejudgments or outcomes to these matters, as well as potential ranges of probablelosses for certain of these matters. The determination of the liabilitiesrequired, if any, for loss contingencies is made after careful analysis of eachindividual issue. In the opinion of management, the ultimate outcome of thesematters will not materially affect the Company’s consolidated financialposition and results of operations.

·      As discussed more fully inNote 9, the Company currently sponsors two Equity Incentive Plans (the “StockPlans”) for certain employees, outside directors and consultants of theCompany, which were approved by the Company’s shareholders. The Stock Planspermit issuance by the Company of awards in the form of restricted shares,stock units, performance shares, stock options and stock appreciation rights.

Effective January 1, 2006, the Company adoptedSFAS No. 123(R), *Share-BasedPayment*, using the modified-prospective-transitionmethod. Since the fair value recognition provisions of SFAS No. 123, *Accounting for Stock-Based Compensation*and SFAS No. 123(R) were materially consistent under the Company’sPlans, the adoption of SFAS No. 123(R) did not have a significantimpact on the Company’s financial position or results of operations. TheCompany has not made any stock option grants since 2003 and consequently thecompensation expense resulting from stock option grants prior to 2003 waseither fully expensed as of January 1, 2006, or not material to theCompany’s financial statements.

Prior to January 1, 2006, the Company accountedfor the Stock Plans under the fair value recognition provisions of SFAS No. 123.Under the provisions of SFAS No. 148, *Accountingfor Stock-Based Compensation–Transition and Disclosure*, thefair value method of accounting was applied to all employee awards granted,modified, or settled after January 1, 2003.

As of December 31, 2006, total unrecognizedcompensation cost related to nonvested restricted stock was $1,959 and will berecognized over a weighted-average period of approximately two years. Thetotal fair value of the restricted common stock and restricted common stockunits that vested for the years ended December 31, 2006, 2005 and 2004 was$1,424, $833 and $591, respectively.

Stock based compensation for restricted stock reflectsthe cost of restricted stock that is expected to vest. The Company calculatedan estimated forfeiture rate based on historic forfeiture experience to date. Ifactual forfeitures are not consistent with the Company’s estimated forfeiturerate, it will be required to record adjustments to compensation expense.

The Black-Scholes-Merton option-pricingmodel used to value stock option grants includes assumptions regarding dividendyields, expected volatility, expected lives and risk-free interest rates.These assumptions reflect management’s best estimates, but these items involveinherent uncertainties based on market conditions generally outside of thecontrol of the Company.

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**RecentAccounting Pronouncements**

In February 2007, theFASB issued SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities–Including an Amendment of FASBStatement No. 115*. This standard permits an entity to elect tomeasure many financial instruments and certain other items at fair value.Unrealized gains and losses on items for which the fair value option has beenelected will be recognized in earnings at each subsequent reporting date. SFAS No. 159is effective as of the beginning of an entity’s first fiscal year that beginsafter November 15, 2007. Early adoption is permitted as of the beginningof the previous fiscal year provided that the entity makes that choice in thefirst 120 days of that fiscal year and also elects to apply the provisions ofFASB Statement No. 157, *Fair Value Measurements*.The Company is currently evaluating the impact, if any, the adoption of SFAS No. 159will have on its consolidated financial statements.

In September 2006,the FASB issued SFAS No. 157,*FairValue Measurements,* which defines fair value, establishes aframework for measuring fair value in generally accepted accounting principles,and expands disclosures about fair value measurements. SFAS No. 157 iseffective for financial statements issued for fiscal years beginning after November 15,2007, and for interim periods within those fiscal years. The Company iscurrently evaluating the impact, if any, the adoption of SFAS No. 157 willhave on its consolidated financial statements.

In September 2006,the FASB issued SFAS No. 158, *Employers’ Accounting forDefined Benefit Pension and Other Postretirement Plans, an Amendment of FASBStatements No. 87, 88, 106 and 132(R).*SFAS No. 158 requires anemployer to recognize the funded status of a defined benefit postretirementplan as an asset or liability in its statement of financial position and torecognize changes in that funded status in the year in which the changes occurthrough comprehensive income. The Statement also requires an employer to measurethe funded status of a plan as of the date of its year-end statement offinancial position. Prior to the adoption of SFAS No. 158, the Companyused its fiscal year end as the measurement date for the Plans; consequentlythis requirement did not have an effect on the Company’s consolidated statementof financial position for the year ended December 31, 2006. SFAS No. 158requires an employer with publicly traded equity securities to initiallyrecognize the funded status of a defined benefit postretirement plan and therequired disclosures as of the end of the fiscal year ending after December 15,2006. See Note 7, for a more detailed discussion of the effects ofapplying the provisions of SFAS No. 158 to the Company’s consolidatedfinancial statements. The Company adopted SFAS No. 158 on December 31,2006.

In June 2006, theFASB issued FIN No. 48, *Accounting forUncertainty in Income Taxes.*FIN No. 48 clarifies theaccounting for uncertainty in income taxes recognized in a company’s financialstatements in accordance with FASB No. 109, *Accounting for Income Taxes*. Specifically, the pronouncementprescribes a recognition threshold and a measurement attribute for thefinancial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. This interpretation also providesguidance on de-recognition, classification, interest and penalties,accounting in interim periods, disclosure and transition of uncertain taxpositions. The interpretation is effective for fiscal years beginning after December 15,2006. The Company is currently evaluating the impact that FIN No. 48 willhave on its consolidated financial statements.

Effective January 1,2006, the Company adopted SFAS No. 154, *AccountingChanges and Error Corrections.*The Statement applies to allvoluntary changes in accounting principle, and changes the requirements foraccounting for and reporting of a change in accounting principle. The adoptionof SFAS No. 154 has not had a material effect on the Company’s consolidatedfinancial position, results of operations or cash flows.

**FactorsThat Could Affect Future Results**

As a result of thefollowing factors, as well as other variables affecting our operating results,past financial performance may not be a reliable indicator of futureperformance, and historical trends should not necessarily be used to anticipateresults or trends in future periods.

Representative examples ofthese factors include (without limitation) the following:

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*We expect to continue to face significant competitionin all parts of our business and the level of competition is expected tointensify.*   The telecommunicationsindustry is highly competitive. We face actual or potential competition frommany existing and emerging companies, including other incumbent and competitivelocal telephone companies, long-distance carriers and resellers, wirelesstelephone companies, Internet service providers, satellite companies and cabletelevision companies. We may not be able to successfully anticipate and respondto various competitive factors affecting the industry, including regulatorychanges that may affect our competitors and us differently, new technologiesand services that may be introduced, changes in consumer preferences,demographic trends and discount pricing strategies by competitors. As theincumbent carrier in Sacramento, AT&T enjoys certain business advantages,including its size, financial resources, favorable regulatory position, brandrecognition and connection to virtually all of our customers and potentialcustomers there. As the largest cable operator in Sacramento and Placer County,Comcast enjoys certain business advantages, including its size, financialresources, ownership or superior access to programming and other content, brandrecognition, and first-in-the-field advantages with acustomer base that generates positive cash flow for its operations. We faceintense competition in our markets for long-distance, Internet access andother ancillary services that are important to our business and to our growthstrategy.

*We must adapt to rapid technological change.*   Technologicaldevelopments could increase our costs and cause a decline in demand for ourservices. In addition, technology changes can reduce the costs of entry forothers and give competitors significant new advantages. If we do not replace orupgrade technology and equipment that becomes obsolete, we will be unable tocompete effectively because we will not be able to meet the needs orexpectations of our customers, and we may be placed at a cost disadvantage inoffering our services. Additionally, replacing or upgrading our infrastructurein the future could result in significant capital expenditures.

*We are subject to a complex and uncertain regulatoryenvironment.**  *Someparts of our business are extensively regulated, and the nature of regulationcontinues to undergo fundamental change and reinterpretation. Many businessesthat compete with the Company are comparatively less regulated. Manysignificant regulatory decisions have had to be accommodated in recent years,and there are pending decisions on issues affecting the Company that are ofgreat importance.

*Our operations have undergone material changes, andour actual operating results can be expected to differ from the resultsindicated in our historical financial statements.*   Asa result of our 2002 acquisition of assets, which launched our residentialbroadband business, and the subsequent expansion of our video business, our mixof operating assets differs from those operations upon which our historicalfinancial statements are based. In addition, the February sale of ourdirectories business will affect our results of operations in the future.Consequently, our historical financial statements may not be reliable as anindicator of future results.

*Our success depends upon our ability to manage ourgrowth and expansion. If our recent acquisitions and growth initiatives are notsuccessful, we could suffer an adverse effect on our business and results ofoperations.*   Our growth strategy willcontinue to require us to invest significant capital in facilities and servicesthat may not achieve the desired returns. Our future success depends, in part,upon our ability to manage our growth, including our ability to build networkand related facilities to serve new customers, integrate our operations to takeadvantage of new capabilities and systems; attract and retain skilled personnelacross the Company, effectively manage the demands of day to day operations innew areas while attempting to execute our business strategy, and realize theprojected growth and revenue targets developed by Company management.

*We receive support from various funds establishedunder federal and state law and the continued receipt of that support is notassured.*   While we do not receiveany support from the rural or non-rural Federal Universal Service highcost loop fund, we do receive payments from various other federal or stateprograms. These include interstate CL support, CHCF and the Lifeline, Educationand Libraries 

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programs. These governmental programs are reviewed andamended from time to time, and are likely to change in the near future. Asdescribed in the Regulation section above, the Company in 2007 will receivefunding of $10,200 from the CHCF, a program designed by the CPUC to establish afair and equitable local rate structure and to reduce any disparity in therates charged by certain telephone companies serving high-cost areas. Theamount of this support from the CHCF is the subject of pending regulatoryproceedings, and its continuation is dependent upon many factors. In addition,the state legislative authorization for the CHCF is scheduled to expire January 1,2009. The outcome and impact on the Company’s operations resulting from futurechanges to these governmental programs cannot be determined at this time.

*We could be harmed by the recent developmentsaffecting other communications companies.*   Therehave been numerous bankruptcies and other financial difficulties experienced byother carriers and suppliers in the telecommunications and Internet sectors.Similar situations with our suppliers, some of whom provide products andservices for which there are few substitutes, could cause us to experiencedelays, service interruptions or additional expenses. Situations with carrierand other customers could affect our ability to collect services that have beenprovided.

*We depend on third parties, over whom we have nocontrol, to deliver our services.*   Becauseof the interconnected nature of the telecommunications industry, we dependheavily on other local telephone companies, long-distance carriers, andnumerous other third parties to deliver our services. In addition, we aredependent on easements, franchises and licenses from various private partiessuch as established telephone companies and other utilities, railroads, long-distancecompanies, and from state highway authorities, local governments and transitauthorities for access to aerial pole space, underground conduits and otherrights-of-way in order to construct and operate our networks. Thefailure to maintain in effect the necessary third party arrangements onacceptable terms would have an adverse effect on our ability to conduct ourbusiness.

*We are subject to corporate governance and internalcontrol reporting requirements, and our failure to comply with existing andfuture requirements could adversely affect our business.*   Pursuantto Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”)and related Securities and Exchange Commission rules, we have issued a reportof management’s assessment of the effectiveness of our internal controls at December 31,2006. In addition, our Independent Registered Public Accounting Firm auditedand reported on management’s assessment. Management concluded that the Company’sinternal control over financial reporting was effective at December 31,2006. If we are unable to maintain effective internal controls or if futuredeficiencies are not adequately addressed, we could experience accountingerrors that could result in misstatements of our financial position and resultsof operations, potential restatements of our financial statements or otherwiseadversely affect our business, reputation and results of operations. Inferiorinternal controls could also cause investors to lose confidence in our reportedfinancial information, which could have a negative effect on the trading priceof our securities.

**Regulatoryand Legal Matters**

SureWest Telephone issubject to regulation by the FCC and CPUC. In the past, there have been variousproceedings before these agencies to which SureWest Telephone has been a party.In 1996, Congress passed the Telecommunications Act of 1996 (the “Act”), whichsignificantly changed the regulatory environment for telecommunicationscompanies. Beginning in 1996, the FCC conducted proceedings and adopted ordersimplementing the Act’s provisions to open local exchange service markets, suchas the market of SureWest Telephone, to competition. These proceedings andorders address interconnection, intercarrier compensation, access charges,universal service and Internet protocol (“IP”) enabled service. With respect tolocal competition, the FCC rules outline pricing methodologies for thestates to follow when setting rates for incumbent carriers (such as SureWestTelephone) to charge competitors for resale, interconnection and unbundlednetwork elements.

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Due to the ongoing actionstaken by the FCC to promulgate rules and regulations on interconnectionaccess charges and universal service reform, and the various on-goinglegal challenges considering the validity of these FCC orders, it is not yetpossible to determine fully the impact of the Act and related FCC regulationson SureWest Telephone’s operations.

TheCompany’s financial condition and results of operations have been and will beaffected by recent and future proceedings before the CPUC and FCC. Pendingbefore the FCC and CPUC are proceedings, which are considering:

·       Additionalrules governing the opening of markets to competition and the regulationof the competing telecommunications providers;

·       Thenature and extent of the compensation, if any, to be paid by carriers and otherproviders to one another for network use, and the sums to be recovered throughend users and other sources;

·       Thegoals and definition of universal telephone service in a changing environment,including examination of subsidy support mechanisms for subscribers ofdifferent carriers (including incumbent carriers) and in various geographicareas;

·       Rules thatwill provide non-discriminatory access by competing service providers tothe network capabilities of local exchange carriers; and

·       Theregulated rates and earnings of SureWest Telephone.

There are a number of pendingand anticipated other regulatory proceedings occurring at the federal and statelevels that may have a material impact on SureWest Telephone. These regulatoryproceedings include, but are not limited to, consideration of changes to theinterstate universal service fund, intercarrier compensation, reform and theregulation of local exchange carriers and their competitors, and regulation ofIP-enabled services. The outcomes and impact on SureWest Telephone’soperations of these proceedings and related court matters cannot be determinedat this time.

The eventual impact on theCompany of the effect of all the proceedings described above cannot presentlybe determined.

**Item7A.**                Quantitative andQualitative Disclosures About Market Risk.

The Company has limitedexposure to the impact of interest rate fluctuations. To manage its exposure tointerest rate fluctuations, the Company uses a combination of variable short-termand fixed rate long-term financial instruments. In addition, the Companyhas a contractual obligation related to its intrastate shareable earnings inthe form of a surcredit to its customers over a period of four years beginning January 1,2005, which is subject to variable interest rates. The Company does not usederivative financial instruments in its investment portfolio or for any otherpurposes.

The Company primarilyenters into debt obligations to fund operations and planned capitalexpenditures. The Company currently has no cash flow exposure related to itslong-term debt obligations as all obligations are at fixed rates. As of December 31,2006, the Company had fixed rate debt obligations of $125,454 with an averageinterest rate of 5.6%. Based on borrowing rates currently available for loanswith similar terms and maturities, the estimated fair value of long-termdebt as of December 31, 2006 was $124,947.

The Company currently hasno outstanding short-term debt obligations as of December 31, 2006. TheCompany believes there is limited exposure to market risk for change ininterest rates related to contractual shareable earnings obligations. Theinterest rate on the contractual shareable earnings obligations is variablebased on a 30-day commercial paper rate. Assuming a fluctuation of 100basis points in the interest rate of the contractual shareable earningsobligations, the fair value would increase $45 or decrease $39. As of December 31,2006, the Company had variable rate debt obligations of $3,713 with an averageinterest rate of 3.0%.

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**Item8. Financial Statements and Supplementary Data.**
|                                                                                                                              | ** ** | **Page** |
|------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| Report of Independent Registered Public Accounting  Firm                                                                     |       | 52       |
| Consolidated Statements of Operations for each of the  three years in the period ended December 31, 2006                |       | 53       |
| Consolidated Balance Sheets as of December 31,  2006 and 2005                                                           |       | 54       |
| Consolidated Statements of Shareholders’ Equity for  each of the three years in the period ended December 31, 2006 |       | 56       |
| Consolidated Statements of Cash Flows for each of the  three years in the period ended December 31, 2006                |       | 57       |
| Notes to Consolidated Financial Statements                                                                                   |       | 58       |

 

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**Report ofIndependent Registered Public Accounting Firm**

The Board of Directors and Shareholders of SureWestCommunications

We have audited the accompanying consolidated balancesheets of SureWest Communications as of December 31, 2006 and 2005, andthe related consolidated statements of operations, shareholders’ equity, andcash flows for each of the three years in the period ended December 31,2006. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of SureWest Communications at December 31, 2006 and 2005, and theconsolidated results of its operations and its cash flows for each of the threeyears in the period ended December 31, 2006, in conformity with U.S.generally accepted accounting principles.

We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theeffectiveness of SureWest Communications’ internal control over financialreporting as of December 31, 2006, based on criteria established inInternal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission and our report dated March 9, 2007expressed an unqualified opinion thereon.

Asdiscussed in Note 1 to the consolidated financial statements, in 2006 theCompany adopted Statement of Financial Accounting Standards No. 158, *Employers’ Accounting for Defined Benefit Pension and OtherPostretirement Plans, an Amendment of Financial Accounting Standards BoardStatements No. 87, 88, 106 and 132(R) *and Statement ofFinancial Accounting Standards No. 123(R), *Share-Based Payment*. 
|  |   | /s/ Ernst & Young LLP |
|--|--------|--------------------------------|

 

Sacramento,California

March 9, 2007

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**SUREWESTCOMMUNICATIONSCONSOLIDATED STATEMENTS OF OPERATIONS**(amounts in thousands, except per share amounts)
| ** **                                                                       | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                       | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Operating revenues:                                                              |       |                                        |       |   |   |   |   |
| Telecom                                                                          |       | $                                           | 128,758    |   | $ | 134,468 |   | $ | 141,086 |   |
| Broadband                                                                        |       | 59,794                                      |       | 49,915 |   | 39,416 |   |
| Wireless                                                                         |       | 34,193                                      |       | 34,205 |   | 31,261 |   |
| Total operating  revenues                                                        |       | 222,745                                     |       | 218,588 |   | 211,763 |   |
| Operating  expenses:                                                             |       |                                        |       |   |   |   |   |
| Cost of services  and products (exclusive of depreciation and amortization) |       | 77,123                                      |       | 77,071 |   | 80,853 |   |
| Customer  operations and selling                                                 |       | 36,101                                      |       | 34,595 |   | 37,175 |   |
| General and  administrative                                                      |       | 33,084                                      |       | 37,222 |   | 43,820 |   |
| Depreciation and  amortization                                                   |       | 59,778                                      |       | 53,770 |   | 48,596 |   |
| Total operating  expenses                                                        |       | 206,086                                     |       | 202,658 |   | 210,444 |   |
| Income from  operations                                                          |       | 16,659                                      |       | 15,930 |   | 1,319 |   |
| Other income (expense):                                                          |       |                                        |       |   |   |   |   |
| Investment income                                                                |       | 504                                         |       | 445 |   | 201 |   |
| Interest expense                                                                 |       | (6,882                                      | )          | (5,675 | ) | (4,505 | ) |
| Corporate  treasury loss recovery                                                |       | –                                      |       | – |   | 1,803 |   |
| Other, net                                                                       |       | (613                                        | )          | (414 | ) | (443 | ) |
| Total other  income (expense), net                                               |       | (6,991                                      | )          | (5,644 | ) | (2,944 | ) |
| Income (loss)  before income taxes                                               |       | 9,668                                       |       | 10,286 |   | (1,625 | ) |
| Income tax  expense (benefit)                                                    |       | 3,930                                       |       | 3,908 |   | (497 | ) |
| Net income (loss)                                                                |       | $                                           | 5,738      |   | $ | 6,378 |   | $ | (1,128 | ) |
| Basic and diluted  earnings (loss) per share                                     |       | $                                           | 0.39       |   | $ | 0.44 |   | $ | (0.08 | ) |
| Shares of common  stock used to calculate earnings (loss) per share:             |       |                                        |       |   |   |   |   |
| Basic                                                                            |       | 14,531                                      |       | 14,552 |   | 14,531 |   |
| Diluted                                                                          |       | 14,615                                      |       | 14,631 |   | 14,531 |   |

 

See accompanying notes.

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**SUREWESTCOMMUNICATIONSCONSOLIDATED BALANCE SHEETS**(amounts in thousands)
| ** **                                                                                                              | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                              | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                              |       |                  |       |   |   |
| Current assets:                                                                                                         |       |                  |       |   |   |
| Cash and cash  equivalents                                                                                              |       | $                     | 6,371      |   | $ | 7,633 |   |
| Short-term  investments                                                                                                 |       | 695                   |       | 617 |   |
| Accounts  receivable (less allowances of $5,451 and $5,219 at December 31, 2006 and  2005, respectively) |       | 22,791                |       | 23,234 |   |
| Inventories                                                                                                             |       | 5,348                 |       | 5,626 |   |
| Deferred  directory costs                                                                                               |       | 4,888                 |       | 5,130 |   |
| Prepaid expenses                                                                                                        |       | 4,285                 |       | 3,918 |   |
| Deferred income  taxes                                                                                                  |       | 7,685                 |       | 14,502 |   |
| Total current assets                                                                                                    |       | 52,063                |       | 60,660 |   |
| Property, plant  and equipment, net                                                                                     |       | 376,421               |       | 381,075 |   |
| Intangible and  other assets:                                                                                           |       |                  |       |   |   |
| Wireless  licenses, net                                                                                                 |       | 13,566                |       | 13,566 |   |
| Goodwill                                                                                                                |       | 2,171                 |       | 2,171 |   |
| Intangible asset  relating to pension plans                                                                             |       | –                |       | 456 |   |
| Intangible asset  relating to favorable operating leases, net                                                           |       | 309                   |       | 393 |   |
| Deferred charges  and other assets                                                                                      |       | 1,220                 |       | 708 |   |
|                                                                                                                    |       | 17,266                |       | 17,294 |   |
|                                                                                                                    |       | $                     | 445,750    |   | $ | 459,029 |   |

 

See accompanying notes.

54

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**SUREWESTCOMMUNICATIONSCONSOLIDATED BALANCE SHEETS (Continued)**(amountsin thousands)
| ** **                                                                                                                                                                                   | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                   | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                                |       |                  |       |   |   |
| Current liabilities:                                                                                                                                                                         |       |                  |       |   |   |
| Short-term borrowings                                                                                                                                                                        |       | $                     | –     |   | $ | 30,000 |   |
| Current portion of long-term debt and capital  lease obligations                                                                                                                             |       | 3,642                 |       | 3,669 |   |
| Accounts payable                                                                                                                                                                             |       | 3,069                 |       | 3,634 |   |
| Other accrued liabilities                                                                                                                                                                    |       | 21,766                |       | 20,496 |   |
| Current portion of contractual shareable earnings  obligations                                                                                                                               |       | 1,707                 |       | 2,932 |   |
| Estimated shareable earnings obligations                                                                                                                                                     |       | 73                    |       | 293 |   |
| Advance billings and deferred revenues                                                                                                                                                       |       | 9,435                 |       | 9,730 |   |
| Accrued income taxes                                                                                                                                                                         |       | 345                   |       | 1,015 |   |
| Accrued pension benefits                                                                                                                                                                     |       | 215                   |       | 7,615 |   |
| Accrued compensation                                                                                                                                                                         |       | 5,301                 |       | 5,772 |   |
| Total current liabilities                                                                                                                                                                    |       | 45,553                |       | 85,156 |   |
| Long-term debt and capital lease obligations                                                                                                                                                 |       | 121,831               |       | 85,473 |   |
| Long-term contractual shareable earnings  obligations                                                                                                                                        |       | 1,891                 |       | 3,695 |   |
| Deferred income taxes                                                                                                                                                                        |       | 37,785                |       | 40,398 |   |
| Other liabilities and deferred revenues                                                                                                                                                      |       | 12,914                |       | 12,556 |   |
| Commitments and contingencies                                                                                                                                                                |       |                  |       |   |   |
| Shareholders’ equity:                                                                                                                                                                   |       |                  |       |   |   |
| Common stock, without par value; 100,000 shares  authorized, 14,465 and 14,629 shares issued and outstanding at  December 31, 2006 and 2005, respectively |       | 157,926               |       | 164,598 |   |
| Deferred stock-based compensation                                                                                                                                                            |       | –                |       | (2,255 | ) |
| Accumulated other comprehensive income (loss)                                                                                                                                                |       | 565                   |       | (4,909 | ) |
| Retained earnings                                                                                                                                                                            |       | 67,285                |       | 74,317 |   |
| Total shareholders’ equity                                                                                                                                                              |       | 225,776               |       | 231,751 |   |
|                                                                                                                                                                                         |       | $                     | 445,750    |   | $ | 459,029 |   |

 

See accompanying notes.

55

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**SUREWEST COMMUNICATIONSCONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY**(amountsin thousands)
|                                                                                                 | ** ** | **Common Stock**  | ** ** | ** ** | ** ** | ** **                              | ** ** | ** **                                   | ** ** | ** **             | ** ** |
|-------------------------------------------------------------------------------------------------|------------|------------------------|------------|------------|------------|-----------------------------------------|------------|----------------------------------------------|------------|------------------------|------------|
| ** **                                                                                      | ** ** | **Number  of  Shares** | ** ** | **Amount** | ** ** | **Deferred  Stock-Based  Compensation** | ** ** | **Other  Comprehensive  Income (Loss)** | ** ** | **Retained  Earnings** | ** ** | **Total** | ** ** |
| Balance at  December 31, 2003                                                              |       |                   | 14,578     |       |       | $                                       | 160,911    |                                         |       | $                      | (1,419     | ) |   |   | $ | (261 | ) |   | $ | 98,297 |   | $ | 257,528 |   |
| Issuance of  common stock upon exercise of options                                              |       |                   | –     |       |       | 10                                      |       |                                         | –     |                   |       |   | – |   |   | – |   | 10 |   |
| Recognition of  stock options issued to employees                                               |       |                   | –     |       |       | 29                                      |       |                                         | –     |                   |       |   | – |   |   | – |   | 29 |   |
| Issuance and  amortization of restricted common stock, net of forfeitures and stock  surrenders |       |                   | 13         |       |       | 465                                     |       |                                         | 470        |                   |       |   | – |   |   | – |   | 935 |   |
| Tax effect from  stock plans                                                                    |       |                   | –     |       |       | 409                                     |       |                                         | –     |                   |       |   | – |   |   | – |   | 409 |   |
| Other  comprehensive (loss)                                                                     |       |                   | –     |       |       | –                                  |       |                                         | –     |                   |       |   | (1,865 | ) |   | – |   | (1,865 | ) |
| Cash dividends                                                                                  |       |                   | –     |       |       | –                                  |       |                                         | –     |                   |       |   | – |   |   | (14,581 | ) | (14,581 | ) |
| Net loss                                                                                        |       |                   | –     |       |       | –                                  |       |                                         | –     |                   |       |   | – |   |   | (1,128 | ) | (1,128 | ) |
| Balance at  December 31, 2004                                                              |       |                   | 14,591     |       |       | 161,824                                 |       |                                         | (949       | )                      |       |   | (2,126 | ) |   | 82,588 |   | 241,337 |   |
| Recognition of  stock options issued to employees                                               |       |                   | –     |       |       | 18                                      |       |                                         | –     |                   |       |   | – |   |   | – |   | 18 |   |
| Issuance and  amortization of restricted common stock, net of forfeitures and stock  surrenders |       |                   | 38         |       |       | 2,747                                   |       |                                         | (1,306     | )                      |       |   | – |   |   | 1 |   | 1,442 |   |
| Tax effect from  stock plans                                                                    |       |                   | –     |       |       | (50                                     | )          |                                         | –     |                   |       |   | – |   |   | – |   | (50 | ) |
| Other  comprehensive (loss)                                                                     |       |                   | –     |       |       | –                                  |       |                                         | –     |                   |       |   | (2,783 | ) |   | – |   | (2,783 | ) |
| Cash dividends                                                                                  |       |                   | –     |       |       | –                                  |       |                                         | –     |                   |       |   | – |   |   | (14,591 | ) | (14,591 | ) |
| Restricted Stock  Unit dividends                                                                |       |                   | –     |       |       | 59                                      |       |                                         | –     |                   |       |   | – |   |   | (59 | ) | – |   |
| Net income                                                                                      |       |                   | –     |       |       | –                                  |       |                                         | –     |                   |       |   | – |   |   | 6,378 |   | 6,378 |   |
| Balance at  December 31, 2005                                                              |       |                   | 14,629     |       |       | 164,598                                 |       |                                         | (2,255     | )                      |       |   | (4,909 | ) |   | 74,317 |   | 231,751 |   |
| Adjustment to  initially apply the provisions of SFAS No. 123(R)                           |       |                   | –     |       |       | (2,255                                  | )          |                                         | 2,255      |                   |       |   | – |   |   | – |   | – |   |
| Recognition of  stock options issued to employees                                               |       |                   | –     |       |       | 7                                       |       |                                         | –     |                   |       |   | – |   |   | – |   | 7 |   |
| Issuance and  amortization of restricted common stock, net of forfeitures and stock  surrenders |       |                   | 29         |       |       | 1,052                                   |       |                                         | –     |                   |       |   | – |   |   | 2 |   | 1,054 |   |
| Stock repurchases                                                                               |       |                   | (193       | )          |       | (5,543                                  | )          |                                         | –     |                   |       |   |   |   |   | 1,865 |   | (3,678 | ) |
| Other  comprehensive income                                                                     |       |                   | –     |       |       | –                                  |       |                                         | –     |                   |       |   | 5,474 |   |   | – |   | 5,474 |   |
| Cash dividends                                                                                  |       |                   | –     |       |       | –                                  |       |                                         | –     |                   |       |   | – |   |   | (14,570 | ) | (14,570 | ) |
| Restricted Stock  Unit dividends                                                                |       |                   | –     |       |       | 67                                      |       |                                         | –     |                   |       |   | – |   |   | (67 | ) | – |   |
| Net income                                                                                      |       |                   | –     |       |       | –                                  |       |                                         | –     |                   |       |   | – |   |   | 5,738 |   | 5,738 |   |
| Balance at December 31, 2006                                                               |       |                   | 14,465     |       |       | $                                       | 157,926    |                                         |       | $                      | –     |   |   |   | $ | 565 |   |   | $ | 67,285 |   | $ | 225,776 |   |

 

 

See accompanying notes.

56

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**SUREWEST COMMUNICATIONSCONSOLIDATED STATEMENTS OF CASH FLOWS**(amounts in thousands)
| ** **                                                                                | ** ** | **Years ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Cash flows from operating  activities:**                                                |       |                                        |       |   |   |   |   |
| Net income (loss)                                                                         |       | $                                           | 5,738      |   | $ | 6,378 |   | $ | (1,128 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |                                        |       |   |   |   |   |
| Depreciation and  amortization                                                            |       | 59,778                                      |       | 53,770 |   | 48,596 |   |
| Provision for  deferred income taxes                                                      |       | 4,162                                       |       | 3,417 |   | (372 | ) |
| Provision for  doubtful accounts                                                          |       | 4,169                                       |       | 3,892 |   | 3,441 |   |
| Stock-based  compensation                                                                 |       | 1,061                                       |       | 1,509 |   | 968 |   |
| Non-cash  portion of MCI settlement                                                       |       | –                                      |       | (617 | ) | – |   |
| Other, net                                                                                |       | 364                                         |       | 311 |   | – |   |
| Net changes in:                                                                           |       |                                        |       |   |   |   |   |
| Receivables                                                                               |       | (3,726                                      | )          | (6,971 | ) | (4,750 | ) |
| Accrued income  taxes, net                                                                |       | (671                                        | )          | (534 | ) | (359 | ) |
| Inventories,  prepaid expenses and other current assets                                   |       | (693                                        | )          | (1,217 | ) | (379 | ) |
| Accounts payable                                                                          |       | (565                                        | )          | 748 |   | 680 |   |
| Accrued  liabilities, other liabilities and deferred credits                              |       | (3,922                                      | )          | (3,245 | ) | 9,373 |   |
| Net cash provided by  operating activities                                                |       | 65,695                                      |       | 57,441 |   | 56,070 |   |
| **Cash  flows from investing activities:**                                                |       |                                        |       |   |   |   |   |
| Capital  expenditures for property, plant and equipment                                   |       | (55,393                                     | )          | (69,768 | ) | (70,833 | ) |
| Purchases of held-to-maturity  investments                                                |       | –                                      |       | – |   | (4,275 | ) |
| Maturities of  held-to-maturity investments                                               |       | –                                      |       | – |   | 6,974 |   |
| Other, net                                                                                |       | 352                                         |       | 424 |   | (123 | ) |
| Net cash used in  investing activities                                                    |       | (55,041                                     | )          | (69,344 | ) | (68,257 | ) |
| **Cash  flows from financing activities:**                                                |       |                                        |       |   |   |   |   |
| Increase (decrease) in  short-term borrowings                                             |       | (30,000                                     | )          | 20,000 |   | 10,000 |   |
| Principal payments of  long-term debt and capital lease obligations                       |       | (3,669                                      | )          | (3,992 | ) | (4,127 | ) |
| Proceeds from issuance  of long-term debt                                                 |       | 40,000                                      |       | – |   | – |   |
| Dividends paid                                                                            |       | (14,570                                     | )          | (14,591 | ) | (14,581 | ) |
| Repurchase of common  stock                                                               |       | (3,678                                      | )          |   |   |   |   |
| Other, net                                                                                |       | 1                                           |       | – |   | 6 |   |
| Net cash provided by  (used in) financing activities                                      |       | (11,916                                     | )          | 1,417 |   | (8,702 | ) |
| Decrease in cash  and cash equivalents                                                    |       | (1,262                                      | )          | (10,486 | ) | (20,889 | ) |
| Cash and cash  equivalents at beginning of year                                           |       | 7,633                                       |       | 18,119 |   | 39,008 |   |
| Cash and cash equivalents at end of year                                                  |       | $                                           | 6,371      |   | $ | 7,633 |   | $ | 18,119 |   |

 

See accompanying notes.

57

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**SUREWEST COMMUNICATIONS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004**

**1.   SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

**Business and Basisof Accounting**

SureWest Communications (the “Company”) is a holdingcompany with wholly-owned subsidiaries that provide integratedcommunications services in Northern California. The Company’s principaloperating subsidiary is SureWest Telephone. SureWest Directories, SureWest LongDistance, SureWest Wireless, SureWest Broadband, SureWest TeleVideo andSureWest TeleVideo of Roseville (collectively referred to as “SureWestBroadband/Residential Services”), SureWest Internet and SureWest Custom DataServices are each subsidiaries of the Company. As discussed in Note 13 below,in January 2007 the Company enteredinto a definitive agreement to sell SureWest Directories and the transactionwas consummated on February 28, 2007. The Company expects that thesources of its revenues and its cost structure may be different in futureperiods, both as a result of changes in the communications markets andcompetitive forces in each of the markets in which the Company has operations.

Preparation of thefinancial statements in conformity with principles generally accepted in theUnited States and pursuant to the rules and regulations of the Securitiesand Exchange Commission (the “SEC”) requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities at thedate of the financial statements and the reported amounts of revenues andexpenses during the reporting period. Actual results may differ materially fromthose estimates. The Company’s critical accounting estimates include (i) revenuerecognition and the establishment of estimated shareable earnings obligations,accounts receivable allowances and customer refund obligations (Notes 1, 2 and3), (ii) inventory valuation (Note 1), (iii) useful life assignmentsand impairment evaluations associated with property, plant and equipment andintangible assets (Note 1), (iv) asset retirement obligations (Note 1), (v) valuationallowances associated with deferred tax assets (Notes 1 and 6), (vi) pensionand post-retirement benefit costs and obligations (Note 7), (vii) anticipatedoutcomes of litigation, regulatory proceedings and other contingencies (Notes 3and 8) and (viii) employee stock-based compensation (Notes 1and 9).

**Principles ofConsolidation**

The consolidated financialstatements include the accounts of the Company and its wholly-ownedsubsidiaries. All significant intercompany transactions have been eliminated.

**Concentration ofCash**

The Company maintains itscash in bank deposit accounts, which, at times may exceed federally insuredlimits. The Company has not experienced any losses in such accounts.

**Cash Equivalentsand Short-term Investments**

The Company invests its excess cash in high-qualitydebt instruments and money market mutual funds. The Company considers highlyliquid investments with maturities of three months or less from the acquisitiondate of the instrument to be cash equivalents. Short-term investmentsconsisted of 17,970 shares of Verizon common stock and 31,292 shares of MCIcommon stock with an aggregate value of approximately $669 and $617 at December 31,2006 and 2005, respectively. The MCI stock was received as part of the MCI Planof Reorganization bankruptcy settlement on October 14, 2005 and wassubsequently replaced with Verizon common stock as a result of the MCI-Verizonmerger. In November 2006, Verizon spun off 

58

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**SUREWEST COMMUNICATIONS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (C**ontinued) YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004

**1.**   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

their domestic print and yellow pages directoriespublishing operations and as a result the Company received a stock dividendfrom Verizon of 898 shares of Idearc, Inc. common stock. The Idearc, Inc.common stock had an aggregate value of approximately $26 at December 31,2006 and is included in the Company’s short-term investments. All of theCompany’s cash equivalents and short-term investments are consideredavailable-for-sale.

Thefollowing is a summary of the Company’s cash equivalents and short-terminvestments as of December 31, 2006 and 2005:
| ** **                  | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|
| Money market mutual  funds  |       | $        | 15         |     | $          | 1 |   |
| Investment in  common stock |       | 695      |       | 617      |       |
|                        |       | $        | 710        |     | $          | 618 |   |

 

**Fair Value**

The carrying values of cash equivalents and short-terminvestments at December 31, 2006 and 2005 approximated their fair valuesat such dates. Fair values for cash equivalents and short-terminvestments were determined by quoted market prices.

The aggregate carrying value and fair value of theCompany’s short-term borrowings was $30,000 as of December 31, 2005.The Company had no short-term borrowings as of December 31, 2006. Thecarrying value of the Company’s long-term debt (including currentmaturities) was $125,454 and $89,091 at December 31, 2006 and 2005,respectively. The aggregate fair value of the long-term debt wasapproximately $124,947 and $89,137 at December 31, 2006 and 2005,respectively. The carrying value of the Company’s capital lease obligations was$19 and $51 as of December 31, 2006 and 2005, respectively. The aggregatefair value of the capital lease obligations was $14 and $40 as of December 31,2006 and 2005, respectively. The aggregate carrying value and fair value of theCompany’s contractual intrastate shareable earnings obligations was $3,713 at December 31,2006 and $6,901 as of December 31, 2005.

The fair values of the Company’s short-termborrowings, long-term debt, capital lease obligations and contractualintrastate shareable earnings obligations were determined through discountedcash flow analyses based on the Company’s current incremental interest ratesfor similar instruments.

Declines in the fair valueof available-for-sale securities below their cost that are deemedto be other than temporary are reflected in earnings as realized losses. Inestimating other-than-temporary impairment losses, managementconsiders, among other things, (i) the length of time and the extent towhich the fair value has been less than cost, (ii) the financial conditionand near-term prospects of the issuer, and (iii) the intent andability of the Company to retain its investment in the issuer for a period oftime sufficient to allow for any anticipated recovery in fair value.

**Allowance forDoubtful Accounts**

The Company maintains an allowance for doubtfulaccounts for estimated losses, which result from the inability of customers tomake required payments. Such allowance is based on the likelihood ofrecoverability of accounts receivable based on past experience and management’sbest estimates of current 

59

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**SUREWEST COMMUNICATIONS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (C**ontinued) YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004

**1.**   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

bad debt exposures. TheCompany performs ongoing credit evaluations of its customers’ financialcondition and management believes that adequate allowances for doubtfulaccounts have been provided. Accounts are determined to be past due if customerpayments have not been received in accordance with the payment terms.Uncollectible accounts are charged against the allowance for doubtful accountsand removed from the accounts receivable balances when internal collectionefforts have been unsuccessful in collecting the amount due. In addition,certain revenues are subject to refund if the customer terminates services orreturns equipment within a stipulated time period, or if certain performancecriteria are not met. Accordingly, the Company maintains accounts receivableallowances and recognizes certain customer refund liabilities, through chargesto revenues, based on the Company’s best estimates of the resolution of thesecontingencies, which are based on historical experience. For the years ended December 31,2006, 2005 and 2004, the Company wrote-off certain accounts receivablebalances aggregating $5,283, $3,389 and $3,032, respectively. During the yearsended December 31, 2006, 2005 and 2004, the Company recovered $1,348, $866and $776, respectively, of accounts receivable balances previously written-offagainst such allowance.

**Inventories**

Telephone networkinventories consist of materials and supplies, which are stated at weightedaverage cost. Non-regulated wireline equipment inventory held for sale isstated at the lower of weighted average cost or market value. Wireless handsetand accessory inventories are stated at the lower of average cost or marketvalue. Inventories at SureWest Broadband are comprised of network materials andsupplies, which are stated at weighted average cost.

**Property, Plant andEquipment**

Property, plant andequipment is recorded at cost. Additions and substantial improvements arecapitalized. Repairs and maintenance costs are charged to expense as incurred.Retirements and other reductions of property, plant and equipment wereapproximately $5,362, $3,993 and $2,861 in 2006, 2005 and 2004, respectively.Retirements of regulated telephone plant and equipment are charged against accumulateddepreciation with no gain or loss recognized in accordance with the compositegroup remaining life methodology utilized for telephone plant assets. Whenproperty applicable to non-telephone operations is sold or retired, theasset and related accumulated depreciation are removed from the accounts andthe associated gain or loss is recognized.

60

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**SUREWEST COMMUNICATIONS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (C**ontinued) YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004

**1.**   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Property, plant andequipment consisted of the following as of December 31, 2006 and 2005:
| ** **                         | ** ** | **2006** | ** ** | **2005** | ** ** | **Estimated  Useful  Lives** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|------------------------------|------------|
| Land                               |       | $        | 4,178      |     | $          | 4,198                        |       |   |   |
| Buildings                          |       | 82,592   |       | 82,433   |       | 35 years                     |       |
| Central office  equipment          |       | 224,204  |       | 203,125  |       | 3-21 years                   |       |
| Outside plant  equipment           |       | 389,709  |       | 362,784  |       | 5-40 years                   |       |
| Internal-use  software             |       | 57,787   |       | 55,791   |       | 5 years                      |       |
| Other                              |       | 57,847   |       | 59,993   |       | 3-21 years                   |       |
| Total plant in  service            |       | 816,317  |       | 768,324  |       |                         |       |
| Less accumulated  depreciation     |       | 455,608  |       | 400,504  |       |                         |       |
| Plant in service,  net             |       | 360,709  |       | 367,820  |       |                         |       |
| Plant under  construction          |       | 15,712   |       | 13,255   |       |                         |       |
| Property plant and  equipment, net |       | $        | 376,421    |     | $          | 381,075                      |       |   |   |

 

Property, plant andequipment is depreciated using the straight-line method over theirestimated economic lives. The useful lives are estimated at the time the assetsare acquired and are based on historical experience with similar assets,anticipated technological changes and the expected impact of the Company’sstrategic operating plan on its network infrastructure. Average annualcomposite depreciation rates were 7.6%, 7.3% and 7.3% in 2006, 2005 and 2004,respectively.

**Asset RetirementObligations**

The Company accounts forits asset retirement obligations in accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 143, *Accountingfor Asset Retirement Obligations*, and Financial Accounting StandardsBoard (“FASB”) Interpretation (“FIN”) No. 47, *Accounting for Conditional Retirement Obligations*. Inaccordance with the provisions of SFAS No. 143 and FIN No. 47, theCompany recognizes a retirement obligation pertaining to its long-livedassets, principally wireless cell sites and disposal obligations relating tocertain building materials containing asbestos, when a legal obligation existsto remove plant at some point in the future or if legislation exists thatrequires special disposal procedures of the asset. Based on terms outlined inits wireless tower leases, the Company is obligated to return the land or facilitiesto their original condition at the end of the cell site lease term, should thelease be terminated. Based on the Company’s estimates, it believes that thedisposal requirement relating to certain building materials containing asbestosis the expected retirement date of the underlying assets. The Company has useda probability-weighted cash flow approach in estimating its potentialretirement obligations. As of December 31, 2006 and 2005, the Company’sconsolidated balance sheet includes a liability in the amount of $95 and $88,respectively, pertaining to estimated asset retirement obligations.

**Intangible Assets**

Under the provisions ofSFAS No. 142, *Goodwill and OtherIntangible Assets,* goodwill and intangible assets that are notsubject to amortization are tested for impairment at least annually or whenevents or changes in circumstances indicate that the asset might be impaired.

61

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**SUREWEST COMMUNICATIONS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (C**ontinued) YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004

**1.**   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Goodwill is not amortized but instead evaluatedannually for impairment using a two-step process. In the first step ofthe impairment test, the fair value of the reporting unit is compared with thecarrying amount of the reporting unit, including goodwill. The Company hasdetermined that reporting units are equal to its operating segments and itsgoodwill has been allocated to the Telephone operating segment. The estimatedfair value of the reporting unit is determined using a discounted cash flowmodel. The assumptions used in the estimate of fair value are based upon a combinationof historical results and trends, new industry developments and the Company’scurrent operating plans. Such assumptions are subject to change as a result ofchanging economic and competitive conditions. If the carrying value of thereporting unit exceeds its fair value, the second step of the impairment testis performed to measure the amount of impairment loss.

The second step compares the implied fair value of thereporting unit goodwill with the carrying amount of that goodwill. The impliedfair value is determined by allocating the fair value of the reporting unit toall of the assets and liabilities other than goodwill in a manner similar to apurchase price allocation. The excess of the fair value of a reporting unitover the amounts assigned to its assets and liabilities is the implied fairvalue of goodwill. If the carrying amount of goodwill is greater than theimplied fair value of that goodwill, then an impairment charge would berecorded equal to the difference between the implied fair value and thecarrying value.

Indefinite-lived intangible assets consist ofthe Company’s wireless licenses. Wireless licenses include PersonalCommunications Services (“PCS”) and Local Multipoint Distribution System (“LMDS”),which are stated at cost, less accumulated depreciation recognized prior to theadoption of SFAS No. 142. The Company determined these licenses haveindefinite lives as such licenses can be renewed indefinitely for a nominalfee. Accordingly, the Company has applied the nonamortization provisions ofSFAS No. 142 to these licenses.

The Company’s wirelesslicenses are evaluated for impairment at least annually by comparing thecarrying value to the estimated fair value. The fair value of the Company’s PCSlicenses is determined through review of transactions involving sales ofcomparable wireless licenses in the aftermarket. The fair value of the Company’sLMDS licenses is obtained using a discounted cash flow model. The assumptionsused in the estimate of fair value are based on a combination of historicalresults and trends, new industry developments and the Company’s currentoperating plans. Such assumptions are subject to change as a result of changingeconomic and competitive conditions. The Company’s LMDS licenses may beimpaired in the future if the estimates and assumptions used in the 2006 LMDSlicense discounted cash flow model are not met. If the carrying value is inexcess of the estimated fair value, then an impairment loss is recognized equalto that excess. Accumulated amortization related to these licenses was $1,195at December 31, 2006 and 2005.

During 2006 and 2005, theCompany obtained independent valuations, which resulted in no impairmentcharges related to goodwill or wireless licenses as the fair values exceededtheir respective carrying values.

The Company has an intangible asset of $893 related tofavorable operating leases assumed from the purchase of Western Integrated Networks in July, 2002. This intangible assetis being amortized to rent expense over the remaining lease terms, which rangefrom two to ten years. As of December 31, 2006, 2005 and 2004, accumulatedamortization associated with this intangible asset was $584, $500 and $387, 

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**1.**   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

respectively. Intangibleamortization expense was $84, $113 and $143 in 2006, 2005 and 2004,respectively. As of December 31, 2006 future estimated amortizationexpense related to the intangible asset will be $84 in the years 2007 through2009 and $57 in 2010.

**NonmonetaryTransactions**

In the normal course ofbusiness, the Company entered into certain other nonmonetary transactionsduring 2006 and 2005 that are not material, either individually or in theaggregate, to the Company’s consolidated financial statements.

**Stock-basedCompensation**

The Company has two stock-based compensationplans, which are described more fully in Note 9. Effective January 1,2006, the Company adopted SFAS No. 123(R), *Share-Based Payment*, using the modified-prospective-transitionmethod. Since the fair value recognition provisions of SFAS No. 123, *Accounting for Stock-Based Compensation*and SFAS No. 123(R) were materially consistent under the Company’sPlans, the adoption of SFAS No. 123(R) did not have a significantimpact on the Company’s financial position or results of operations. TheCompany has not made any stock option grants since 2003 and consequently thecompensation expense resulting from stock option grants prior to 2003 waseither fully expensed as of January 1, 2006, or not material to theCompany’s financial statements.

Prior to January 1, 2006, the Company accountedfor the Stock Plans under the fair value recognition provisions of SFAS No. 123.Under the provisions of SFAS No. 148, *Accountingfor Stock-Based Compensation–Transition and Disclosure*, thefair value method of accounting was applied to all employee awards granted,modified, or settled after January 1, 2003.

The fair value of the Company’s employee stock optionswas estimated at the date of grant using the Black-Scholes-Mertonoption-pricing model with weighted-average assumptions for 2003 asfollows: risk-free interest rate of 1.79%, expected dividend yield of2.50%, expected volatility of 42.48% and an expected life of four years. Nooptions were granted during 2006, 2005 or 2004.

The Black-Scholes-Mertonoption-pricing model includes assumptions regarding dividend yields,expected volatility, expected lives and risk-free interest rates. Theseassumptions reflect management’s best estimates, but these items involveinherent uncertainties based on market conditions generally outside of thecontrol of the Company. As a result, if other assumptions had been used in thecurrent period, actual and proforma stock-based compensation expensecould have been materially different. If management uses different assumptionsin future periods, stock-based compensation expense could be materiallyimpacted in future years.

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**1.**   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

***Proforma***

Hadthe Company elected to adopt the fair value recognition provisions of SFAS No. 123as of its original effective date, proforma net income and earnings per sharefor 2005 and 2004 would have been:
| ** **                                                                                                                            | ** ** | **Years Ended December 31,**                          | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                                                                                            | ** ** | **     2005     ** | ** ** | **     2004     ** | ** ** |
| Net income  (loss), as reported                                                                                                       |       |                                                                 | $          | 6,378 |   |   |   | $ | (1,128 | ) |   |
| Add: Stock-based employee compensation expense  included in reported net income (loss), net of related tax effects                    |       |                                                                 | 935        |   |   |   | 672 |   |   |
| Deduct: Stock-based employee compensation  expense determined using the fair value method for all awards, net of related  tax effects |       |                                                                 | (967       | ) |   |   | (912 | ) |   |
| Proforma net income (loss)                                                                                                            |       |                                                                 | $          | 6,346 |   |   |   | $ | (1,368 | ) |   |
| Earnings (loss) per share:                                                                                                            |       |                                                                 |       |   |   |   |   |   |   |
| Basic–as reported                                                                                                                |       |                                                                 | $          | 0.44 |   |   |   | $ | (0.08 | ) |   |
| Basic–proforma                                                                                                                   |       |                                                                 | $          | 0.44 |   |   |   | $ | (0.09 | ) |   |
| Diluted–as reported                                                                                                              |       |                                                                 | $          | 0.44 |   |   |   | $ | (0.08 | ) |   |
| Diluted–proforma                                                                                                                 |       |                                                                 | $          | 0.43 |   |   |   | $ | (0.09 | ) |   |

 

**Advertising Costs**

The costs of advertising are charged to expense asincurred. Advertising expense was $5,742, $3,814 and $5,143 in 2006, 2005 and2004, respectively.

The Company makes marketdevelopment funds (“MDF”) available to certain retailers that serve as agentsfor SureWest Wireless for the reimbursement of co-branded advertising expenses.To the extent that MDF is used by the Company’s customers for co-brandedadvertising, and (i) the agents provide the Company with third-partyevidence of such co-branded advertising as prescribed by Company policyand (ii) the Company can reasonably estimate the fair value of its portionof the advertising, such amounts are charged to advertising expense asincurred. To the extent that MDF do not meet the aforementioned criteria, theCompany records these expenditures as a reduction of revenue in the period inwhich they are incurred.

**Income Taxes**

The Company accounts for income taxes using theliability method. Under this method, deferred tax assets and liabilities aredetermined based on differences between the financial reporting and tax basesof assets and liabilities and are measured using the enacted tax rates and lawsthat are expected to be in effect when the differences are expected to reverse.

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**1.   SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)**

**Per Share Amounts**

Shares used in thecomputation of basic earnings (loss) per share are based on the weightedaverage number of common shares and restricted common stock units (“RSUs”)outstanding, excluding unvested restricted common shares and unvested RSUs.Shares used in the computation of diluted earnings per share are based on theweighted average number of common shares, restricted common shares and RSUsoutstanding, along with other potentially dilutive securities outstanding ineach period. Shares used in the computation of diluted loss per share are basedon the weighted average number of vested common shares and vested RSUs andexclude potential dilutive common shares, unvested restricted common shares andunvested RSUs outstanding, as the effect is anti-dilutive.

Cash dividends per shareare based on the actual dividends per share, as declared by the Company’s Boardof Directors. On each date that the Company pays a cash dividend to the holdersof the Company’s common stock, the Company credits to the holders of RSUs anadditional number of RSUs equal to the total number of whole RSUs andadditional RSUs previously credited to the holders multiplied by the dollaramount of the cash dividend per share of common stock. Any fractional RSUsresulting from such calculation are included in the additional RSUs.

The following tablepresents the calculations of weighted average common shares and RSUs used inthe computations of basic and diluted per share amounts presented in theaccompanying consolidated statements of operations:
| ** **                                                                                                                   | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                   | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Basic:**                                                                                                                   |       |                                        |       |   |   |   |   |
| Weighted average  number of shares of common stock and RSUs outstanding                                                      |       | 14,615                                      |       | 14,631 |   | 14,571 |   |
| Less weighted  average number of unvested shares of restricted common stock and unvested  RSUs outstanding                   |       | 84                                          |       | 79 |   | 40 |   |
| Weighted average  number of common shares and RSUs used in computing basic per share amounts                                 |       | 14,531                                      |       | 14,552 |   | 14,531 |   |
| **Diluted:**                                                                                                                 |       |                                        |       |   |   |   |   |
| Weighted average  number of shares of common stock and RSUs outstanding                                                      |       | 14,615                                      |       | 14,631 |   | 14,571 |   |
| Less weighted  average number of unvested shares of restricted common stock and unvested  RSUs outstanding, if anti-dilutive |       | –                                      |       | – |   | 40 |   |
| Weighted average number of common shares and RSUs  used in computing diluted per share amounts                               |       | 14,615                                      |       | 14,631 |   | 14,531 |   |

 

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**1.**   SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES (Continued)

**Statements of Cash Flows Information**

During2006, 2005 and 2004, the Company made payments for interest and income taxes asfollows:
| ** **                                                                          | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Interest, net of  amounts capitalized ($495 in 2006, $489 in 2005 and $827 in 2004) |       | $        | 6,199      |     | $          | 5,589    |       | $ | 4,453 |   |
| Income taxes                                                                        |       | $        | 3,523      |     | $          | 1,025    |       | $ | 404 |   |

 

**Other ComprehensiveIncome (loss)**

Significantcomponents of the Company’s other comprehensive income (loss) are as follows:
| ** **                                                                                                                               | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                               | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income (loss)                                                                                                                        |       | $                                           | 5,738      |   | $ | 6,378 |   | $ | (1,128 | ) |
| Minimum pension  and post-retirement benefit liability adjustment, net of income taxes  of $344, $1,706, and $822 in 2006, 2005 and 2004 |       | 500                                         |       | (2,783 | ) | (1,865 | ) |
| Unrealized gain  on investment, net of income taxes of $42                                                                               |       | 65                                          |       | – |   | – |   |
| Other comprehensive  income (loss)                                                                                                       |       | $                                           | 6,303      |   | $ | 3,595 |   | $ | (2,993 | ) |

 

As of December 31,2006 accumulated other comprehensive income was $565 and accumulated othercomprehensive loss as of December 31, 2005 and 2004 was $4,909 and $2,126,respectively. Accumulated other comprehensive income and loss consist ofadjustments, net of tax related to unrealized gains and losses on available forsale securities and minimum pension and post-retirement benefits.

**Recent AccountingPronouncements**

In February 2007, the FASB issued SFAS No. 159,*The Fair Value Option for Financial Assets andFinancial Liabilities - Including an Amendment of FASB Statement No. 115*.This standard permits an entity to elect to measure many financial instrumentsand certain other items at fair value. Unrealized gains and losses on items forwhich the fair value option has been elected will be recognized in earnings ateach subsequent reporting date. SFAS No. 159 is effective as of thebeginning of an entity’s first fiscal year that begins after November 15,2007. Early adoption is permitted as of the beginning of the previous fiscalyear provided that the entity makes that choice in the first 120 days of thatfiscal year and also elects to apply the provisions of FASB Statement No. 157,*Fair Value Measurements*. The Company iscurrently evaluating the impact, if any, the adoption of SFAS No. 159 willhave on its consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements,* which definesfair value, establishes a framework for measuring fair value in generallyaccepted accounting principles, and expands disclosures about fair valuemeasurements. SFAS No. 157 is effective for financial statements issuedfor fiscal years beginning after November 15, 2007, and for interimperiods within those fiscal years. The Company is currently evaluating theimpact, if any, the adoption of SFAS No. 157 will have on its consolidatedfinancial statements.

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**1.**   SUMMARY OF SIGNIFICANTACCOUNTING POLICIES (Continued)

In September 2006,the FASB issued SFAS No. 158, *Employers’ Accounting forDefined Benefit Pension and Other Postretirement Plans, an Amendment of FASBStatements No. 87, 88, 106 and 132(R)*. SFAS No. 158 requires anemployer to recognize the funded status of a defined benefit postretirementplan as an asset or liability in its statement of financial position and torecognize changes in that funded status in the year in which the changes occurthrough comprehensive income. The Statement also requires an employer tomeasure the funded status of a plan as of the date of its year-endstatement of financial position. Prior to the adoption of SFAS No. 158,the Company used its fiscal year end as the measurement date for the Plan;consequently this requirement did not have an effect on the Company’sconsolidated statement of financial. SFAS No. 158 requires an employerwith publicly traded equity securities to initially recognize the funded statusof a defined benefit postretirement plan and the required disclosures as of theend of the fiscal year ending after December 15, 2006. The Company adoptedSFAS No. 158 on December 31, 2006. See Note 7, for a more detaileddiscussion of the effects of applying the provisions of SFAS No. 158 tothe Company’s consolidated financial statements.

In June 2006, theFASB issued FIN No. 48, *Accounting forUncertainty in Income Taxes.*FIN No. 48 clarifies the accountingfor uncertainty in income taxes recognized in a company’s financial statementsin accordance with FASB No. 109, *Accountingfor Income Taxes*. Specifically, the pronouncement prescribes arecognition threshold and a measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return. This interpretation also provides guidance on de-recognition,classification, interest and penalties, accounting in interim periods,disclosure and transition of uncertain tax positions. The interpretation iseffective for fiscal years beginning after December 15, 2006. The Companyis currently evaluating the impact that FIN No. 48 will have on itsconsolidated financial statements.

Effective January 1, 2006, the Company adoptedSFAS No. 154, *Accounting Changes andError Corrections.*The Statement applies to all voluntary changes inaccounting principle, and changes the requirements for accounting for andreporting of a change in accounting principle. The adoption of SFAS No. 154has not had a material effect on the Company’s consolidated financial position,results of operations or cash flows.

**Adjustments and Reclassifications**

Certain amounts in the Company’s 2005 and 2004consolidated financial statements have been reclassified to conform to thepresentation of the Company’s 2006 consolidated financial statements.

**2.   REVENUERECOGNITION**

The Company recognizes revenue when (i) persuasiveevidence of an arrangement between the Company and the customer exists, (ii) deliveryof the product to the customer has occurred or service has been provided to thecustomer, (iii) the price to the customer is fixed or determinable and (iv) collectibilityof the sales price is reasonably assured. Revenues based on a flat fee, derivedprincipally from local telephone, dedicated network access, datacommunications, Internet access service, residential/business broadband serviceand non-contract wireless services, are billed in advance and recognizedin subsequent periods when the services are provided. Contract wirelessservices are billed in arrears. Revenues based on usage, derived primarily fromnetwork access and long distance services, are recognized monthly as servicesare provided. Incremental direct costs of telecommunications service activationare charged to expense in the period in which they are incurred. Directoryadvertising revenues and costs related to publishing and distributingdirectories are recognized using the “circulation period” method, under which 

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**2.**   REVENUERECOGNITION (Continued)

revenues and related costsare recognized ratably over the expected useful life of the directory,generally one year from the date of publication. For all other operations,revenue is recognized when products are delivered or services are rendered tocustomers.

The Company appliesEmerging Issues Task Force (“EITF”) Issue No. 00-21, *Revenue Arrangements with Multiple Deliverables*to all wireless handset sales below cost, which approximates fair value in theabsence of an activation “subsidy,” when it receives an up-front fee ofany kind (e.g., a service activation fee). The application of EITF Issue No. 00-21results in the immediate recognition of all or a portion of such up-frontfees as equipment sales revenue. Additionally, when the Company activateswireless service for a customer, but does not concurrently provide the customerwith a handset, any up-front fees received continue to be deferred andamortized over the expected term of the customer relationship. The Companyprovides a general right of return within the first 30 days of service for a100% refund of the handset cost. The estimated equipment return liabilityassociated with this right of return is estimated based on historicalexperience.

Certain of the Company’scustomers filed for bankruptcy protection in 2002, the most notable of whichwas WorldCom, Inc. (“WorldCom”), which, together with its affiliates(collectively “MCI”), filed for bankruptcy protection in July 2002. In April 2004,MCI emerged from federal bankruptcy protection. In October 2005, theCompany resolved its claim filed in January 2003 related to pre-petitionaccounts receivable, and to a conditional payment made by the Company to MCI inconnection with anticipated overearnings during the 1999-2000 monitoringperiod.

In accordance with the MCI Plan of Reorganization, in October 2005the Company received a distribution of cash and stock, with a combined fairvalue of approximately $1,400. The distribution was recognized in the Company’s2005 consolidated statement of operations as an increase to network accessservice revenue and a decrease to general and administrative expense of $800and $600, respectively.

**3.   ESTIMATEDSHAREABLE EARNINGS OBLIGATIONS**

Certain of the Company’srates are subject to regulation by the Federal Communications Commission (“FCC”)and the California Public Utilities Commission (“CPUC”). Intrastate servicerates are subject to regulation by the CPUC. With respect to toll callsinitiated by interexchange carriers’ customers, the interexchange carriers areassessed access charges based on tariffs filed by SureWest Telephone.Interstate access rates and resultant earnings are subject to regulation by theFCC. With respect to interstate services, SureWest Telephone has detariffed itsDigital Subscriber Line (“DSL”) services and files its own tariff with the FCCfor switched and special access services. For interstate common line (“CL”)charges, SureWest Telephone concurs with tariffs filed by the National ExchangeCarrier Association (“NECA”). Pending and future regulatory actions may have amaterial impact on the Company’s consolidated financial position and results ofoperations.

The FCC monitors SureWest Telephone’s interstateearnings through the use of annual cost separation studies prepared by SureWestTelephone, which utilize estimated cost information and projected demand usage.The FCC establishes rules that carriers must follow in the preparation ofthe annual studies. Additionally, under current FCC rules governing ratemaking, SureWest Telephone is required to establish interstate rates based onprojected demand usage for its various services and determine the actualearnings from these rates once actual volumes and costs are known. Based onpreliminary cost studies, the 

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**3.**   ESTIMATEDSHAREABLE EARNINGS OBLIGATIONS (Continued)

Company recognizedliabilities relating to SureWest Telephone’s estimated interstate shareableearnings obligations of $157 for the year ended December 31, 2005 throughreductions of revenues. The Company did not identify any interstate shareableearrings obligations at SureWest Telephone during the years ended December 31,2006 or 2004.

As a result of periodiccost separation studies, SureWest Telephone changed its estimates for a portionof its interstate shareable earnings obligations and certain NECA CL accountsreceivable balances related to prior year monitoring periods during the yearsended December 31, 2006, 2005 and 2004. For the year ended December 312006 and 2005 these changes in estimates increased the Company’s consolidatedrevenues by $145 and $791, respectively, and net income by $86 ($0.01 pershare) and $482 ($0.03 per share), respectively. For the year ended December 31,2004, similar changes in accounting estimates, including a change in estimateto the Company’s intrastate shareable earnings obligations, increased theCompany’s consolidated revenues by $1,258 and decreased the net loss by $873($0.06 per share).

During September 2005,SureWest Telephone made a payment of $100 to a certain carrier customer in fullsettlement of an interstate overearnings dispute for the monitoring period 2001-2002.The limitations period applicable to this monitoring period expired. Therefore,SureWest Telephone released all other amounts reserved in connection with thepotential overearnings claims for 2001-2002 monitoring period, whichincreased the Company’s revenues and net income for the year ended December 31,2005 by $125 and $78 ($0.01 per share), respectively.

The FCC has a pendingrulemaking proceeding to re-examine all regulated forms of intercarriercompensation and develop a more unified mechanism to govern the payment flowsamong telecommunications carriers. Intercarrier compensation is the regulatedfees that service providers charge each other to carry and terminate traffic.Reform has been suggested due to the changing nature of the industry withincreasing competition from new technologies, such as Internet and Internet-basedservices and wireless services. Various plans have been submitted to the FCCwith divergent approaches to handle intercarrier compensation that may reduceper-minute access and reciprocal compensation charges and replace theserevenues with a combination of increases to the subscriber line charge andrevenues obtained from a new restructure mechanism. The ultimate results ofthis proceeding and the potential effects on SureWest Telephone cannot yet bedetermined.

The Company was involvedin a proceeding at the CPUC that considered the continued need for certainsharing requirements in the intrastate jurisdiction and, in connection withthat review, also considered the issue of whether the Company overearned in theintrastate jurisdiction in recent monitoring periods and the amount of overearningsthat should be shared with customers. In July 2004, the Company enteredinto a settlement agreement (the “settlement agreement”) with the other partiesin the proceeding, the Division of Ratepayer Advocates (“DRA”) (formerly Officeof Ratepayer Advocates) (“ORA”), and The Utility Reform Network (“TURN”), toresolve all issues in the proceeding. In November 2004, the CPUC approvedthe settlement agreement. The settlement agreement resolved existing intrastatesharing obligations and related earnings issues for the monitoring periods 2000through 2004, put into place a surcredit mechanism for the amount of thesettlement, and suspended the requirement for any intrastate sharing formonitoring periods from January 1, 2005 through at least December 31,2010. The settlement agreement resulted in SureWest Telephone recognizing anincrease in local revenues of $2,948 due to a change in accounting estimateduring the fourth quarter of 2004. This increase in revenues decreased theCompany’s net loss by $2,046 ($0.14 per share) during 2004.

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**3.   ESTIMATEDSHAREABLE EARNINGS OBLIGATIONS (Continued)**

In accordance with the settlement agreement, SureWestTelephone is returning approximately $6,500 (“Dividend A”), plus interest atthe 90-day commercial paper rate for non-financial institutions,which was 5.19% as of December 31, 2006, and an imputed rate of 3.15%, toits end users through a consumer dividend over a period of approximately fouryears, which began January 1, 2005. In addition, SureWest Telephone ispaying a one-time consumer dividend of $2,600 (“Dividend B”), which isbeing returned to the consumers to settle the monitoring periods 2000 to 2004. Theconsumer dividend is recorded as a reduction of the Company’s contractualshareable earnings obligations over approximately two years, which began January 1,2005. The consumer dividend includes an annual imputed interest rate of 3.15%(no stated contractual interest rate). At December 31, 2006, the aggregatecontractual shareable earnings obligation for these surcredits was $3,598 (whichis net of an unamortized discount pertaining to imputed interest of $115 atthat date). Future payments for these obligations are $1,857 and $1,856 in 2007and 2008, respectively.

The following tablesummarizes the amounts returned to end users through consumer dividends for theyears ended December 31, 2006 and 2005:

| ** ** | ** ** | **Years Ended  December 31,** | ** ** |
|------------|------------|-----------------------------------------|------------|
| ** ** | ** ** | **2006**                                | ** ** | **2005** | ** ** |
| Dividend A |       | $                                       | 2,011      |   | $ | 1,655 |   |
| Dividend B |       | 1,177                                   |       | 1,210 |   |
| Total      |       | $                                       | 3,188      |   | $ | 2,865 |   |

 

Further, as part of the settlement agreement SureWestTelephone was to implement an additional annual consumer dividend of $1,300 on January 1,2007 to end-users receiving SureWest Telephone services subject tosharing on or after that date. However, this consumer dividend was subject toreduction based upon the results of other pending regulatory proceedings and in2007 has been offset by a reduction in the Company’s draw from the CaliforniaHigh Cost Fund (“CHCF”), as discussed below.

During the fourth quarter of 2005, the Company filedan Advice Letter with the CPUC proposing an increase to the consumer dividendsin order to return the amounts entitled in accordance with the settlementagreement. The change in the consumer dividends resulted from the increase ininterest rates during 2005. The increase was effective January 1, 2006.

Prior to 2000, AT&T Inc. (“AT&T”) (formerlySBC Communications), had been paying SureWest Telephone approximately $11,500per year for extended area service (“EAS”) pursuant to a Settlement TransitionAgreement. In November 2000, the CPUC authorized AT&T to terminate itsannual EAS payments to SureWest Telephone effective November 30, 2000. TheCPUC authorized replacement funding to SureWest Telephone on an interim basisusing funds from the CHCF. The CHCF is a program designed by the CPUC toestablish a fair and equitable local rate structure and to reduce any disparityin the rates charged by telephone companies serving high-cost areas. TheCHCF is scheduled to expire January 1, 2009. In addition, the CPUC openedan Order Instituting Investigation (“OII”) for the purpose of determiningwhether future recovery of all, none, or a portion of the annual paymentsreceived from the CHCF should come from SureWest Telephone’s ratepayers orother regulatory recovery mechanisms.

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**3.**   ESTIMATED SHAREABLE EARNINGS OBLIGATIONS (Continued)

In August 2005, the CPUC adopted a decision which(i) authorized SureWest Telephone to continue receiving $11,500 annuallyfrom the CHCF to offset its intrastate regulated operating expenses on an interimbasis, (ii) required SureWest Telephone to prepare and submit withintwelve months a cost proxy model (which is used generally as a basis for CHCFfunding) based on its current cost data, including analyses of the resultingimpacts on rates, the Universal Lifeline Telephone Service (“ULTS”) fund andthe CHCF fund and (iii) authorized SureWest Telephone to file an adviceletter with the Commission’s Telecommunications Division to implement  reductions to its business access line rates.

In August 2006, the Company filed a petition formodification (the “petition”) of the decision that reviewed SureWest Telephone’srevenue requirement, which seeks CPUC authorization for a graduated phase-downof its $11,500 interim draw from the CHCF over a period of time that isintended to assure the continued maintenance of good service to SureWestTelephone customers while avoiding precipitous rate increases. The Company’spetition proposed a transitional phase-down over a five-to-tenyear period and requested elimination of the requirement to file its cost proxymodel. The Company will seek to recover the eliminated revenues through rateincreases and/or operating efficiencies. In August 2006, the DRA filedopposition to the Company’s petition and instead proposed the Companyimmediately discontinue receipt of CHCF funds. In October 2006, theCompany filed a request for an interim decision on its petition by which theCompany proposed to reduce its annual interim CHCF draw by a $1,300 consumerdividend required by the settlement agreement, as described above. In December 2006,the CPUC issued an interim decision approving the Company’s proposal to offsetits draw from the CHCF by the $1,300 consumer dividend. The results of thisproceeding and the potential effects on SureWest Telephone could impact futurefunding levels through the CHCF.

In June 2006, the CPUC instituted a rulemakingproceeding to review the CHCF program. The goals of this review include, butare not limited to, adjusting universal service rate support payments toreflect updated operating costs, evaluating whether CHCF fund support levelscan be reduced and made more predictable while still meeting the goals of theprogram, ensuring it is competitively neutral, reducing rate disparity inresidential basic service between urban and rural areas in the state, andmaking the current administration of the program more efficient. In addition,the CHCF rulemaking requested comments as to whether SureWest Telephone shouldcontinue receiving the annual payments from the CHCF and the advisability andimpacts of phasing out the EAS payments gradually over a period ofapproximately five years. The results of this proceeding and the potentialeffects on SureWest Telephone could impact future funding levels through the CHCF.

In 1996, the CPUC issued a decision that authorizedSureWest Telephone to implement a New Regulatory Framework (“NRF”) for servicesfurnished within SureWest Telephone’s service area in order to accommodatemarket and regulatory movement toward competition and greater pricingflexibility. Under the NRF, SureWest Telephone is subject to ongoing monitoringand reporting requirements, and it was initially required to share earningswith customers through a reduction of revenues if its earned annual rate-of-returnexceeds that authorized by the CPUC.

In April 2005, the CPUC opened a rulemakingproceeding to assess and revise the regulation of telecommunications utilitiesto develop a uniform regulatory framework (“URF”) to apply to most providers ofregulated telecommunications services, to the extent that it is feasible and inthe public interest to do so. In August 2006, the CPUC adopted Decision 06-08-030(the “URF Decision”) which 

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**3.**   ESTIMATED SHAREABLE EARNINGS OBLIGATIONS (Continued)

revises the regulations of telecommunicationsutilities, such as SureWest Telephone, which were previously subject to theNRF. The URF Decision grants carriers broad pricing freedoms in the provisionof telecommunications services, bundles of services, promotions and contracts. Thedecision, among other things:  (i) freezesthe Company’s basic residential and lifeline rates until at least January 1,2009 in order to address the subsidy levels supporting these services, subjectto review in the CHCF review and public policy programs proceedings, (ii) eliminatesprice regulation and allows full pricing flexibility for all new and retailservices except lifeline and basic residential services, (iii) allowsbundles and promotional packages on any telecommunication service, (iv) allocatesall gains and losses from the sale of assets to shareholders and (v) eliminatesprice caps, the annual price cap filing, the productivity factor, and allresidual elements of rate of return regulation, including the calculation ofshareable earnings. In accordance with the URF Decision, the CPUC ordered aseparate briefing cycle to consider whether to detariff altogethertelecommunications services other than basic residential service.

In December 2006, the CPUC adopted D. 06-12-044,an order clarifying the URF Decision and granting limited rehearing of the URFDecision with respect to the elimination of all asymmetric requirementsconcerning marketing, disclosure, or administrative processes with theexception of conditions relating to basic residential rates. Pending theoutcome of this limited rehearing, the rules adopted with respect to theelimination of asymmetric regulations are suspended.

Pursuant to the URF Decision, further proceedings inthis matter will be held during 2007 to address detariffing of telephoneservice other than basic exchange service; the pricing of retail special accessservices, determination of the extent to which the Commission requiresmonitoring reports in addition to, or different from, the reports carriersroutinely file with the FCC, and issues relating to the implementation of theURF Phase I decision. In addition, pursuant to an assigned commissioner’sruling issued in December 2006 in accordance with D. 06-12-044,these further proceedings will also examine customer disclosure rules and the rulesadopted governing elimination of asymmetric administrative processes.

Also, in January 2007, TURN filed a petition forwrit of review in the Court of Appeal of the State of California challengingthe URF Decision and seeking an order that the CPUC’s decision be set aside. Theultimate results of this proceeding and the potential effects on SureWestTelephone cannot yet be determined.

As of December 31, 2006, the Company’sconsolidated balance sheet reflected aggregate liabilities of $73 relating toSureWest Telephone’s estimated interstate shareable earnings obligations. Thecalculations supporting these liabilities are very complex and involve avariety of estimates prior to the ultimate settlement of such obligations. Inaddition, SureWest Telephone’s interstate shareable earnings obligations lapseover time if SureWest Telephone’s interexchange carrier and other customers donot claim the amounts ascribed to them. Accordingly, it is reasonably possiblethat management’s estimates of the Company’s liabilities for interstateshareable earnings obligations could change in the near term, and the amountsinvolved could be material.

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**4.**   CORPORATETREASURY INVESTIGATION

In December 2003, the Company discovered certainirregular bank transactions and deposits in a routine investigation followingthe abrupt resignation of the Company’s Treasury Analyst. An investigationrevealed concealed illegal transfers in violation of the Company’s investmentand cash management policies. The Company concluded that the irregularitieswere limited to the 2003 calendar year and nearly all of the funds had beenrecovered; however, approximately $1,828 remained outstanding as of December 31,2003. During 2004, the Company received an insurance recovery in the amount of$1,803, which was reflected as a non-operating gain in the Company’s 2004consolidated financial statements.

**5.   CREDITARRANGEMENTS**

Long-termdebt outstanding as of December 31, 2006 and 2005 consisted of thefollowing:
| ** **                                                                                                                                                                                                                               | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Unsecured Series A  Senior Notes, with interest payable semiannually at a fixed rate of 6.30%;  principal payments are due in equal annual installments of approximately  $3,636, through December 2013                        |       | $        | 25,454     |     | $          | 29,091 |   |
| Unsecured Series B  Senior Notes, with interest payable semiannually at a fixed rate of 4.74%;  principal payments are due in equal annual installments of $12,000, commencing  March 2009 through March 2013             |       | 60,000   |       | 60,000   |       |
| Unsecured Term Loan  Credit Agreement, with interest payable quarterly at a fixed rate of 6.29%;  principal payments are due in equal quarterly installments of approximately  $1,176, commencing March 2008 through June 2016 |       | 40,000   |       | –   |       |
| Total long-term  debt                                                                                                                                                                                                                    |       | 125,454  |       | 89,091   |       |
| Less current portion                                                                                                                                                                                                                     |       | 3,636    |       | 3,636    |       |
| Total long-term debt, net of current                                                                                                                                                                                                     |       | $        | 121,818    |     | $          | 85,455 |   |

 

At December 31, 2006,the aggregate maturities of long-term debt were (i) $3,636 in 2007, (ii) $8,342in 2008, (iii) $20,342 annually from 2009 through 2013 and (iv) $11,766thereafter, for a total of $125,454.

On May 1, 2006, theCompany completed an unsecured Credit Agreement for a Term Loan facility and aRevolving Loan facility (collectively “Loan Facilities”) in principal amountsup to $75,000 and $25,000, respectively. Interest on the Loan Facilities ispayable quarterly and based on a LIBOR, variable interest rate, or a fixedinterest rate pricing formula, or a combination, as defined in the CreditAgreement. Principal payments on the outstanding amounts borrowed under theTerm Loan facility as of December 31, 2007 are due in equal quarterlyinstallments commencing March 31, 2008 through June 30, 2016. TheRevolving Loan facility has an expiration date of June 30, 2013. As of December 31,2006, $40,000 was outstanding under the Term Loan Facility and no amounts wereoutstanding under the Revolving Loan facility.

The Company had a business loan agreement with a bankfor a $50,000 unsecured line of credit, which was originally due to expire July 1,2006. As of December 31, 2005 there was $30,000 outstanding under thiscredit facility, and the weighted average interest rate was 5.75%, which isbased on a LIBOR-based pricing 

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**SUREWEST COMMUNICATIONS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (C**ontinued) YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004

**5.**   CREDIT ARRANGEMENTS (Continued)

formula. As a result of the availability of the LoanFacilities the Company terminated its business loan agreement effective May 1,2006.

Certain of the Company’s credit arrangements containfinancial and operating covenants that restrict, among other things, thepayment of cash dividends, repurchase of the Company’s capital stock, themaking of certain other restricted payments and the incurrence of additionalindebtedness. The covenants also require the Company to maintain certainfinancial ratios and minimum levels of tangible net worth. At December 31,2006 and 2005, retained earnings of approximately $65,776, and $28,266,respectively, were available for the payment of cash dividends or otherrestricted payments under the terms of the Company’s credit arrangements.

**6.**   INCOME TAXES

Income tax expense(benefit) consists of the following components:
| ** **                          | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **     2004     ** | ** ** |
|-------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| Current expense  (benefit):         |       |                                                                 |       |                                                                 |       |                                                                 |       |   |   |   |   |   |   |
| Federal                             |       |                                                                 | $          | 840                                                                  |       |                                                                 |       | $ | 523 |   |   |   | $ | (71 | ) |   |
| State                               |       |                                                                 | 1,544      |                                                                 |       |                                                                 | (33        | ) |   |   | (54 | ) |   |
| Total current  expense (benefit)    |       |                                                                 | 2,384      |                                                                 |       |                                                                 | 490        |   |   |   | (125 | ) |   |
| Deferred expense (benefit):         |       |                                                                 |       |                                                                 |       |                                                                 |       |   |   |   |   |   |   |
| Federal                             |       |                                                                 | 2,250      |                                                                 |       |                                                                 | 2,581      |   |   |   | (299 | ) |   |
| State                               |       |                                                                 | (704       | )                                                                    |       |                                                                 | 837        |   |   |   | (73 | ) |   |
| Total deferred  expense (benefit)   |       |                                                                 | 1,546      |                                                                 |       |                                                                 | 3,418      |   |   |   | (372 | ) |   |
| Total income tax  expense (benefit) |       |                                                                 | $          | 3,930                                                                |       |                                                                 |       | $ | 3,908 |   |   |   | $ | (497 | ) |   |

 

Income tax expense (benefit) differs from the amountscomputed by using the statutory federal tax rate (35% in all years presented)due to the following:
| ** **                            | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **     2004     ** | ** ** |
|---------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| Computed at  statutory rates          |       |                                                                 | $          | 3,384                                                                |       |                                                                 |       | $ | 3,600 |   |   |   | $ | (569 | ) |   |
| Increase (decrease):                  |       |                                                                 |       |                                                                 |       |                                                                 |       |   |   |   |   |   |   |
| State taxes, net of federal benefit   |       |                                                                 | 546        |                                                                 |       |                                                                 | 523        |   |   |   | (82 | ) |   |
| Other, net                            |       |                                                                 | –     |                                                                 |       |                                                                 | (215       | ) |   |   | 154 |   |   |
| Income tax expense (benefit)          |       |                                                                 | $          | 3,930                                                                |       |                                                                 |       | $ | 3,908 |   |   |   | $ | (497 | ) |   |
| Effective federal  and state tax rate |       |                                                                 | 40.7       | %                                                                    |       |                                                                 | 38.0       | % |   |   | 30.6 | % |   |

 

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**6.**   INCOME TAXES (Continued)

The significant components of the Company’s deferredincome tax assets and liabilities were as follows at December 31, 2006 and2005:
| ** **                                                                                     | ** ** | **Deferred Income Taxes** | ** ** |
|------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                     | ** ** | **2006**                            | ** ** | **2005** | ** ** |
| ** **                                                                                     | ** ** | **Assets**                          | ** ** | **Liabilities** | ** ** | **Assets** | ** ** | **Liabilities** | ** ** |
| Property, plant  and equipment-primarily due to timing of recognition of depreciation  expense |       | $                                   | –     |   |   | $ | 43,070 |   |   | $ | – |   |   | $ | 52,900 |   |   |
| Differences in the timing of recognition of revenues                                           |       | 6,353                               |       |   | – |   |   | 7,685 |   |   | – |   |   |
| Net operating losses                                                                           |       | 1,934                               |       |   | – |   |   | 11,705 |   |   | – |   |   |
| Post-retirement and post-employment  benefits                                                  |       | 2,102                               |       |   | – |   |   | 6,709 |   |   | – |   |   |
| Accrued compensation                                                                           |       | 1,330                               |       |   | – |   |   | 1,016 |   |   | – |   |   |
| Other, net                                                                                     |       | 1,555                               |       |   | 304 |   |   | 1,068 |   |   | 1,179 |   |   |
| Total deferred income taxes                                                                    |       | $                                   | 13,274     |   |   | $ | 43,374 |   |   | $ | 28,183 |   |   | $ | 54,079 |   |   |
| Net deferred  income tax liability                                                             |       |                                |       |   | $ | 30,100 |   |   |   |   |   | $ | 25,896 |   |   |

 

As of December 31, 2006, the Company had netoperating loss carryforwards for federal income tax purposes of approximately$5,489, which will expire in the years 2018 through 2024, if not utilized. Asof December 31, 2006, the Company also had net operating losscarryforwards for state income tax purposes of approximately $218, which willexpire in the years 2007 through 2014, if not utilized. As of December 31,2006, the Company also had research and development tax credit carryforwards ofapproximately $100 for federal income tax purposes. The federal credit willexpire in 2022 if it is not utilized. The Company has an Alternative MinimumTax carryforward of $930 for federal and $324 for state, which do not expire.

The Company believes it is more likely than not thatthe benefit associated with the deferred tax assets resulting from netoperating loss carryforwards will be ultimately realized based on itsassessment of future taxable income during the periods in which the netoperating losses remain available. The Company considers the scheduled reversalof its deferred tax liabilities, primarily depreciation expense-related,and projected future taxable income in making this assessment. As a result ofthis assessment, the Company has not recognized a valuation allowanceassociated with its deferred tax assets as of December 31, 2006, 2005 and2004.

**7.   PENSIONAND OTHER POST-RETIREMENT BENEFITS**

The Company sponsors anoncontributory defined benefit pension plan (the “Pension Plan”) coveringsubstantially all of its employees. Benefits are based on years of service andthe employee’s average compensation during the five highest consecutive yearsof the last ten years of credited service. The Company’s funding policy is tocontribute annually an actuarially determined amount consistent with applicablefederal income tax regulations. Contributions are intended to provide forbenefits attributed to service to date. Pension Plan assets are primarilyinvested in domestic equity securities, United States government and agencysecurities and international equity securities.

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**7.**   PENSION AND OTHERPOST-RETIREMENT BENEFITS (Continued)

TheCompany also has an unfunded Supplemental Executive Retirement Plan (“SERP”),which provides supplemental retirement benefits to certain executives of theCompany. The SERP provides for incremental pension payments to partially offsetthe reduction in amounts that would have been payable under the Pension Plan ifit were not for limitations imposed by federal income tax regulations.

In addition, the Companyprovides certain post-retirement benefits other than pensions (“OtherBenefits”) to substantially all employees, including life insurance benefitsand a stated reimbursement for Medicare supplemental insurance. During the yearended December 31, 2006, the Company reimbursed participants of the trust of theOther Benefits Plan for certain eligible medical expenses. As of December 31,2006, the Company recorded a $424 receivable from the Other Benefits Plan,which was received during the first quarter of 2007.

In January 2007, theCompany’s Board of Directors authorized amendments to the Pension Plan, SERPand Other Benefits (collectively “the Plans”). As a result of these amendments,effective April 1, 2007, the Company will freeze the Pension Plan so thatno person will become eligible to participate in the Plans on or following theeffective date and all future benefit accruals under the Plans shall cease. Theamendments to the Plans have been accounted for as plan curtailments, resultingin the recognition of a $574 non-cash pretax curtailment loss ($0.04 pershare) reflected in operating expenses in the Company’s consolidated statementof operation for the year ended December 31, 2006.

In December 2004, theCompany initiated a voluntary enhanced early retirement program (the “REWARD program”).The REWARD program was offered to certain eligible employees across allbusiness units. In addition to retirement benefits, eligible employees receiveenhanced medical benefits for a specified period of time. As of December 31,2004, 59 employees had accepted the REWARD program. Accordingly, the Companyrecorded $3,768 in operating expenses related to the REWARD program during thefourth quarter of 2004. Prior to the completion of the REWARD program in February of2005, 13 additional employees accepted the REWARD program, and the Companyrecorded an additional $791 in operating expenses during the first quarter of2005.

In September 2006,the FASB issued SFAS No. 158, *Employers’ Accounting forDefined Benefit Pension and Other Postretirement Plans, an Amendment of FASBStatements No's 87, 88, 106 and 132(R)*.  SFAS No. 158 requires an employer torecognize the funded status of a defined benefit postretirement plan as anasset or liability in its statement of financial position and to recognizechanges in that funded status in the year in which the changes occur throughcomprehensive income.  The Statement alsorequires an employer to measure the funded status of a plan as of the date ofits year-end statement of financial position.  SFAS No. 158 requires an employer withpublicly traded equity securities to initially recognize the funded status of adefined benefit postretirement plan and the required disclosures as of the endof the fiscal year ending after December 15, 2006.  The Company adopted SFAS No. 158 onDecember 31, 2006.

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**7.**   PENSION AND OTHER POST-RETIREMENT BENEFITS (Continued)

**IncrementalEffect of Applying SFAS No. 158on Individual Line Items in the Consolidated Balance SheetDecember 31, 2006**
| ** **                                             | ** ** | **Before Application  of SFAS No. 158** | ** ** | **Adjustments** | ** ** | **After Application  of SFAS No. 158** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------------------|------------|-----------------|------------|------------------------------------------------------------|------------|
| Intangible assets-pension  plan                        |       |                                                        | $          | 8               |       |                                                       |       | $ | (8 | ) |   |   | $ | – |   |   |
| Total assets                                           |       |                                                        | $          | 445,758         |       |                                                       |       | $ | (8 | ) |   |   | $ | 445,750 |   |   |
| Current liability for Pension Plan & SERP     |       |                                                        | $          | 1,144           |       |                                                       |       | $ | (929 | ) |   |   | $ | 215 |   |   |
| Noncurrent  liability for Pension Plan & SERP |       |                                                        | –     |            |       |                                                       | 3,398      |   |   |   | 3,398 |   |   |
| Noncurrent  liability for PBOP                         |       |                                                        | 6,339      |            |       |                                                       | (3,313     | ) |   |   | 3,026 |   |   |
| Additional  minimum pension liability                  |       |                                                        | 2,469      |            |       |                                                       | (2,469     | ) |   |   | – |   |   |
| Deferred income  taxes                                 |       |                                                        | (1,006     | )               |       |                                                       | 1,350      |   |   |   | 344 |   |   |
| Total liabilities                                      |       |                                                        | $          | 221,937         |       |                                                       |       | $ | (1,963 | ) |   |   | $ | 219,974 |   |   |
| Accumulated other comprehensive income                 |       |                                                        | $          | (1,455          | )          |                                                       |       | $ | 1,955 |   |   |   | $ | 500 |   |   |
| Total stockholder’s  equity                       |       |                                                        | $          | 223,821         |       |                                                       |       | $ | 1,955 |   |   |   | $ | 225,776 |   |   |

 

The following table sets forth the change in benefitobligation, change in plan assets and funded status of the Pension Plan (whichencompasses the REWARD program), SERP and Other Benefits (which encompasses theREWARD program) as of December 31, 2006 and 2005:
| ** **                               | ** ** | **Pension Plan & SERP** | ** ** | **Other Benefits** | ** ** |
|------------------------------------------|------------|--------------------------------------------|------------|-------------------------|------------|
| ** **                               | ** ** | **2006**                                   | ** ** | **2005**                | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Change  in benefit obligation:**       |       |                                       |       |                    |       |   |   |   |   |
| Benefit  obligation at beginning of year |       | $                                          | 138,409    |                    | $          | 126,862 |   | $ | 13,241 |   | $ | 9,547 |   |
| Service cost                             |       | 4,471                                      |       | 5,629                   |       | 484 |   | 645 |   |
| Interest cost                            |       | 7,587                                      |       | 7,464                   |       | 607 |   | 692 |   |
| Plan participants’ contributions    |       | –                                     |       | –                  |       | 459 |   | 381 |   |
| Amendments                               |       | –                                     |       | –                  |       | (3,078 | ) | – |   |
| Actuarial (gains) losses                 |       | (12,038                                    | )          | 6,870                   |       | (2,160 | ) | 1,710 |   |
| Curtailments                             |       | (8,822                                     | )          | –                  |       | (105 | ) | – |   |
| Special termination benefits             |       | –                                     |       | 51                      |       | – |   | 740 |   |
| Benefits paid                            |       | (6,752                                     | )          | (8,467                  | )          | (1,006 | ) | (474 | ) |
| Benefit obligation at  end of year       |       | $                                          | 122,855    |                    | $          | 138,409 |   | $ | 8,442 |   | $ | 13,241 |   |

 

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**7.**   PENSION ANDOTHER POST-RETIREMENT BENEFITS (Continued)
| ** **                                      | ** ** | **Pension Plan & SERP** | ** ** | **Other Benefits** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **2006**                                   | ** ** | **2005**                | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Change  in plan assets:**                     |       |                                       |       |                    |       |   |   |   |   |
| Fair value of  plan assets at beginning of year |       | $                                          | 109,415    |                    | $          | 105,338 |   | $ | 4,015 |   | $ | 2,102 |   |
| Actual return on  plan assets                   |       | 13,377                                     |       | 7,404                   |       | 331 |   | 154 |   |
| Company  contribution                           |       | 3,202                                      |       | 5,140                   |       | 1,617 |   | 1,852 |   |
| Participants’  contributions               |       | –                                     |       | –                  |       | 459 |   | 381 |   |
| Benefits paid                                   |       | (6,752                                     | )          | (8,467                  | )          | (1,006 | ) | (474 | ) |
| Fair value of  plan assets at end of year       |       | $                                          | 119,242    |                    | $          | 109,415 |   | $ | 5,416 |   | $ | 4,015 |   |
| Funded status at year  end                      |       | $                                          | (3,613     | )                       | $          | (28,994 | ) | $ | (3,026 | ) | $ | (9,226 | ) |

 
| ** **                              | ** ** | **For the year ended  December 31, 2005** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                              | ** ** | **Pension Plan  & SERP**                             | ** ** | **Other  Benefits** | ** ** |
| Unfunded status  of plan at end of year |       |                                                               | $          | (28,994 | ) |   | $ | (9,226 | ) |
| Unrecognized  actuarial loss            |       |                                                               | 28,997     |   |   | 1,980 |   |
| Unrecognized  prior service cost        |       |                                                               | 418        |   |   | 366 |   |
| Unrecognized net  transition obligation |       |                                                               | 38         |   |   | – |   |
| Prepaid (accrued)  benefits             |       |                                                               | $          | 459 |   |   | $ | (6,880 | ) |

 

Amountsrecognized in the consolidated balance sheets at December 31, 2005 consistof:
| ** **                            | ** ** | **Pension Plan   & SERP** | ** ** | **Other  Benefits** | ** ** |
|---------------------------------------|------------|----------------------------------------------|------------|---------------------|------------|
| Prepaid benefit  cost                 |       |                                         | $          | 2,220               |       |   | $ | – |   |
| Accrued benefit  cost                 |       |                                         | (1,761     | )                   |       | (6,880 | ) |
| Additional  minimum liability         |       |                                         | (8,074     | )                   |       | – |   |
| Intangible assets                     |       |                                         | 456        |                |       | – |   |
| Accumulated other  comprehensive loss |       |                                         | 7,618      |                |       | – |   |
| Prepaid (accrued)  benefits           |       |                                         | $          | 459                 |       |   | $ | (6,880 | ) |

 

Amountsrecognized in the consolidated balance sheets at December 31, 2006 consistof:
| ** **             | ** ** | **Pension Plan  & SERP** | ** ** | **Other  Benefits** | ** ** |
|------------------------|------------|----------------------------------------|------------|---------------------|------------|
| Current liabilities    |       |                                   | $          | 215                 |       |   |   | $ | – |   |   |
| Noncurrent liabilities |       |                                   | $          | 3,398               |       |   |   | $ | 3,026 |   |   |

 

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**7.   PENSION AND OTHERPOST-RETIREMENT BENEFITS (Continued)**

Amountsrecognized in accumulated other comprehensive income consist of for the yearended December 31, 2006:
| ** **                 | ** ** | **Pension Plan  & SERP** | ** ** | **Other**

**Benefits** | ** ** |
|----------------------------|------------|----------------------------------------|------------|-------------------------|------------|
| ** **                 | ** ** | **2006**                               | ** ** | **2006**                | ** ** |
| Net actuarial  (gain) loss |       |                                   | $          | 2,461                   |       |   | $ | (235 | ) |
| Prior service  cost        |       |                                   | 8          |                    |       | (3,078 | ) |
|                       |       |                                   | $          | 2,469                   |       |   | $ | (3,313 | ) |

 

The estimated net loss, prior service cost andtransition obligation for the defined benefit pension plans that will beamortized from accumulated other comprehensive income in net periodic benefitcost over the next fiscal year are $21, $8 and $0, respectively. The estimatednet loss, prior service credit and transition obligation for the other definedbenefit postretirement plans that will be amortized from accumulated othercomprehensive income into net periodic benefit cost over the next fiscal yearare $0, $147 and $0, respectively .

Informationfor the Pension Plan and SERP, which have accumulated benefit obligations inexcess of plan assets as of December 31, 2006 and 2005 is as follows:
| ** **                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Projected benefit  obligation   |       | $        | 122,855    |     | $          | 138,409 |   |
| Accumulated benefit  obligation |       | $        | 122,855    |     | $          | 117,031 |   |
| Fair value of plan assets       |       | $        | 119,242    |     | $          | 109,415 |   |

 

Netperiodic pension cost recognized in the consolidated statements of operationsfor the years ended December 31, 2006, 2005 and 2004 under the PensionPlan, SERP and Other Benefits plan included the following components:
| ** **                                      | ** ** | **Pension Plan & SERP** | ** ** | **Other Benefits** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **2006**                                   | ** ** | **2005**                | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Service cost-benefits  earned during the period |       | $                                          | 4,471      |                    | $          | 5,629 |   | $ | 5,360 |   | $ | 484 |   | $ | 645 |   | $ | 469 |   |
| Interest cost on  projected benefit obligation  |       | 7,587                                      |       | 7,464                   |       | 7,095 |   | 607 |   | 692 |   | 351 |   |
| Expected return on plan  assets                 |       | (8,630                                     | )          | (8,733                  | )          | (8,033 | ) | (276 | ) | (135 | ) | (151 | ) |
| Amortization of prior  service cost             |       | 56                                         |       | 78                      |       | 78 |   | 43 |   | 43 |   | 43 |   |
| Recognized net actuarial  loss                  |       | 928                                        |       | 704                     |       | 480 |   | – |   | 97 |   | – |   |
| Amortization of  transition obligation          |       | 38                                         |       | 267                     |       | 267 |   | – |   | – |   | – |   |
| Recognized actuarial  loss due to curtailments  |       | 355                                        |       | –                  |       | – |   | 219 |   | – |   | – |   |
| Effect of special termination  benefits         |       | –                                     |       | 51                      |       | 632 |   | – |   | 740 |   | 3,136 |   |
| Net pension cost                                |       | $                                          | 4,805      |                    | $          | 5,460 |   | $ | 5,879 |   | $ | 1,077 |   | $ | 2,082 |   | $ | 3,848 |   |

 

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**7.**   PENSION AND OTHER POST-RETIREMENT BENEFITS (Continued)

The weighted-averageassumptions used to determine projected benefit obligations as of December 31,2006 and 2005 were as follows:
| ** **                    | ** ** | **Pension Plan & SERP** | ** ** | **Other Benefits** | ** ** |
|-------------------------------|------------|--------------------------------------------|------------|-------------------------|------------|
| ** **                    | ** ** | **2006**                                   | ** ** | **2005**                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Discount rate                 |       | 6.00%                                      |       | 5.75%                   |       | 5.50% |   | 5.50% |   |
| Rate of compensation increase |       | Age Graded                                 |       | 5.00%                   |       | Age Graded |   | 5.00% |   |

 

The weighted-averageassumptions used to determine net periodic benefit cost for the years ended December 31,2006, 2005 and 2004 were as follows:
| ** **                                | ** ** | **Pension Plan & SERP** | ** ** | **Other Benefits** | ** ** |
|-------------------------------------------|------------|--------------------------------------------|------------|-------------------------|------------|
| ** **                                | ** ** | **2006**                                   | ** ** | **2005**                | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Discount rate                             |       | 5.75%                                      |       | 5.75%                   |       | 6.25% |   | 5.50% |   | 5.75% |   | 6.25% |   |
| Expected long-term  return on plan assets |       | 8.00%                                      |       | 8.50%                   |       | 8.50% |   | 8.00% |   | 8.50% |   | 8.50% |   |
| Rate of compensation increase             |       | Age Graded                                 |       | 5.00%                   |       | 5.00% |   | Age Graded |   | 5.00% |   | 5.00% |   |

 

The expected rate of return on plan assets is theweighted average of expected long-term asset return assumptions.

Assumedhealth care cost trend rates at December 31, 2006 and 2005 were asfollows:
| ** **                                                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Health care cost  trend assumed for the next year                             |       | 9.00     | %          | 10.00    | %          |
| Rate to which the  cost trend is assumed to decline (the ultimate trend rate) |       | 5.00     | %          | 5.00     | %          |
| Year that the rate  reaches the ultimate trend rate                           |       | 2013     |       | 2010     |       |

 

Assumedhealth care cost trend rates have a significant effect on the amounts reportedfor the Other Benefits plan. A one-percentage-point change inassumed health care cost trend rates would have the following effects:
| ** **                                                             | ** ** | **1-Percentage-  Point Increase** | ** ** | **1-Percentage-  Point Decrease** | ** ** |
|------------------------------------------------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|
| Effect on total  2006 service and interest costs                       |       |                                   | $          | 72                                     |       |   |   | $ | (63 | ) |   |
| Effect on Other Benefits  plan obligation as of December 31, 2006 |       |                                   | $          | 137                                    |       |   |   | $ | (130 | ) |   |

 

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**7.**   PENSION AND OTHER POST-RETIREMENT BENEFITS (Continued)

The assets of the PensionPlan and Other Benefits plan are combined in a single trust and invested in theaggregate. The SERP benefit obligation is funded by the Company’s assets. Theallocation for the Pension Plan and Other Benefits plan assets at the end of2006 and 2005, and the target allocation for 2007, by asset category is asfollows:
| ** **                                      | ** ** | **Target Allocation** | ** ** | **Percentage of   Plan Assets at  December 31,** | ** ** |
|-------------------------------------------------|------------|----------------------------|------------|---------------------------------------------------------------------------|------------|
| **Asset Category**                         | ** ** | **2007**                   | ** ** | **2006**                                                                  | ** ** | **2005** | ** ** |
| Domestic equity  securities                     |       |                       | 39%        |                                                                      |       | 40% |   | 39% |   |
| United States  government and agency securities |       |                       | 40%        |                                                                      |       | 39% |   | 38% |   |
| International  equity securities                |       |                       | 20%        |                                                                      |       | 20% |   | 21% |   |
| Cash equivalents                                |       |                       | 1%         |                                                                      |       | 1% |   | 2% |   |
| Total                                           |       |                       | 100%       |                                                                      |       | 100% |   | 100% |   |

 

The fair value of plan assets for these plans is$124,658 and $113,430 at December 31, 2006 and 2005, respectively. Theexpected long-term rate of return on these plans assets for 2006 and 2005was 8.0% and 8.5% , respectively.

The Company’s investmentstrategy is designed to provide a stable environment to secure participantretirement benefits and minimize the reliance on contributions as a source ofbenefit security. As such, plan assets are invested to maximize the plan’sfunded ratios over the long-term while managing the downside risk that fundedratios fall below some specified threshold level. The asset return objective isto achieve, as a minimum over time, the passively managed return earned bymanaged index funds, weighted in the proportions outlined by the asset classexposures identified in the plan’s strategic allocation.

The Company does notexpect to contribute to the Pension Plan and Other Benefits plan in 2007.

*Estimated FutureBenefit Payments*

Thefollowing table reflects the total benefits expected to be paid from thePension Plan, SERP and Other Benefits plans or from the Company’s assets,including both the Company’s share of the benefit cost and the participants’share of the cost, which is funded by participant contributions to the plans.Expected contributions reflect amounts expected to be contributed to fundedplans.
| ** **                  | ** ** | **Pension Plan & SERP** | ** ** | **Other Benefits** | ** ** |
|-----------------------------|------------|--------------------------------------------|------------|-------------------------|------------|
| Expected benefit  payments: |       |                                       |       |                    |       |   |   |   |   |
| 2007                        |       |                                       | $          | 6,583                   |       |   |   | $ | 1,261 |   |   |
| 2008                        |       |                                       | 6,722      |                    |       |   | 910 |   |   |
| 2009                        |       |                                       | 6,977      |                    |       |   | 965 |   |   |
| 2010                        |       |                                       | 7,278      |                    |       |   | 1,003 |   |   |
| 2011                        |       |                                       | 7,479      |                    |       |   | 1,035 |   |   |
| 2012-2016                   |       |                                       | 42,039     |                    |       |   | 3,724 |   |   |
|                             |            |                                            |            |                         |            |  |  |  |  |  |  |

 

The Company maintains a defined contributionretirement plan, the SureWest KSOP (the “KSOP”). The Company has retained aninvestment management company to be the record keeper and fund manager of 

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**7.**   PENSION AND OTHER POST-RETIREMENT BENEFITS (Continued)

the KSOP. The KSOP allowsits participants an opportunity to diversify their retirement holdings.Employees may choose from eleven investment options, including the Company’scommon stock. The KSOP has both a retirement and savings feature. Theretirement feature allows for qualified tax deferred contributions by employeesunder Section 401(k) of the Internal Revenue Code. The Companymatches an employee’s contributions dollar-for-dollar up to sixpercent of an employee’s salary. The KSOP provides for voting rights as to theparticipant’s share of the Company’s common stock held by the KSOP and forcertain diversification rights of the participant’s account balances. Aggregatematching contributions made by the Company and charged to expense under theKSOP were $2,248, $2,308 and $2,466 in 2006, 2005 and 2004, respectively. At December 31,2006, 2005 and 2004 the KSOP held approximately 769,000, 880,000, and 1,085,000shares, respectively, of the Company’s common stock. During the years ended December 31,2006, 2005 and 2004, the KSOP received dividends from the Company ofapproximately $807, $957 and $1,166, respectively. The Company’s earnings(loss) per share calculations include the issued and outstanding shares held bythe KSOP.

**8.   COMMITMENTS ANDCONTINGENCIES**

**Capital andOperating Leases**

The Company holds capital leases for certain vehicles.These leases bear interest at imputed rates of 6.3% to 16.2% per annum andexpire at various dates through December 2009. The capitalized costsrelated to assets under capital leases were $1,057 and $1,064 as of December 31,2006 and 2005, respectively. The amortization of assets under capital leases isincluded in depreciation and amortization expense in the accompanyingconsolidated financial statements. As of December 31, 2006 and 2005, theaccumulated amortization for these assets was $938 and $734, respectively.

The Company leases certain facilities and equipmentused in its operations under arrangements accounted for as operating leases. Thefacility leases generally require the Company to pay operating costs, includingproperty taxes, insurance and maintenance, and certain of them containscheduled rent increases and renewal options. Leasehold improvements areamortized over their estimated useful lives or lease period, whichever isshorter. The Company recognizes rent expense on a straight-line basisover the term of each lease. Total rent expense for all operating leases was$6,629, $6,246 and $5,567 in 2006, 2005 and 2004, respectively.

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**8.**   COMMITMENTS AND CONTINGENCIES (Continued)

As of December 31,2006, the Company had various non-cancelable operating and capital leaseswith terms greater than one year. Future minimum lease payments for all non-cancelableoperating and capital leases at December 31, 2006 were as follows:
| ** **                                   | ** ** | **Operating** | ** ** | **Capital** | ** ** |
|----------------------------------------------|------------|---------------|------------|-------------|------------|
| ** **                                   | ** ** | **Leases**    | ** ** | **Leases**  | ** ** |
| 2007                                         |       |          | $          | 5,335       |       |   |   | $ | 7 |   |   |
| 2008                                         |       |          | 5,411      |        |       |   | 7 |   |   |
| 2009                                         |       |          | 5,477      |        |       |   | 8 |   |   |
| 2010                                         |       |          | 5,554      |        |       |   | – |   |   |
| 2011                                         |       |          | 3,966      |        |       |   | – |   |   |
| Thereafter                                   |       |          | 18,893     |        |       |   | – |   |   |
|                                         |       |          | $          | 44,636      |       |   |   | 22 |   |   |
| Less: amount  representing interest          |       |          |       |        |       |   | 3 |   |   |
| Present value of  net minimum lease payments |       |          |       |        |       |   | 19 |   |   |
| Less: current  portion                       |       |          |       |        |       |   | 6 |   |   |
|                                         |       |          |       |        |       |   | $ | 13 |   |   |

 

**Other Commitments**

As of December 31, 2006, binding commitments forfuture capital expenditures were approximately $1,600 in the aggregate.

SureWest Long Distance provides long distance servicesunder resale arrangements with two interexchange carriers, Global Crossing Ltd.(“Global Crossing”) and Sprint Communications Company L.P. (“Sprint”). Theagreement with Global Crossing expired in July 2004. SureWest LongDistance now maintains a month-to-month agreement with GlobalCrossing. During 2005, the Company renegotiated its agreement with Sprintthrough March 2007. The Company’s minimum usage requirement for Sprint for2007 is $630. For the years ended December 31, 2006, 2005 and 2004, theCompany paid $2,378, $2,088 and $1,435, respectively, under these long distanceresale arrangements.

SureWest Broadbandprovides Internet access services and has procured dedicated access andtransport agreements with various communication providers. The Company’sminimum usage requirement related to these agreements for 2007 is $213. For theyears ended December 31, 2006 and 2005, the Company paid $422 and $419,respectively (none in 2004).

**Litigation,Regulatory Proceedings and Other Contingencies**

The Company is subject to certain legal and regulatoryproceedings, Internal Revenue Service examinations and other income taxexposures, and other claims arising in the ordinary course of its business. Inthe opinion of management, the ultimate outcome of these matters will notmaterially affect the consolidated financial position, results of operations orcash flows of the Company.

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**9.   EQUITY INCENTIVEPLANS**

***Stock Plans***

The Company has two EquityIncentive Plans (the “Stock Plans”) for certain employees, outside directorsand consultants of the Company, which were approved by shareholders. TheCompany authorized for future issuance under the Stock Plans approximately 1.7million shares (subject to upward adjustment based upon the Company’s issuedand outstanding shares) of authorized, but unissued, common stock. As of December 31,2006, 1,069,925 shares were available for grant. The Stock Plans permitissuance by the Company of awards in the form of restricted common shares (“RSAs”),RSUs, performance shares, stock options and stock appreciation rights. Theexercise price per share of the Company’s common stock purchasable under anystock option shall not be less than 100% of the fair market value of a share ofthe Company’s common stock on the date of the grant, and the exercise priceunder a non-qualified stock option shall not be less than 85% of the fairmarket value of the Company’s common stock at the date of the grant. The termof any stock option shall not exceed ten years.

***Restricted Common Stock Awards and Units***

Thefollowing table summarizes the RSAs and RSUs granted to certain eligibleparticipants during the years ended December 31, 2006, 2005 and 2004:
| ** **    | ** ** | **Year ended December 31,** | ** ** |
|---------------|------------|--------------------------------------------|------------|
| ** **    | ** ** | **2006**                                   | ** ** | **Grant Date  Fair Value** | ** ** | **2005** | ** ** | **Grant Date  Fair Value** | ** ** | **2004** | ** ** | **Grant Date  Fair Value** | ** ** |
| RSAs Granted  |       | 38,171                                     |       | $ | 17.70-$27.63 |   | 40,414 |   | $ | 27.65-$29.05 |   | 18,875 |   | $ | 26.57-$32.01 |   |
| RSUs Granted  |       | 18,462                                     |       | $ | 22.54-$27.63 |   | 66,749 |   | $ | 22.43-$29.05 |   | 5,200 |   | $28.75 |   |
| RSU Dividends |       | 101                                        |       | $ | 18.75-$19.62 |   | 36 |   | $24.02 |   | – |   | – |   |
| Total         |       | 56,734                                     |       |   |   | 107,199 |   |   |   | 24,075 |   |   |   |
|               |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Stock-based compensation expense for both RSAsand RSUs of $1,219, $1,489 and $939 was recorded during the years ended December 31,2006, 2005 and 2004, respectively. RSAs and RSUs are amortized over theirrespective vesting periods, which range from immediate vesting to a five-yearvesting period. The Company records stock-based compensation for grantsof RSAs and RSUs on a straight-line basis. The Company will continue torecognize stock-based compensation for RSAs and RSUs granted prior to theadoption of SFAS No. 123(R) using the graded vesting method. TheCompany has estimated expected forfeitures based on historical experience andis recognizing compensation expense only for those RSAs and RSUs expected tovest. In accordance with SFAS No. 123(R), on January 1, 2006 theCompany reversed the deferred stock compensation balance of $2,255 to commonstock.

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**surewest communications notes to consolidated financial statements (Continued) years ended december 31, 2005, 2004 and 2003**

**9.**   EQUITY INCENTIVE PLANS (Continued)

The following tablesummarizes the restricted common stock activity during the year ended December 31,2006:
| **Nonvested Shares**              | ** ** | ** ** | ** ** | **Shares** | ** ** | **Weighted Average  Grant Date Fair Value** | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|-----------------------------------------------------------------|------------|
| Nonvested–January 1, 2006    |       | 128,998    |       |       | $          | 29.44                                                           |       |   |
| Granted                                |       | 56,734     |       |       | 24.82      |                                                            |       |
| Vested                                 |       | (51,432    | )          |       | 27.68      |                                                            |       |
| Forfeited                              |       | (8,833     | )          |       | 26.62      |                                                            |       |
| Nonvested–December 31,  2006 |       | 125,467    |       |       | $          | 27.00                                                           |       |   |

 

As of December 31, 2006, total unrecognizedcompensation cost related to nonvested restricted stock was $1,959 and will berecognized over a weighted-average period of approximately two years. Thetotal fair value of RSAs and RSUs vested during the years ended December 31,2006, 2005 and 2004 was $1,424, $833 and $591, respectively.

On each date that theCompany pays a cash dividend to the holders of the Company’s common stock, theCompany credits to the holders of RSUs an additional number of RSUs equal tothe total number of whole RSUs and additional RSUs previously credited to theholders multiplied by the dollar amount of the cash dividend per share ofcommon stock. Any fractional RSUs resulting from such calculation will beincluded in the additional RSUs. Additional RSUs are subject to the same termsand conditions of the RSUs to which they relate. The Company recorded theadditional RSUs of $74 and $59 for the years ended December 31, 2006 and2005 (none for 2004).

***Stock Options***

TheCompany issues new shares of common stock upon exercise of stock options. Thefollowing table summarizes stock option activity for the year ended December 31,2006, along with options exercisable at the end of the year:
| ** **                                            | ** ** | **Options** | ** ** | **Weighted  Average  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** |
|-------------------------------------------------------|------------|-------------|------------|------------------------------|------------|-----------------------------------------------------|------------|
| Outstanding–January 1, 2006                 |       | 622,313     |       |                         | $          | 40.65                                               |       |   |   |   |   |   |
| Forfeited                                             |       | (238,599    | )          |                         | –     |                                                |       |   |   |   |   |
| Outstanding–December 31, 2006               |       | 383,714     |       |                         | $          | 40.28                                               |       |   |   | 4 |   |   |
| Vested or expected to  vest at December 31, 2006 |       | 383,714     |       |                         | $          | 40.28                                               |       |   |   | 4 |   |   |
| Exercisable at end of year                            |       | 383,615     |       |                         | $          | 40.28                                               |       |   |   | 4 |   |   |

 

There were no stockoptions granted, exercised or expired during the year ended December 31,2006. In addition, the exercise price of stock options in the aggregate wasabove the current market price of the Company’s stock.

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**surewest communications notes to consolidated financial statements (Continued) years ended december 31, 2005, 2004 and 2003**

**10.   STOCK REPURCHASE**

In November 2006, the Company’s Board ofDirectors increased the number of shares of the Company’s common stockauthorized for repurchase from 1.5 million shares up to 2.5 million shares.Shares are purchased from time to time in the open market, or through privatelynegotiated transactions, subject to overall financial and market conditions.Through December 31, 2006, approximately 1.2 million shares of commonstock have been repurchased. The Company has remaining authorization from the Boardof Directors to repurchase an additional 1.3 million outstanding shares as of December 31,2006. The purchase of common shares did not have a substantive effect on theaverage number of common shares outstanding or on the calculation of basic anddiluted earnings per share.

**11.   SHAREHOLDERRIGHTS PLAN AND CHANGE IN CONTROL AGREEMENT**

The Company has a Shareholder Rights Plan whereinshareholders of the Company receive rights to purchase the Company’s commonstock, or an acquirer’s common stock, at a discount in certain events involvingan acquisition of 20% or more of the Company’s common stock by any person orgroup in a transaction not approved by the Company’s Board of Directors. Therights expire in March 2008.

The Company has change in control agreements withapproximately 23 employees, which provide upon (i) a change in control ofthe Company and (ii) a constructive termination of employment, the paymentof a severance benefit approximately equal to twice the employee’s annualcompensation.

**12.   BUSINESSSEGMENTS**

The Company has three reportable business segments:Telecom, Broadband and Wireless. The Telecom segment has included SureWestTelephone, SureWest Directories and SureWest Long Distance, which providelandline telecommunications services, directory advertising, DSL service, longdistance services and certain non-regulated services. SureWest Telephone,which is the principal operating subsidiary of the Telecom segment, provideslocal services, toll telephone services, network access services and certainnon-regulated services. SureWest Directories published and distributedSureWest Telephone’s directory, including the sale of yellow pages advertising.SureWest Directories was also engaged in the business of producing, publishingand distributing directories in other Northern California communities outsideof SureWest Telephone’s service area. SureWest Long Distance provides longdistance services.

The Broadband segment provides various services,including: high-speed and dial-up Internet; digital video; voice,network access and toll telephone; and managed services in the greaterSacramento area, principally to customers residing outside of SureWestTelephone’s service area. The Broadband segment includes the Company’ssubsidiary SureWest Broadband and SureWest Broadband Business services, whichis comprised, in part, of a division of SureWest Telephone operating as aCompetitive Local Exchange Carrier.

The Wireless segment consists of the Company’ssubsidiary SureWest Wireless, which provides wireless services. Wirelessrevenues include wireless voice services, sales of handsets and relatedaccessories, long distance, roaming service and custom calling features.Wireless services are provided on a month-to-month basis and aregenerally billed in advance for non-contract subscribers and in arrearsfor contract subscribers.

In accordance with the provisions of SFAS No. 131,*Disclosure About Segments of an Enterpriseand Related Information*, the Company has aggregated certain of itsoperating segments within the Telecom and 

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**surewest communications notes to consolidated financial statements (Continued) years ended december 31, 2005, 2004 and 2003**

**12.**   BUSINESS SEGMENTS (Continued)

Broadband segments because it believes that suchoperating segments share similar economic characteristics.

Corporate Operations are allocated to the appropriatesegment, except for cash; investments, certain property, plant, and equipment;and miscellaneous other assets, which are not allocated to the segments.However, the investment income associated with cash and investments held byCorporate Operations is included in the results of the operations of theCompany’s segments. The Company evaluates the performance of its segments basedon income (loss) from operations.

These segments are strategic business units that offerdifferent products and services. The accounting policies of these segments arethe same as those described in Notes 1 and 2. The Company accounts forintersegment revenues and expenses at prevailing market rates. The Company’sbusiness segment information is as follows:
| **2006**                                       | ** ** | **Telecom** | ** ** | **Broadband** | ** ** | **Wireless** | ** ** | **Corporate  Operations** | ** ** | **Intercompany  Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------|------------|-------------|------------|---------------|------------|--------------|------------|---------------------------|------------|--------------------------------|------------|------------------|------------|
| Operating  revenues from external customers    |       | $           | 128,758    |          |       | $            | 59,794     |                      |       | $                              | 34,193     |             |       | $ | – |   |   | $ | – |   |   | $ | 222,745 |   |   |
| Intersegment  revenues                         |       | 29,484      |       |          | 1,507      |         |       | 2,864                     |       |                           | –     |             |       | (33,855 | ) |   | – |   |   |
| Operating  expenses*                           |       | 75,368      |       |          | 64,811     |         |       | 39,984                    |       |                           | –     |             |       | (33,855 | ) |   | 146,308 |   |   |
| Depreciation and  amortization                 |       | 25,041      |       |          | 22,827     |         |       | 11,910                    |       |                           | –     |             |       | – |   |   | 59,778 |   |   |
| Income (loss)  from operations                 |       | 57,833      |       |          | (26,337    | )            |       | (14,837                   | )          |                           | –     |             |       | – |   |   | 16,659 |   |   |
| Interest income                                |       | 488         |       |          | 14         |         |       | 2                         |       |                           | –     |             |       | – |   |   | 504 |   |   |
| Interest expense,  net of capitalized interest |       | (642        | )          |          | (4,723     | )            |       | (1,517                    | )          |                           | –     |             |       | – |   |   | (6,882 | ) |   |
| Income tax  expense (benefit)                  |       | 23,496      |       |          | (12,875    | )            |       | (6,691                    | )          |                           | –     |             |       | – |   |   | 3,930 |   |   |
| Net income (loss)                              |       | $           | 34,022     |          |       | $            | (18,597    | )                         |       | $                              | (9,687     | )                |       | $ | – |   |   | $ | – |   |   | $ | 5,738 |   |   |
| Total assets                                   |       | $           | 724,080    |          |       | $            | 395,296    |                      |       | $                              | 152,722    |             |       | $ | 500,868 |   |   | $ | (1,327,216 | ) |   | $ | 445,750 |   |   |
| Capital expenditures                           |       | $           | 10,367     |          |       | $            | 39,285     |                      |       | $                              | 2,319      |             |       | $ | 3,422 |   |   | $ | – |   |   | $ | 55,393 |   |   |

 
| **2005**                                       | ** ** | **Telecom** | ** ** | **Broadband** | ** ** | **Wireless** | ** ** | **Corporate  Operations** | ** ** | **Intercompany  Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------|------------|-------------|------------|---------------|------------|--------------|------------|---------------------------|------------|--------------------------------|------------|------------------|------------|
| Operating revenues from  external customers    |       | $           | 134,468    |          |       | $            | 49,915     |                      |       | $                              | 34,205     |             |       | $ | – |   |   |   | $ | – |   |   |   | $ | 218,588 |   |   |
| Intersegment revenues                          |       | 30,056      |       |          | 1,693      |         |       | 2,592                     |       |                           | –     |             |       |   | (34,341 | ) |   |   | – |   |   |
| Operating expenses*                            |       | 85,503      |       |          | 59,942     |         |       | 37,784                    |       |                           | –     |             |       |   | (34,341 | ) |   |   | 148,888 |   |   |
| Depreciation and  amortization                 |       | 25,428      |       |          | 16,451     |         |       | 11,891                    |       |                           | –     |             |       |   | – |   |   |   | 53,770 |   |   |
| Income (loss) from  operations                 |       | 53,593      |       |          | (24,785    | )            |       | (12,878                   | )          |                           | –     |             |       |   | – |   |   |   | 15,930 |   |   |
| Interest income                                |       | 437         |       |          | 7          |         |       | 1                         |       |                           | –     |             |       |   | – |   |   |   | 445 |   |   |
| Interest expense, net of  capitalized interest |       | (841        | )          |          | (3,171     | )            |       | (1,663                    | )          |                           | –     |             |       |   | – |   |   |   | (5,675 | ) |   |
| Income tax expense  (benefit)                  |       | 22,951      |       |          | (12,579    | )            |       | (6,464                    | )          |                           | –     |             |       |   | – |   |   |   | 3,908 |   |   |
| Net income (loss)                              |       | $           | 30,033     |          |       | $            | (15,438    | )                         |       | $                              | (8,217     | )                |       | $ | – |   |   |   | $ | – |   |   |   | $ | 6,378 |   |   |
| Total assets                                   |       | $           | 674,894    |          |       | $            | 292,903    |                      |       | $                              | 147,955    |             |       | $ | 318,056 |   |   |   | $ | (974,779 | ) |   |   | $ | 459,029 |   |   |
| Capital expenditures                           |       | $           | 10,205     |          |       | $            | 54,677     |                      |       | $                              | 3,061      |             |       | $ | 1,825 |   |   |   | $ | – |   |   |   | $ | 69,768 |   |   |

 

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**SUREWEST COMMUNICATIONS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (C**ontinued) YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004

**12.**   BUSINESSSEGMENTS (Continued)
| **2004**                                       | ** ** | **Telecom** | ** ** | **Broadband** | ** ** | **Wireless** | ** ** | **Corporate  Operations** | ** ** | **Intercompany  Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------|------------|-------------|------------|---------------|------------|--------------|------------|---------------------------|------------|--------------------------------|------------|------------------|------------|
| Operating revenues from  external customers    |       | $           | 141,086    |          |       | $            | 39,416     |                      |       | $                              | 31,261     |             |       | $ | – |   |   |   | $ | – |   |   |   | $ | 211,763 |   |   |
| Intersegment revenues                          |       | 25,814      |       |          | 1,784      |         |       | 1,699                     |       |                           | –     |             |       |   | (29,297 | ) |   |   | – |   |   |
| Operating expenses*                            |       | 91,736      |       |          | 61,143     |         |       | 38,266                    |       |                           | –     |             |       |   | (29,297 | ) |   |   | 161,848 |   |   |
| Depreciation and  amortization                 |       | 25,227      |       |          | 11,397     |         |       | 11,972                    |       |                           | –     |             |       |   | – |   |   |   | 48,596 |   |   |
| Income (loss) from  operations                 |       | 49,937      |       |          | (31,340    | )            |       | (17,278                   | )          |                           | –     |             |       |   | – |   |   |   | 1,319 |   |   |
| Interest income                                |       | 193         |       |          | 8          |         |       | –                    |       |                           | –     |             |       |   | – |   |   |   | 201 |   |   |
| Interest expense, net of  capitalized interest |       | (488        | )          |          | (2,247     | )            |       | (1,770                    | )          |                           | –     |             |       |   | – |   |   |   | (4,505 | ) |   |
| Corporate treasury loss  recovery              |       | 1,246       |       |          | 342        |         |       | 215                       |       |                           | –     |             |       |   | – |   |   |   | 1,803 |   |   |
| Income tax expense  (benefit)                  |       | 22,347      |       |          | (14,558    | )            |       | (8,286                    | )          |                           | –     |             |       |   | – |   |   |   | (497 | ) |   |
| Net income (loss)                              |       | $           | 28,322     |          |       | $            | (18,627    | )                         |       | $                              | (10,823    | )                |       | $ | – |   |   |   | $ | – |   |   |   | $ | (1,128 | ) |   |
| Total assets                                   |       | $           | 622,668    |          |       | $            | 202,335    |                      |       | $                              | 139,830    |             |       | $ | 178,904 |   |   |   | $ | (694,834 | ) |   |   | $ | 448,903 |   |   |
| Capital expenditures                           |       | $           | 9,678      |          |       | $            | 50,330     |                      |       | $                              | 5,605      |             |       | $ | 5,220 |   |   |   | $ | – |   |   |   | $ | 70,833 |   |   |

 

*Exclusive of depreciationand amortization

**13.   SUBSEQUENT EVENT (UNAUDITED)**

In January 2007, the Company entered into adefinitive agreement with GateHouse Media to sell SureWest Directories, itsdirectory publishing business. The transaction was consummated on February 28,2007. Under the agreement, GateHouse Media acquired 100% of the stock ofSureWest Directories for an aggregate cash purchase price of $110,123, subjectto a post-closing working capital adjustment. Under related agreements,GateHouse Media will continue to publish SureWest Telephone’s directory.

Summarizedfinancial information for SureWest Directories operations for the years ended December 31,2006, 2005 and 2004 are set forth below:
| ** **                      | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Directory advertising  revenues |       | $        | 17,849     |     | $          | 16,559   |       | $ | 15,848 |   |
| Income before income  taxes     |       | 9,757    |       | 9,234    |       | 8,844    |       |
| Income tax expense              |       | (3,966   | )          | (3,749   | )          | (3,591   | )          |
| Net income                      |       | $        | 5,791      |     | $          | 5,485    |       | $ | 5,253 |   |

 

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**SUREWEST COMMUNICATIONS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (C**ontinued) YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004

**13.**   SUBSEQUENT EVENT (UNAUDITED) (Continued)

As of December 31,2006 and 2005 the major components of SureWest Directories assets andliabilities to be sold were as follows:
| ** **                              | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|
| Accounts receivable, net                |       | $        | 777        |     | $          | 1,068 |   |
| Prepaid and deferred  directory costs   |       | 4,898    |       | 5,135    |       |
| Property, plant and  equipment, net     |       | 57       |       | 106      |       |
| Total assets                            |       | $        | 5,732      |     | $          | 6,309 |   |
| Accounts payable  and other liabilities |       | $        | 164        |     | $          | 128 |   |
| Accrued compensation                    |       | 134      |       | 162      |       |
| Total liabilities                       |       | $        | 298        |     | $          | 290 |   |

 

Presentedbelow is the Company’s consolidated net income (loss) included in theconsolidated statement of operations for the years ended December 31,2006, 2005, and 2004 and on an unaudited proforma basis to reflect the sale ofthe sale of SureWest Directories and classification of its results ofoperations as discontinued operations:
| ** **                                                                        | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Consolidated net  income (loss)                                                   |       | $        | 5,738      |     | $          | 6,378    |       | $ | (1,128 | ) |
| Less SureWest  Directories results of operations:                                 |       |     |       |     |       |     |       |
| Revenues                                                                          |       | 17,849   |       | 16,559   |       | 15,848   |       |
| Cost and expenses                                                                 |       | (8,095   | )          | (7,329   | )          | (7,007   | )          |
| SureWest Directories income from operations before  other income and income taxes |       | 9,754    |       | 9,230    |       | 8,841    |       |
| Other income                                                                      |       | 3        |       | 4        |       | 3        |       |
| Income tax (expense)                                                              |       | (3,966   | )          | (3,749   | )          | (3,591   | )          |
| SureWest Directories net  income                                                  |       | 5,791    |       | 5,485    |       | 5,253    |       |
| Consolidated proforma  net income (loss)                                          |       | $        | (53        | )        | $          | 893      |       | $ | (6,381 | ) |

 

**14.   QUARTERLYFINANCIAL INFORMATION (UNAUDITED)**
| **2006**                    | ** ** | **March 31** | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
|-----------------------------|------------|-------------------|------------|------------------|------------|-----------------------|------------|----------------------|------------|
| Operating  revenues         |       |              | $          | 54,371           |       |                  | $          | 55,568               |       |   | $ | 56,882 |   |   |   | $ | 55,924 |   |   |
| Income from  operations     |       |              | $          | 3,613            |       |                  | $          | 4,174                |       |   | $ | 5,376 |   |   |   | $ | 3,496 |   |   |
| Net income                  |       |              | $          | 1,199            |       |                  | $          | 1,404                |       |   | $ | 2,157 |   |   |   | $ | 978 |   |   |
| Basic earnings per  share   |       |              | $          | 0.08             |       |                  | $          | 0.10                 |       |   | $ | 0.15 |   |   |   | $ | 0.06 |   |   |
| Diluted earnings per  share |       |              | $          | 0.08             |       |                  | $          | 0.10                 |       |   | $ | 0.15 |   |   |   | $ | 0.06 |   |   |

 
| **2005**                    | ** ** | **March 31** | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
|-----------------------------|------------|-------------------|------------|------------------|------------|-----------------------|------------|----------------------|------------|
| Operating  revenues         |       |              | $          | 53,456           |       |                  | $          | 54,706               |       |   | $ | 55,569 |   |   |   | $ | 54,857 |   |   |
| Income from  operations     |       |              | $          | 2,569            |       |                  | $          | 4,897                |       |   | $ | 4,797 |   |   |   | $ | 3,667 |   |   |
| Net income                  |       |              | $          | 843              |       |                  | $          | 2,147                |       |   | $ | 1,960 |   |   |   | $ | 1,428 |   |   |
| Basic earnings  per share   |       |              | $          | 0.06             |       |                  | $          | 0.15                 |       |   | $ | 0.13 |   |   |   | $ | 0.10 |   |   |
| Diluted earnings per  share |       |              | $          | 0.06             |       |                  | $          | 0.15                 |       |   | $ | 0.13 |   |   |   | $ | 0.10 |   |   |

 

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**SUREWEST COMMUNICATIONS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (C**ontinued) YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004

**14.**   QUARTERLY FINANCIAL INFORMATION (UNAUDITED)(Continued)

In December 2004, the Company initiated theREWARD program which was offered to certain eligible employees across allbusiness units. In addition to retirement benefits, eligible employees receiveenhanced medical benefits for a specified period of time. As of December 31,2004, 59 employees had accepted the REWARD program and the Company recordedoperating expenses of $3,768 related to the REWARD program during the fourthquarter of 2004. During the quarter ended March 31, 2005, the Companyrecorded $791 in operating expenses attributed to 13 employees that acceptedthe REWARD program in 2005.

In October 2005, the Company resolved its claimfiled in January 2003 related to pre-petition accounts receivable,and to a conditional payment made by SureWest to MCI in connection withanticipated overearnings during the 1999-2000 monitoring period. Inaccordance with the MCI Plan of Reorganization, the Company received adistribution of cash and stock, with a combined fair value of approximately$1,400. The distribution was recognized in the Company’s 2005 consolidatedstatement of operations as an increase to network access service revenue and adecrease to general and administrative expense of $800 and $600, respectively.

As a result of periodic cost separation studies,SureWest Telephone changed its estimates for a portion of its interstateshareable earnings obligations and certain NECA CL accounts receivable balancesrelated to current and prior year monitoring periods during the years ended December 31,2006 and 2005. These changes in accounting estimates increased the Company’sconsolidated revenues and net income by $136 and $82 ($0.01 per share), $177and $108 ($0.01 per share), $185 and $112 ($0.01 per share) during the first,second and third quarters of 2006, respectively. The Company did not record anysignificant changes in estimates during the fourth quarter of 2006. In 2005,these changes in accounting estimates increased the Company’s consolidatedrevenues and net income by $57 and $35 (no effect on earnings per share), $757and $462 (no effect on earnings per share), $175 and $107 (no effect onearnings per share) and $47 and $29 (no effect on earnings per share) duringthe first, second, third and fourth quarters of 2005, respectively.

During the quarters ended June 30, 2006 and September 30,2006, the Company changed its estimated costs for 2006 related to its PensionPlan and Post-retirement Welfare Plan based on revised actuarial calculations.In addition, during the quarter ended September 30, 2006, the Company alsorevised its 2006 estimate of certain employee compensation incentives. Thecombined effect of these changes in estimates decreased operating expenses byapproximately $1,039 and $679 and increased net income by $632 ($0.04 pershare) and $409 ($0.03 per share) during the quarters ended June 30 and September 30,2006, respectively.

In January 2007, the Company’s Board of Directorsauthorized amendments to the Plans. As a result of these amendments, effectiveas of April 1, 2007, the Company will freeze the Pension Plan so that noperson will become eligible to participate in the Plans on or following theeffective date and all future benefit accruals under the Plans shall cease. Theamendments to the Plans have been accounted for as plan curtailments, resultingin the recognition of a $574 non-cash pretax curtailment loss ($0.04 pershare) reflected in operating expenses in the Company’s consolidated statementof operations during the fourth quarter ended December 31, 2006.

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**Item 9.**                        Changesin and Disagreements With Accountants on Accounting and Financial Disclosure.

Not Applicable.

**Item 9A.**                Controlsand Procedures.

**Controls andProcedures**

As of the end of theperiod covered by this report, we carried out an evaluation, under thesupervision and with the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934). Based on thisevaluation, the Chief Executive Officer and Chief Financial Officer haveconcluded that, as of December 31, 2006, the Company’s disclosure controlsand procedures were effective to ensure that information required to bedisclosed by the Company in reports that it files or submits under theSecurities Exchange Act is authorized, recorded, processed, summarized andreported within the time periods specified in Securities and Exchange Commissionrules and forms.

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**Management’s Reporton Internal Control over Financial Reporting**

The management of the Company is responsible forestablishing and maintaining adequate internal control over financialreporting. The Company’s internal control system was designed to providereasonable assurance to the Company’s management, Board of Directors and AuditCommittee regarding the reliability of financial reporting and the preparationof published financial statements in accordance with generally accepted accountingprinciples in the United States of America. Under the supervision and with theparticipation of our management, including our Chief Executive Officer andChief Financial Officer, we conducted an evaluation of the effectiveness of ourinternal control over financial reporting as of December 31, 2006 based onthe framework in Internal Control-Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission (“COSO”).Based on this assessment, the Company’s management concluded that, as of December 31,2006, the Company’s internal control over financial reporting was effective.

All internal control systems, no matter how welldesigned, have inherent limitations. Therefore, even those systems determinedto be effective can provide only reasonable assurance with respect to financialstatement preparation and presentation.

Management’s assessment of the effectiveness of ourinternal control over financial reporting as of December 31, 2006 has beenaudited by Ernst & Young LLP, an independent registered publicaccounting firm, as stated in its report, which is included elsewhere herein.

**Change in InternalControl over Financial Reporting**

During the fourth quarterof 2006 the Company implemented an upgrade to its existing enterprise resourceplanning system. Except for the enterprise resource planning system upgrade,there has been no change in the Company’s internal control over financialreporting during the fourth quarter of 2006 that has materially affected, or isreasonably likely to materially affect, the Company’s control over financialreporting.

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**Report ofIndependent Registered Public Accounting Firm**

**The Board ofDirectors and Shareholders of SureWest Communications**

We have audited management’s assessment, included inthe accompanying “Management’s Report on Internal Control Over FinancialReporting,” that SureWest Communications maintained effective internal controlover financial reporting as of December 31, 2006, based on criteriaestablished in Internal Control–Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission (the COSO criteria).SureWest Communication’s management is responsible for maintaining effectiveinternal control over financial reporting and for its assessment of theeffectiveness of internal control over financial reporting. Our responsibilityis to express an opinion on management’s assessment and an opinion on theeffectiveness of the company’s internal control over financial reporting basedon our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonable assurancethat transactions are recorded as necessary to permit preparation of financialstatements in accordance with generally accepted accounting principles, andthat receipts and expenditures of the company are being made only in accordancewith authorizations of management and directors of the company; and (3) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the company’s assets that could have amaterial effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

In our opinion, management’s assessment that SureWestCommunications maintained effective internal control over financial reportingas of December 31, 2006, is fairly stated, in all material respects, basedon the COSO criteria. Also, in our opinion, SureWest Communications maintained,in all material respects, effective internal control over financial reportingas of December 31, 2006, based on****theCOSO criteria**.**

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheets of SureWest Communications asof December 31, 2006 and 2005, and the related consolidated statements ofoperations, shareholders’ equity, and cash flows for each of the three years inthe period ended December 31, 2006 of SureWest Communications and ourreport dated March 9, 2007 expressed an unqualified opinion thereon.

/s/ Ernst & YoungLLP

Sacramento, CaliforniaMarch 9, 2007

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**Item 9B.**               OtherInformation.

Not applicable.

94

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**PART III**

**Item 10.**                 Directors,Executive Officers and Corporate Governance.

For information regardingthe executive officers of the Company, see “Executive Officers” in Part I,Item 1 of this report. Other information required by this item is incorporatedherein by reference from the proxy statement for the annual meeting of theCompany’s shareholders to be filed pursuant to Regulation 14A within 120 daysafter the Company’s fiscal year-end of December 31, 2006.

**Item 11.**                 ExecutiveCompensation.

Incorporated herein byreference from the proxy statement for the annual meeting of the Company’sshareholders to be filed pursuant to Regulation 14A within 120 days after theCompany’s fiscal year-end of December 31, 2006.

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters.

**Equity CompensationPlan Information**

The Company maintains the 1999 Restricted Stock BonusPlan (the “1999 Plan”) and the 2000 Equity Incentive Plan (the “2000 Plan”),pursuant to which it may grant equity awards to eligible persons. The 1999 Planand the 2000 Plan were approved by the Company’s shareholders.

The following table provides information about equityawards under the 1999 Plan and the 2000 Plan.
| **Plan category**                                      | ** ** | **Number of securities  to be issued upon  exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted-average  exercise price of  outstanding options  warrants and rights** | ** ** | **Number of securities  remaining available  for future issuance  under equity  compensation plans  (excluding securities  reflected in column (a)** | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **(a)**                                                                                                                                          | ** ** | **(b)**                                                                                                    | ** ** | **(c)**                                                                                                                                                                                                     | ** ** |
| Equity compensation  plans approved by security holders     |       |                                                                                                                                             | 383,714    |                                                                                                       |       |                                                                                                                                                                                                        | $          | 40.28 |   |   |   | 1,069,925 |   |   |
| Equity compensation  plans not approved by security holders |       |                                                                                                                                             | –     |                                                                                                       |       |                                                                                                                                                                                                        | –     |   |   |   | – |   |   |
| Total                                                       |       |                                                                                                                                             | 383,714    |                                                                                                       |       |                                                                                                                                                                                                        | $          | 40.28 |   |   |   | 1,069,925 |   |   |

 

(1)          The 1999 Plan permits only the issuance ofRestricted Shares. As of December 31, 2006, the Company had madeRestricted Share grants of 34,268 shares of the Company’s common stock, and166,107 shares of the Company’s common stock remain available under the 1999Plan.

(2)          The 2000 Plan, asoriginally approved by the Company’s shareholders, contemplated the issuance ofup to 800,000 shares of the Company’s common stock. Thereafter, the Company’sshareholders approved an increase to 950,000 shares and the incorporation of anevergreen provision pursuant to which the number of shares of the Company stockwhich shall be made available under the 2000 Plan shall be 950,000 shares plusan annual increase to be added on the first business day of each calendar yearand thereafter beginning with January 2, 2003 equal to one percent of theoutstanding shares as of December 31 of the immediately preceding calendaryear.

Additional informationrequired by Item 12 is incorporated herein by reference from the proxy statementfor the annual meeting of the Company’s shareholders to be filed pursuant toRegulation 14A within 120 days after the Company’s fiscal year-end of December 31,2006.

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**Item 13.**                 CertainRelationships and Related Transactions, and Director Independence.

Incorporated herein byreference from the proxy statement for the annual meeting of the Company’sshareholders to be filed pursuant to Regulation 14A within 120 days after theCompany’s fiscal year-end of December 31, 2006.

**Item 14.**                 PrincipalAccountant Fees and Services.

Incorporated herein byreference from the proxy statement for the annual meeting of the Company’sshareholders to be filed pursuant to Regulation 14A within 120 days after theCompany’s fiscal year-end of December 31, 2006.

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**PART IV**

**Item 15.**                 Exhibits andFinancial Statement Schedules.

(a)            1.      AllFinancial Statements

The following financial statements are filed as partof this report under Item 8–“Financial Statements and Supplementary Data”:

Report of Independent Registered Public AccountingFirm

Consolidated Statements of Operations for each of thethree years in the period ended December 31, 2006

Consolidated Balance Sheets as of December 31,2006 and 2005

Consolidated Statements of Shareholders’ Equity foreach of the three years in the period ended December 31, 2006

Consolidated Statements of Cash Flows for each of thethree years in the period ended December 31, 2006

Notes to Consolidated Financial Statements (including:Quarterly Financial Information (Unaudited))

Management’s Reporton Internal Control over Financial Reporting is contained as part of thisreport under Item 9A–“Controls and Procedures.”

2.                 FinancialStatement Schedules

Financial statement schedules have been omittedbecause they are not required, not applicable or the information is otherwiseincluded in the notes to the consolidated financial statements.

3.                 Exhibits

The exhibits listed on the accompanying Index toExhibits are filed or furnished as part of this report.

 

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**SUREWESTCOMMUNICATIONSINDEX TO EXHIBITS(Item 15 (a) 3)**
| Exhibit   No. | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                 | ** ** | **Method   of Filing**     |
|---------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|
| 3.1           |       | Articles of  Incorporation of Registrant, together with Certificate of Amendment of  Articles of Incorporation dated January 25, 1996 and Certificate of  Amendment of Articles of Incorporation dated June 21, 1996 (Filed as  Exhibit 3(a) to Form 10-Q Quarterly Report for the  quarter ended September 30, 1996)                                                                                             |       | Incorporated  by reference |
| 3.2           |       | Certificate of  Amendment of Articles of Incorporation dated May 18, 2001 (Filed as  Exhibit 3(b) to Form 10-Q Quarterly Report for the  quarter ended June 30, 2001)                                                                                                                                                                                                                                                  |       | Incorporated  by reference |
| 3.3           |       | Bylaws of  Registrant (Filed as Exhibit 3(b) to Form 10-K Annual  Report of the Registrant for the year ended December 31, 2000)                                                                                                                                                                                                                                                                                            |       | Incorporated  by reference |
| 4.1           |       | Shareholder  Rights Plan (Filed as Exhibit 2.1 to Form 8-A Registration  Statement under the Securities Act of 1934)                                                                                                                                                                                                                                                                                                                  |       | Incorporated  by reference |
| 10.1          |       | Note Purchase  Agreement for Series A Senior Notes in the aggregate amount of  $40,000,000 dated December 9, 1998 (Filed as Exhibit 10(b) to  Form 10-K Annual Report of Registrant for the year ended  December 31, 1998)                                                                                                                                                                                        |       | Incorporated  by reference |
| 10.2          |       | Supplement to  Note Purchase Agreement for Series B Senior Notes in the aggregate  amount of $60,000,000 dated March 13, 2003 (Filed as Exhibit 99.1  to the Form 8-K filed March 13, 2003)                                                                                                                                                                                                                            |       | Incorporated  by reference |
| 10.3          |       | Credit agreement  dated as of May 1, 2006 between SureWest Communications and CoBank, ACB  (filed as Exhibit 99.1 to Form 8-K filed May 2, 2006)                                                                                                                                                                                                                                                                            |       | Incorporated  by reference |
| 10.4          |       | Share Purchase  Agreement among SureWest Communications, SureWest Directories and Gatehouse  Media, Inc., dated as of January 28, 2007. Pursuant to Item  601(b)(2) of Regulation S-K, the Registrant agrees to furnish,  supplementally, a copy of any exhibit or schedule omitted from the Share  Purchase Agreement to the Commission upon request (Filed as Exhibit 10.1  to Form 8-K filed January 29, 2007) |       | Incorporated  by reference |
| 10.5          |       | 1999 Restricted  Stock Bonus Plan (Filed as Exhibit 10(d) to Form 10-K Annual  Report of Registrant for the year ended December 31, 1998)                                                                                                                                                                                                                                                                                             |       | Incorporated  by reference |
| 10.6          |       | 2000 Equity  Incentive Plan, as amended                                                                                                                                                                                                                                                                                                                                                                                                         |       | Filed  herewith            |
| 10.7          |       | SureWest KSOP  (Filed as Exhibit 4.1 to Registration Statement on Form S-8  [No. 333-87222])                                                                                                                                                                                                                                                                                                                                     |       | Incorporated  by reference |
| 10.8          |       | Letter agreement  dated January 16, 2001 between Registrant and Bill M. DeMuth (Filed as  Exhibit 10.14 to Form 10-K/A Annual Report of Registrant for  the year ended December 31, 2003)                                                                                                                                                                                                                                   |       | Incorporated  by reference |

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| 10.9  |   | Letter agreement  dated January 16, 2001 between Registrant and Fred A. Arcuri (Filed as  Exhibit 10.15 to Form 10-K/A Annual Report of Registrant for  the year ended December 31, 2003)                                                                                              |   | Incorporated  by reference |
|-------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|
| 10.10 |   | Steven C. Oldham  Employment Agreement dated December 15, 2005 (Filed as Exhibit 99.1  to Form 8-K filed December 16, 2005)                                                                                                                                                            |   | Incorporated  by reference |
| 10.11 |   | Letter agreement  dated December 15, 2005 between Registrant and Steven C. Oldham (Filed  as Exhibit 99.5 to Form 8-K filed December 16, 2005)                                                                                                                                              |   | Incorporated  by reference |
| 10.12 |   | Letter agreement  dated January 16, 2001, between Registrant and Scott K. Barber                                                                                                                                                                                                                 |   | Filed  herewith            |
| 10.13 |   | Release agreement  dated December 15, 2005 between Registrant and Fred A. Arcuri (Filed as  Exhibit 99.1 to Form 8-K filed December 21, 2005)                                                                                                                                          |   | Incorporated  by reference |
| 10.14 |   | Letter agreement  dated October 4, 2004 between Registrant and Philip A. Grybas                                                                                                                                                                                                                       |   | Incorporated  by reference |
| 10.15 |   | Summary of Board  of Directors’ Compensation                                                                                                                                                                                                                                                          |   | Filed  herewith            |
| 10.16 |   | Summary of  Executive Compensation (filed under Form 8-K filed on  December 11, 2006)                                                                                                                                                                                                            |   | Incorporated  by reference |
| 10.17 |   | Restricted Stock  Unit Award, dated December 21, 2004, between Registrant and Roger J.  Valine (Filed as Exhibit 10.15 to Form 10-K Annual Report of  Registrant for the year ended December 31, 2004)                                                                                 |   | Incorporated  by reference |
| 10.18 |   | Form of  Restricted Stock Unit Award, dated December 21, 2004, between Registrant  and each of Guy R. Gibson, Steven C. Oldham, John R. Roberts III and Timothy  D. Taron (Filed as Exhibit 10.16 to Form 10-K Annual Report  of Registrant for the year ended December 31, 2004) |   | Incorporated  by reference |
| 10.19 |   | Form of  Restricted Stock Unit Award, dated January 26, 2005, between Registrant  and Timothy D. Taron and Roger J. Valine (Filed as Item 1.01 to Form 8-K  filed January 27, 2006)                                                                                                    |   | Incorporated  by reference |
| 10.20 |   | Form of  Restricted Stock Unit Award, dated February 23, 2005, between Registrant  and each of Fred A. Arcuri, Bill M. DeMuth and Jay B. Kinder (Filed as  Exhibit 10.18 to Form 10-K Annual Report of Registrant for  the year ended December 31, 2004)                          |   | Incorporated  by reference |
| 10.21 |   | Form of  Restricted Stock Unit Award for Registrant’s 2000 Equity Incentive Plan  (Filed as Exhibit 10.19 to Form 10-K Annual Report of  Registrant for the year ended December 31, 2004)                                                                                         |   | Incorporated  by reference |
| 10.22 |   | Form of  Stock Option Agreement for Registrant’s 2000 Equity Incentive Plan (Filed as  Exhibit 10.20 to Form 10-K Annual Report of Registrant for  the year ended December 31, 2004)                                                                                              |   | Incorporated  by reference |

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| 10.23 |   | Form of  Restricted Stock Agreement for Registrant’s 2000 Equity Incentive Plan (Filed  as Exhibit 10.21 to Form 10-K Annual Report of Registrant for  the year ended December 31, 2004) |   | Incorporated  by reference |
|-------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|
| 21.1  |   | List of  Subsidiaries                                                                                                                                                                                             |   | Filed  herewith            |
| 23.1  |   | Consent of  Independent Registered Public Accounting Firm                                                                                                                                                         |   | Filed  herewith            |
| 31.1  |   | Certification of  Steven C. Oldham, President and Chief Executive Officer, as adopted pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002                                                             |   | Filed  herewith            |
| 31.2  |   | Certification of  Philip A. Grybas, Senior Vice President and Chief Financial Officer, as  adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                 |   | Filed  herewith            |
| 32.1  |   | Certification of  Steven C. Oldham, President and Chief Executive Officer, pursuant to 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                   |   | Filed  herewith            |
| 32.2  |   | Certification of  Philip A. Grybas, Senior Vice President and Chief Financial Officer, pursuant  to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002       |   | Filed  herewith            |

 

100

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
| SUREWEST COMMUNICATIONS  (Registrant) |
|---------------------------------------|
|                                  | By: | /s/ STEVEN C. OLDHAM |
|                                  |   | Steven C. Oldham,  President and Chief  Executive Officer |
| Date:  March 12,  2007      |   |   |

 
|                                  | By:    | /s/ PHILIP A. GRYBAS                                                  |
|----------------------------------|--------|-----------------------------------------------------------------------|
|                             |   | Philip A. Grybas,  Senior Vice President  and Chief Financial Officer |
| Date:   March 12, 2007 |   |                                                                  |

 

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.
|                                  | /s/ KIRK C.  DOYLE                                                    |
|----------------------------------|-----------------------------------------------------------------------|
|                             | Kirk C. Doyle,  Chairman of the Board                                 |
|                             | /s/ STEVEN C. OLDHAM                                                  |
|                             | Steven C. Oldham,  President and Chief Executive  Officer, Director   |
|                             | /s/ PHILIP A. GRYBAS                                                  |
|                             | Philip A. Grybas,  Senior Vice President  and Chief Financial Officer |
|                             | /s/ GUY R. GIBSON                                                     |
|                             | Guy R. Gibson,  Director                                              |
|                             | /s/ ROBERT D. KITTREDGE                                               |
|                             | Robert D. Kittredge,  Director                                        |
|                             | /s/ JOHN R. ROBERTS III                                               |
|                             | John R. Roberts III,  Director                                        |
|                             | /s/ TIMOTHY D. TARON                                                  |
|                             | Timothy D. Taron,  Director                                           |
|                             | /s/ ROGER J. VALINE                                                   |
|                             | Roger J. Valine,  Director                                            |
| Date:  March 12,  2007 |                                                                  |

 

 

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