**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

**FORM 10-Q**

[X]                               QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterlyperiod ended September 30, 2006

or

[   ]                               TRANSITION REPORT PURSUANTTO SECTION 13 or 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934

Commission FileNumber 0-556

**SUREWEST COMMUNICATIONS**

(Exact name ofregistrant as specified in its charter)
|                          California                          |             68-0365195                                                                    |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (State or other  jurisdiction  of incorporation or organization)                                                                                                                                                                                                                                                       | (IRS Employer  Identification No.)                                                                                                                                                                                |
|                                                                                                                                                                                                                                                                                                                   |                                                                                                                                                                                                              |
| 200 Vernon  Street, Roseville, California                                                                                                                                                                                                                                                                              |                  95678                  |
| (Address of  principal executive offices)                                                                                                                                                                                                                                                                              | (Zip Code)                                                                                                                                                                                                        |

 

(916) 786-6141

(Registrant’s telephone number, including area code)

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

Yes  X         No      

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer.  Seedefinition of  “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
| Large accelerated filer      | Accelerated filer  X  | Non-accelerated filer      |
|-------------------------------------------------------|--------------------------------------|-----------------------------------------------------|

 

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

Yes            No  X

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

Asof October 30, 2006, 14,436,141 shares of the registrant’s Common Stock wereoutstanding.

 

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**TABLE OF CONTENTS**
|                                     | ** ** | ** **                                                                                  | ** ** | **Page** |
|-------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|----------|
|                                |       |                                                                                        |
| **PART  I - FINANCIAL INFORMATION** |       |                                                                                        |
|                                |       |                                                                                        |
| Item 1.                             |       | Financial  Statements                                                                       |       | 3        |
|                                |       |                                                                                        |       |     |
| Item 2.                             |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |       | 18       |
|                                |       |                                                                                        |       |     |
| Item 3.                             |       | Quantitative  and Qualitative Disclosures About Market Risk                                 |       | 37       |
|                                |       |                                                                                        |       |     |
| Item 4.                             |       | Controls And  Procedures                                                                    |       | 38       |
|                                |       |                                                                                        |       |     |
| **PART II - OTHER  INFORMATION**    |       |                                                                                        |
|                                |       |                                                                                        |
| Item 1.                             |       | Legal  Proceedings                                                                          |       | 39       |
|                                |       |                                                                                        |       |     |
| Item  1A.                           |       | Risk  Factors                                                                               |       | 41       |
|                                |       |                                                                                        |       |     |
| Item 2.                             |       | Unregistered Sales  of Equity Securities and Use of Proceeds                                |       | 41       |
|                                |       |                                                                                        |       |     |
| Item 3.                             |       | Defaults Upon  Senior Securities                                                            |       | 41       |
|                                |       |                                                                                        |       |     |
| Item 4.                             |       | Submission of  Matters to a Vote of Security Holders                                        |       | 41       |
|                                |       |                                                                                        |       |     |
| Item 5.                             |       | Other Information                                                                           |       | 41       |
|                                |       |                                                                                        |       |     |
| Item  6.                            |       | Exhibits                                                                                    |       | 42       |
|                                |       |                                                                                        |       |     |
| SIGNATURES                          |       | 44                                                                                          |

 

2

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**PART I — FINANCIAL INFORMATION**

**ITEM1.  FINANCIAL STATEMENTS.**

**SUREWESTCOMMUNICATIONS**

**CONDENSEDCONSOLIDATED STATEMENTS OF INCOME**

*(Unaudited; Amounts in thousands,except per share amounts)*
| ** **                                                                  | ** ** | **Quarter Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                  | ** ** | **2006**                                       | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                        |       |                                           |       |                                                    |       |   |   |   |   |
| Operating revenues:                                                         |       |                                           |       |                                                    |       |   |   |   |   |
| Telecom                                                                     |       | $                                              | 33,096     |                                                    | $          | 33,758 |   | $ | 97,173 |   | $ | 101,179 |   |
| Broadband                                                                   |       | 15,225                                         |       | 12,979                                                  |       | 44,130 |   | 36,680 |   |
| Wireless                                                                    |       | 8,561                                          |       | 8,832                                                   |       | 25,517 |   | 25,764 |   |
| Total operating  revenues                                                   |       | 56,882                                         |       | 55,569                                                  |       | 166,820 |   | 163,623 |   |
|                                                                        |       |                                           |       |                                                    |       |   |   |   |   |
| Operating expenses:                                                         |       |                                           |       |                                                    |       |   |   |   |   |
| Cost of services  and products (exclusive of depreciation and amortization) |       | 19,528                                         |       | 19,681                                                  |       | 57,447 |   | 58,082 |   |
| Customer  operations and selling                                            |       | 8,645                                          |       | 8,385                                                   |       | 26,544 |   | 25,832 |   |
| General and  administrative                                                 |       | 8,027                                          |       | 8,954                                                   |       | 24,862 |   | 27,595 |   |
| Depreciation and  amortization                                              |       | 15,306                                         |       | 13,752                                                  |       | 44,805 |   | 39,851 |   |
| Total operating  expenses                                                   |       | 51,506                                         |       | 50,772                                                  |       | 153,658 |   | 151,360 |   |
|                                                                        |       |                                           |       |                                                    |       |   |   |   |   |
| Income from operations                                                      |       | 5,376                                          |       | 4,797                                                   |       | 13,162 |   | 12,263 |   |
|                                                                        |       |                                           |       |                                                    |       |   |   |   |   |
| Other income (expense):                                                     |       |                                           |       |                                                    |       |   |   |   |   |
| Interest income                                                             |       | 173                                            |       | 44                                                      |       | 354 |   | 183 |   |
| Interest expense                                                            |       | (1,797                                         | )          | (1,459                                                  | )          | (5,106 | ) | (4,083 | ) |
| Other, net                                                                  |       | (140                                           | )          | (170                                                    | )          | (519 | ) | (249 | ) |
| Total other  income (expense), net                                          |       | (1,764                                         | )          | (1,585                                                  | )          | (5,271 | ) | (4,149 | ) |
|                                                                        |       |                                           |       |                                                    |       |   |   |   |   |
| Income before income  taxes                                                 |       | 3,612                                          |       | 3,212                                                   |       | 7,891 |   | 8,114 |   |
|                                                                        |       |                                           |       |                                                    |       |   |   |   |   |
| Income tax expense                                                          |       | 1,455                                          |       | 1,252                                                   |       | 3,131 |   | 3,164 |   |
|                                                                        |       |                                           |       |                                                    |       |   |   |   |   |
| Net income                                                                  |       | $                                              | 2,157      |                                                    | $          | 1,960 |   | $ | 4,760 |   | $ | 4,950 |   |
|                                                                        |       |                                           |       |                                                    |       |   |   |   |   |
| Earnings per share:                                                         |       |                                           |       |                                                    |       |   |   |   |   |
| Basic                                                                       |       | $                                              | 0.15       |                                                    | $          | 0.13 |   | $ | 0.33 |   | $ | 0.34 |   |
| Diluted                                                                     |       | $                                              | 0.15       |                                                    | $          | 0.13 |   | $ | 0.32 |   | $ | 0.34 |   |
|                                                                        |       |                                           |       |                                                    |       |   |   |   |   |
| Dividends per share                                                         |       | $                                              | 0.25       |                                                    | $          | 0.25 |   | $ | 0.75 |   | $ | 0.75 |   |
|                                                                        |       |                                           |       |                                                    |       |   |   |   |   |
| Shares of common stock  used to calculate earnings per share:               |       |                                           |       |                                                    |       |   |   |   |   |
| Basic                                                                       |       | 14,546                                         |       | 14,548                                                  |       | 14,567 |   | 14,544 |   |
| Diluted                                                                     |       | 14,647                                         |       | 14,659                                                  |       | 14,669 |   | 14,637 |   |

 

See accompanyingnotes.

3

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**SUREWESTCOMMUNICATIONS**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

*(Unaudited;Amounts in thousands)*
| ** **                                                                                                                                                              | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                              | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| **ASSETS**                                                                                                                                                              |       |                   |       |                  |       |
| Current assets:                                                                                                                                                         |       |                   |       |                  |       |
| Cash and cash equivalents                                                                                                                                               |       | $                      | 12,208     |                  | $          | 7,633 |   |
| Short-term investments                                                                                                                                                  |       | 667                    |       | 617                   |       |
| Accounts receivable, net                                                                                                                                                |       | 22,830                 |       | 23,234                |       |
| Income taxes receivable                                                                                                                                                 |       | 234                    |       | —                |       |
| Inventories                                                                                                                                                             |       | 6,462                  |       | 5,626                 |       |
| Deferred directory costs                                                                                                                                                |       | 4,325                  |       | 5,130                 |       |
| Prepaid expenses                                                                                                                                                        |       | 4,342                  |       | 3,918                 |       |
| Deferred income taxes                                                                                                                                                   |       | 13,597                 |       | 14,502                |       |
| Total current  assets                                                                                                                                                   |       | 64,665                 |       | 60,660                |       |
|                                                                                                                                                                    |       |                   |       |                  |       |
| Property, plant  and equipment, net                                                                                                                                     |       | 373,044                |       | 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                    |       | 456                   |       |
| Intangible asset relating to favorable operating  leases, net                                                                                                           |       | 330                    |       | 393                   |       |
| Deferred charges and other assets                                                                                                                                       |       | 1,019                  |       | 708                   |       |
|                                                                                                                                                                    |       | 17,542                 |       | 17,294                |       |
|                                                                                                                                                                    |       | $                      | 455,251    |                  | $          | 459,029 |   |
| ** **                                                                                                                                                              | ** ** | ** **             | ** ** | ** **            | ** ** |
| **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                                                                                                                                                        |       | 2,317                  |       | 3,634                 |       |
| Other accrued liabilities                                                                                                                                               |       | 19,201                 |       | 20,496                |       |
| Current portion of contractual shareable earnings  obligations                                                                                                          |       | 2,017                  |       | 2,932                 |       |
| Estimated shareable earnings obligations                                                                                                                                |       | 73                     |       | 293                   |       |
| Advance billings and deferred revenues                                                                                                                                  |       | 9,810                  |       | 9,730                 |       |
| Accrued income taxes                                                                                                                                                    |       | —                 |       | 1,015                 |       |
| Accrued pension benefits                                                                                                                                                |       | 7,806                  |       | 7,615                 |       |
| Accrued compensation                                                                                                                                                    |       | 5,023                  |       | 5,772                 |       |
| Total current  liabilities                                                                                                                                              |       | 49,889                 |       | 85,156                |       |
|                                                                                                                                                                    |       |                   |       |                  |       |
| Long-term debt  and capital lease obligations                                                                                                                           |       | 125,469                |       | 85,473                |       |
| Long-term  contractual shareable earnings obligations                                                                                                                   |       | 2,329                  |       | 3,695                 |       |
| Deferred income  taxes                                                                                                                                                  |       | 40,640                 |       | 40,398                |       |
| Other  liabilities and deferred revenues                                                                                                                                |       | 13,974                 |       | 12,556                |       |
|                                                                                                                                                                    |       |                   |       |                  |       |
| Commitments and  contingencies                                                                                                                                          |       |                   |       |                  |       |
|                                                                                                                                                                    |       |                   |       |                  |       |
| Shareholders’  equity:                                                                                                                                             |       |                   |       |                  |       |
| Common stock, without par value; 100,000 shares  authorized, 14,456 and 14,629 shares issued and outstanding at September 30,  2006 and December 31, 2005, respectively |       | 157,926                |       | 164,598               |       |
| Deferred stock-based compensation                                                                                                                                       |       | —                 |       | (2,255                | )          |
| Accumulated other comprehensive loss                                                                                                                                    |       | (4,846                 | )          | (4,909                | )          |
| Retained earnings                                                                                                                                                       |       | 69,870                 |       | 74,317                |       |
| Total  shareholders’ equity                                                                                                                                        |       | 222,950                |       | 231,751               |       |
|                                                                                                                                                                    |       | $                      | 455,251    |                  | $          | 459,029 |   |

 

See accompanyingnotes.

4

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**SUREWESTCOMMUNICATIONS**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

*(Unaudited;Amounts in thousands)*
| ** **                                                                                 | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
|                                                                                       |       |                                                |       |   |   |
| Net cash  provided by operating activities                                                 |       | $                                                   | 46,457     |   | $ | 40,959 |   |
|                                                                                       |       |                                                |       |   |   |
| Cash flows from  investing activities:                                                     |       |                                                |       |   |   |
| Capital expenditures for property, plant and  equipment, including network parts inventory |       | (37,413                                             | )          | (50,299 | ) |
| Proceeds from the sale of pay telephone assets                                             |       | —                                              |       | 220 |   |
| Net cash used in investing activities                                                      |       | (37,413                                             | )          | (50,079 | ) |
|                                                                                       |       |                                                |       |   |   |
| Cash flows from  financing activities:                                                     |       |                                                |       |   |   |
| Proceeds from issuance of long-term debt                                                   |       | 40,000                                              |       | — |   |
| Increase (decrease) in short-term borrowings                                               |       | (30,000                                             | )          | 15,000 |   |
| Principal payments of long-term debt and capital  lease obligations                        |       | (31                                                 | )          | (297 | ) |
| Dividends paid                                                                             |       | (10,962                                             | )          | (10,943 | ) |
| Repurchase of common stock                                                                 |       | (3,477                                              | )          | — |   |
| Other, net                                                                                 |       | 1                                                   |       | (9 | ) |
| Net cash provided by (used in) financing activities                                        |       | (4,469                                              | )          | 3,751 |   |
|                                                                                       |       |                                                |       |   |   |
| Increase  (decrease) in cash and cash equivalents                                          |       | 4,575                                               |       | (5,369 | ) |
|                                                                                       |       |                                                |       |   |   |
| Cash and cash  equivalents at beginning of period                                          |       | 7,633                                               |       | 18,119 |   |
|                                                                                       |       |                                                |       |   |   |
| Cash and cash  equivalents at end of period                                                |       | $                                                   | 12,208     |   | $ | 12,750 |   |

 

See accompanyingnotes.

5

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**SUREWESTCOMMUNICATIONS**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

*(Unaudited; Amounts in thousands, except share and per shareamounts)*

## **1.       ****SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

**Business and Basisof Accounting**

SureWestCommunications (the “Company”) is a holding company with wholly-ownedsubsidiaries that provide integrated communications services in NorthernCalifornia. The Company’s principal operating subsidiary is SureWest Telephone.SureWest Directories, SureWest Long Distance, SureWest Wireless, SureWestBroadband, SureWest TeleVideo and SureWest TeleVideo of Roseville (collectivelyreferred to as “SureWest Broadband/Residential Services”), SureWest Internetand SureWest Custom Data Services are each subsidiaries of the Company. The Companyexpects that the sources of its revenues and its cost structure may bedifferent in future periods, both as a result of its entry into newcommunications markets and competitive forces in each of the markets in whichthe Company has operations.

In the opinion ofmanagement, the accompanying condensed consolidated balance sheets and relatedinterim statements of income and cash flows include all adjustments, consistingonly of normal recurring items, necessary for their fair presentation inconformity with accounting principles generally accepted in the United States (“U.S.GAAP”) for interim financial information and pursuant to the rules andregulations of the Securities and Exchange Commission (the “SEC”). Certaininformation and footnote disclosures normally included in annual financialstatements prepared in accordance with U.S. GAAP have been condensed or omittedpursuant to such SEC rules and regulations and accounting principles applicablefor interim periods. Management believes that the disclosures made are adequateto make the information presented not misleading. These condensed consolidatedfinancial statements should be read in conjunction with the consolidatedfinancial statements and notes thereto included in the Company’s 2005 AnnualReport on Form 10-K filed with the SEC.

**Stock-based Compensation**

***Stock Plans***

TheCompany has two Equity Incentive Plans (the “Plans”) for certain employees,outside directors and consultants of the Company, which were approved byshareholders. The Company authorized for future issuance under the Plansapproximately 1.6 million shares (subject to upward adjustment based upon theCompany’s issued and outstanding shares) of authorized, but unissued, commonstock. The Plans permit issuance by the Company of awards in the form ofrestricted common stock (“RSAs”), restricted common stock units (“RSUs”),performance shares, stock options and stock appreciation rights. The exerciseprice per share of the Company’s common stock to be purchased under anyincentive stock option shall not be less than 100% of the fair market value ofa share of the Company’s common stock on the date of the grant, and theexercise price under a non-qualified stock option shall not be less than 85% ofthe fair market value of the Company’s common stock at the date of the grant.The term of any stock option shall not exceed 10 years.

***Adoption ofStatement of Financial Accounting Standards No. 123(R)***

Effective January1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”)No. 123(R), *Share-Based Payment*,using the modified-prospective-transition method. Since the fair valuerecognition provisions of SFAS No. 123, *Accountingfor Stock-Based Compensation* and SFAS No. 123(R) were materiallyconsistent under the Company’s Plans, the adoption of SFAS No. 123(R) did nothave a significant impact on the Company’s financial position or results ofoperations. The Company has not made any stock option grants since 2003 andconsequently the compensation expense resulting from stock option grants priorto 2003 was either fully expensed as of January 1, 2006, or not material to theCompany’s financial statements.

6

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## **1.       ****SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)**

Prior to January1, 2006, the Company accounted for the Plans under the fair value recognitionprovisions of SFAS No. 123. Under the provisions of SFAS No. 148, *Accounting for Stock-Based Compensation — Transitionand Disclosure*, the fair value method of accounting was applied toall employee awards granted, modified, or settled after January 1, 2003.

Prior to theadoption of SFAS No. 123(R), the Company presented all tax benefits ofdeductions resulting from the exercise of share-based payments as operatingcash flows in its statement of cash flows. In accordance with guidance in SFASNo. 123(R), the cash flows resulting from excess tax benefits (tax benefitsrelated to the excess of proceeds from employee’s exercises of share basedpayments over the stock-based compensation cost recognized for those shares)are classified as financing cash flows.

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

The following tablesummarizes the RSAs and RSUs granted to certain eligible participants duringthe quarter and nine-month periods ended September 30, 2006 and 2005:
|               | ** ** | **Quarter Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------|------------|------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **    | ** ** | **2006**                                       | ** ** | **Grant Date  Fair Value**                    | ** ** | **2005** | ** ** | **Grant Date  Fair Value** | ** ** | **2006** | ** ** | **Grant Date  Fair Value** | ** ** | **2005** | ** ** | **Grant Date  Fair Value** | ** ** |
|          |       |                                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| RSAs          |       | 2,500                                          |       | $17.70                                                  |       | — |   | — |   |   | 5,500 |   |   | $17.70 - $27.63 |   | — |   | — |   |
| RSUs Granted  |       | —                                         |       | —                                                  |       | 12,500 |   | $25.56-$25.89 |   |   | 6,500 |   |   | $22.54 - $27.63 |   | 64,749 |   | $22.43-$28.35 |   |
| RSU Dividends |       | —                                         |       | —                                                  |       | — |   | — |   |   | 101 |   |   | $18.75 - $19.62 |   | — |   | — |   |
| Total         |       | 2,500                                          |       |                                                    |       | 12,500 |   |   |   |   | 12,101 |   |   |   |   | 64,749 |   |   |   |

 

Stock-basedcompensation expense for both RSAs and RSUs of $259 and $807 was recordedduring the quarter and nine-month period ended September 30, 2006,respectively. During the comparable prior year periods, the Company recordedstock based compensation expense of $461 and $1,173, respectively. RSAs andRSUs are amortized over their respective vesting periods, which range fromimmediate vesting to a five-year vesting period. In connection with theadoption of SFAS No. 123(R), the Company records stock-based compensation forRSAs and RSUs granted in 2006 on a straight-line basis. The Company willcontinue to recognize stock-based compensation on RSAs and RSUs granted priorto 2006 using the graded vesting method. In accordance with the provisions ofSFAS No. 123(R), the Company has estimated expected forfeitures based onhistorical experience and is recognizing compensation expense only for thoseRSAs and RSUs expected to vest. In accordance with SFAS No. 123(R), on January1, 2006 the Company reversed the deferred stock compensation balance of $2,255to common stock.

The following table summarizes the restricted commonstock activity during the nine-month period ended September 30, 2006:
| Nonvested Shares              | ** ** | **       Shares       ** | ** ** | **Weighted Average  Grant Date Fair Value** | ** ** |
|------------------------------------|------------|------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
|                               |       |                                                                                           |       |                                                            |       |   |   |   |   |
| Nonvested—January  1, 2006    |       |                                                                                           | 128,998    |                                                            |       |   | $ | 29.44 |   |   |
| Granted                            |       |                                                                                           | 12,101     |                                                            |       |   | 23.40 |   |   |
| Vested                             |       |                                                                                           | (28,898    | )                                                               |       |   | 26.75 |   |   |
| Forfeited                          |       |                                                                                           | (8,659     | )                                                               |       |   | 26.52 |   |   |
| Nonvested—September 30,  2006 |       |                                                                                           | 103,542    |                                                            |       |   | $ | 25.81 |   |   |

 

As of September 30, 2006, total unrecognized compensation costrelated to nonvested restricted stock was $1,026 and will be recognized over aweighted-average period of approximately three years. The total fair value ofRSAs and RSUs vested during the nine-month period ended September 30, 2006 was$773.

7

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## **1.       ****SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)**

***Proforma***

Had the Companyelected to adopt the fair value recognition provisions of SFAS No. 123 as ofits original effective date, pro forma net income and earnings per share for2005 would have been:
|                                                                                                                                       | ** ** | **Quarter Ended  September 30,** | ** ** | **Nine Months  Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                                                            | ** ** | **2005**                                   | ** ** | **2005**                                        | ** ** |
|                                                                                                                                  |       |                                       |       |                                            |       |
|                                                                                                                                  |       |                                       |       |                                            |       |
| Net income, as  reported                                                                                                              |       | $                                          | 1,960      |                                            | $          | 4,950 |   |
|                                                                                                                                  |       |                                       |       |                                            |       |
| Add: Stock-based  employee compensation expense included in reported net income, net of related  tax effects                          |       | 290                                        |       | 730                                             |       |
|                                                                                                                                  |       |                                       |       |                                            |       |
| Deduct:  Stock-based employee compensation expense determined using the fair value  method for all awards, net of related tax effects |       | (294                                       | )          | (764                                            | )          |
|                                                                                                                                  |       |                                       |       |                                            |       |
| Pro forma net  income                                                                                                                 |       | $                                          | 1,956      |                                            | $          | 4,916 |   |
|                                                                                                                                  |       |                                       |       |                                            |       |
| Earnings per  share:                                                                                                                  |       |                                       |       |                                            |       |
| Basic—as reported                                                                                                                |       | $                                          | 0.13       |                                            | $          | 0.34 |   |
| Basic—pro forma                                                                                                                  |       | $                                          | 0.13       |                                            | $          | 0.34 |   |
|                                                                                                                                  |       |                                       |       |                                            |       |
| Diluted—as reported                                                                                                              |       | $                                          | 0.13       |                                            | $          | 0.34 |   |
| Diluted—pro  forma                                                                                                               |       | $                                          | 0.13       |                                            | $          | 0.34 |   |

 

***Stock Options Expense***

The Company issuesnew shares of common stock upon exercise of stock options. The following tablesummarizes stock option activity for the Company’s stock option plans for thenine-month period ended September 30, 2006:
| Options                                           | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** |
|---------------------------------------------------|------------|------------|------------|----------------------------------------|------------|---------------------------------------------------------|------------|
|                                              |       |       |       |                                   |       |                                                    |       |
| Outstanding—January  1, 2006                 |       | 622,313    |       | $                                      | 40.65      |                                                    |       |   |
| Forfeited                                         |       | (215,649   | )          | —                                 |       |                                                    |       |
| Outstanding—September  30, 2006              |       | 406,664    |       | $                                      | 40.37      |                                                    | 5          |   |
|                                              |       |       |       |                                   |       |                                                    |       |
| Vested or  Expected to Vest at September 30, 2006 |       | 406,664    |       | $                                      | 40.37      |                                                    | 5          |   |
| Exercisable at  September 30, 2006                |       | 405,315    |       | $                                      | 40.37      |                                                    | 5          |   |

 

There were no stock options granted, exercised orexpired during the nine-month period ended September 30, 2006. In addition,there were no stock options with an exercise price below the market price ofthe Company’s stock at that date.

8

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## **1.        SUMMARY OF SIGNIFICANTACCOUNTING POLICIES (continued)**

**PerShare Amounts**

Sharesused in the computation of basic earnings per share are based on the weightedaverage number of unrestricted common stock shares, RSAs and RSUs outstanding,excluding unvested RSAs and unvested RSUs. Shares used in the computation ofdiluted earnings per share are based on the weighted average number ofunrestricted common stock shares, RSAs and RSUs outstanding, along with otherpotentially dilutive securities outstanding in each period.

Cash dividends pershare are based on the actual dividends per share (including RSAs but excludingRSUs), as declared by the Company’s Board of Directors. 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 of commonstock. Any fractional RSUs resulting from such calculation are included in theadditional RSUs.

**OtherComprehensive Income (Loss)**

Asof September 30, 2006 and 2005 the accumulated other comprehensive loss was$4,846 and $2,126, respectively, which consisted of minimum pension andpost-retirement liability adjustments, net of tax, offset in part by unrealizedgain on investment, net of tax. The following table reconciles net income tocomprehensive income for the quarter and nine month periods ended September 30,2006 and 2005:
|                                                   | ** ** | **Quarter Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                        | ** ** | **2006**                                   | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Net  Income**                                   |       | $                                          | 2,157      |                                                | $          | 1,960 |   | $ | 4,760 |   | $ | 4,950 |   |
| Unrealized gain  (loss) on investment, net of tax |       | 40                                         |       | —                                              |       | 63 |   | — |   |
| **Comprehensive Income**                          |       | $                                          | 2,197      |                                                | $          | 1,960 |   | $ | 4,823 |   | $ | 4,950 |   |

 

**Reclassifications**

Certainamounts in the Company’s 2005 condensed consolidated financial statements havebeen reclassified to conform to the presentation of the Company’s 2006condensed consolidated financial statements.

## **2.        BUSINESSSEGMENTS**

TheCompany has three reportable business segments: Telecom, Broadband andWireless. The Telecom segment includes SureWest Telephone, SureWest Directoriesand SureWest Long Distance, which provide landline telecommunications services,directory advertising, Digital Subscriber Line (“DSL”) service, long distanceservices and certain non-regulated services. SureWest Telephone, which is theprincipal operating subsidiary of the Telecom segment, provides local services,toll telephone services, network access services and certain non-regulatedservices. SureWest Directories publishes and distributes SureWest Telephone’sdirectory, including the sale of yellow pages advertising. SureWestDirectories is also engaged in the business of producing, publishing anddistributing directories in other Northern California communities outside ofSureWest Telephone’s service area. SureWest Long Distance provides longdistance services.

9

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## **2.        BUSINESS SEGMENTS(continued)**

The Broadbandsegment provides various services, including: high-speed and dial-up Internet;digital video; voice, network access and toll telephone; and managed servicesin the greater Sacramento area, principally to customers residing outside ofSureWest Telephone’s service area. The Company offers high-speed Internet,digital video, voice and long distance phone service as a bundled packagereferred to as fiber-to-the-premise (“FTTP”). The Broadband segment includesthe Company’s subsidiary SureWest Broadband and SureWest Broadband Businessservices, which is comprised, in part, of a division of SureWest Telephoneoperating as a Competitive Local Exchange Carrier.

The Wirelesssegment consists of the Company’s subsidiary SureWest Wireless, which provideswireless services. Wireless revenues include wireless voice services, sales ofhandsets and related accessories, long distance, roaming service and customcalling features. Wireless services are provided on a month-to-month basis andare generally billed in advance for non-contract subscribers and in arrears forcontract subscribers.

In accordance withthe provisions of SFAS No. 131, *DisclosureAbout Segments of an Enterprise and Related Information*, the Companyhas aggregated certain of its operating segments within the Telecom andBroadband segments because it believes that such operating segments sharesimilar economic characteristics.

CorporateOperations are allocated to the appropriate segment, except for cash;investments; certain property, plant, and equipment; and miscellaneous otherassets, which are not allocated to the segments. However, the investment incomeassociated with cash and investments held by Corporate Operations is includedin the results of the operations of the Company’s segments. The Companyevaluates the performance of its segments based on income (loss) fromoperations.

Thesesegments are strategic business units that offer different products andservices. The Company accounts for intersegment revenues and expenses atprevailing market rates. The Company’s business segment information is asfollows:
|                                                     | ** ** | **Telecom** | ** ** | **Broadband** | ** ** | **Wireless** | ** ** | **Corporate  Operations** | ** ** | **Intercompany  Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------|------------|-------------|------------|---------------|------------|--------------|------------|---------------------------|------------|--------------------------------|------------|------------------|------------|
| **For the  three months ended September 30, 2006:** | ** ** | ** **  | ** ** | ** **    | ** ** | ** **   | ** ** | ** **                | ** ** | ** **                     | ** ** | ** **       | ** ** |
| Operating revenues  from external customers         |       | $           | 33,096     |          | $          | 15,225       |       | $                         | 8,561      |                           | $          | —           |       | $ | — |   | $ | 56,882 |   |
| Intersegment  revenues                              |       | 7,392       |       | 387           |       | 727          |       | —                    |       | (8,506                         | )          | —           |       |
| Operating  expenses*                                |       | 18,752      |       | 15,880        |       | 10,074       |       | —                    |       | (8,506                         | )          | 36,200           |       |
| Depreciation and  amortization                      |       | 6,323       |       | 5,986         |       | 2,997        |       | —                    |       | —                         |       | 15,306           |       |
| Income (loss)  from operations                      |       | 15,413      |       | (6,254        | )          | (3,783       | )          | —                    |       | —                         |       | 5,376            |       |
| Net income  (loss)                                  |       | $           | 9,088      |          | $          | (4,466       | )          | $                         | (2,465     | )                              | $          | —           |       | $ | — |   | $ | 2,157 |   |
|                                                |       |        |       |          |       |         |       |                      |       |                           |       |             |       |
| **For the  three months ended September 30, 2005:** | ** ** | ** **  | ** ** | ** **    | ** ** | ** **   | ** ** | ** **                | ** ** | ** **                     | ** ** | ** **       | ** ** |
| Operating  revenues from external customers         |       | $           | 33,758     |          | $          | 12,979       |       | $                         | 8,832      |                           | $          | —           |       | $ | — |   | $ | 55,569 |   |
| Intersegment  revenues                              |       | 7,660       |       | 428           |       | 667          |       | —                    |       | (8,755                         | )          | —           |       |
| Operating  expenses*                                |       | 21,277      |       | 14,886        |       | 9,612        |       | —                    |       | (8,755                         | )          | 37,020           |       |
| Depreciation and  amortization                      |       | 6,552       |       | 4,215         |       | 2,985        |       | —                    |       | —                         |       | 13,752           |       |
| Income (loss)  from operations                      |       | 13,589      |       | (5,694        | )          | (3,098       | )          | —                    |       | —                         |       | 4,797            |       |
| Net income (loss)                                   |       | $           | 7,954      |          | $          | (3,851       | )          | $                         | (2,143     | )                              | $          | —           |       | $ | — |   | $ | 1,960 |   |

##  

10

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## **2.        BUSINESS SEGMENTS(continued)**

|                                                              | ** ** | **Telecom** | ** ** | **Broadband** | ** ** | **Wireless** | ** ** | **Corporate  Operations** | ** ** | **Intercompany  Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------|------------|-------------|------------|---------------|------------|--------------|------------|---------------------------|------------|--------------------------------|------------|------------------|------------|
| **As of  and for the nine months ended September 30, 2006:** | ** ** | ** **  | ** ** | ** **    | ** ** | ** **   | ** ** | ** **                | ** ** | ** **                     | ** ** | ** **       | ** ** |
| Operating  revenues from external customers                  |       | $           | 97,173     |          | $          | 44,130       |       | $                         | 25,517     |                           | $          | —           |       | $ | — |   | $ | 166,820 |   |
| Intersegment  revenues                                       |       | 22,170      |       | 1,123         |       | 2,102        |       | —                    |       | (25,395                        | )          | —           |       |
| Operating  expenses*                                         |       | 56,300      |       | 48,877        |       | 29,071       |       | —                    |       | (25,395                        | )          | 108,853          |       |
| Depreciation and  amortization                               |       | 18,964      |       | 16,904        |       | 8,937        |       | —                    |       | —                         |       | 44,805           |       |
| Income (loss)  from operations                               |       | 44,079      |       | (20,528)      |       | (10,389      | )          | —                    |       | —                         |       | 13,162           |       |
| Net income  (loss)                                           |       | 25,906      |       | (14,332)      |       | (6,814       | )          | —                    |       | —                         |       | 4,760            |       |
| Total assets                                                 |       | $           | 723,308    |          | $          | 378,577      |       | $                         | 149,564    |                           | $          | 454,720          |       | $ | (1,250,918 | ) | $ | 455,251 |   |
|                                                         |       |        |       |          |       |         |       |                      |       |                           |       |             |       |
| **As of  and for the nine months ended September 30, 2005:** | ** ** | ** **  | ** ** | ** **    | ** ** | ** **   | ** ** | ** **                | ** ** | ** **                     | ** ** | ** **       | ** ** |
| Operating  revenues from external customers                  |       | $           | 101,179    |          | $          | 36,680       |       | $                         | 25,764     |                           | $          | —           |       | $ | — |   | $ | 163,623 |   |
| Intersegment  revenues                                       |       | 22,133      |       | 1,269         |       | 1,908        |       | —                    |       | (25,310                        | )          | —           |       |
| Operating  expenses*                                         |       | 64,502      |       | 44,036        |       | 28,281       |       | —                    |       | (25,310                        | )          | 111,509          |       |
| Depreciation and  amortization                               |       | 18,910      |       | 11,846        |       | 9,095        |       | —                    |       | —                         |       | 39,851           |       |
| Income (loss)  from operations                               |       | 39,900      |       | (17,933)      |       | (9,704       | )          | —                    |       | —                         |       | 12,263           |       |
| Net income  (loss)                                           |       | 23,333      |       | (11,834)      |       | (6,549       | )          | —                    |       | —                         |       | 4,950            |       |
| Total assets                                                 |       | $           | 655,903    |          | $          | 257,969      |       | $                         | 139,299    |                           | $          | 278,862          |       | $ | (889,449 | ) | $ | 442,584 |   |

 

*Exclusive ofdepreciation and amortization

 

## **3.        ESTIMATEDSHAREABLE EARNINGS OBLIGATIONS**

Certainof the Company’s rates are subject to regulation by the Federal CommunicationsCommission (“FCC”) and the California Public Utilities Commission (“CPUC”).Intrastate service rates are subject to regulation by the CPUC. With respect totoll calls initiated by interexchange carriers’ customers, the interexchangecarriers are assessed access charges based on tariffs filed by SureWestTelephone. Interstate access rates and resultant earnings are subject toregulation by the FCC. With respect to interstate services, SureWest Telephonehas detariffed its DSL services and files its own tariff with the FCC forswitched 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.

TheFCC monitors SureWest Telephone’s interstate earnings through the use of annualcost separation studies prepared by SureWest Telephone, which utilize estimatedcost information and projected demand usage. The FCC establishesrules that carriers must follow in the preparation of the annual studies.Additionally, under current FCC rules governing rate making, SureWestTelephone is required to establish interstate rates based on projected demandusage for its various services and determine the actual earnings from theserates once actual volumes and costs are known. Based on preliminary coststudies, the Company recognized liabilities relating to SureWest Telephone’sestimated interstate shareable earnings obligations of $87 and $167 for thequarter and nine-month period ended September 30, 2005, respectively, throughreductions of revenues (none in 2006).

11

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## **3.        ESTIMATEDSHAREABLE EARNINGS OBLIGATIONS (continued)**

Asa result of periodic cost separation studies, SureWest Telephone changed itsestimates for a portion of its interstate shareable earnings obligations andcertain NECA CL accounts receivable balances. For the quarter and nine-monthperiod ended September 30, 2006, these changes in estimates increased theCompany’s consolidated revenues by $185 and $499 and net income by $112 ($0.01per share) and $301 ($0.02 per share), respectively. For the comparable prioryear periods, these changes in estimates increased the Company’s consolidatedrevenues by $175 and $989 and net income by $107 ($0.01 per share) and $604($0.04 per share), respectively.

Duringthe quarter ended September 30, 2005, SureWest Telephone made a payment of $100to a certain carrier customer in full settlement of an interstate overearningsdispute for the monitoring period 2001-2002. The limitations period applicableto this monitoring period expired during the quarter. Therefore, SureWestTelephone released all other amounts reserved in connection with the potentialoverearnings claims for the 2001-2002 monitoring period, which increased theCompany’s revenues and net income by $125 and $76 ($0.01 per share),respectively, during the quarter ended September 30, 2005.

TheFCC has a pending rulemaking proceeding to re-examine all regulated forms ofintercarrier compensation and develop a more unified mechanism to govern thepayment flows among telecommunications carriers. Intercarrier compensation isthe regulated fees that service providers charge each other to carry andterminate traffic. Reform has been suggested due to the changing nature of theindustry with increasing competition from new technologies, such as Internetand Internet-based services and wireless services. Various plans have beensubmitted to the FCC with divergent approaches to handle intercarriercompensation that may reduce per-minute access and reciprocal compensation chargesand replace these revenues with a combination of increases to the subscriberline charge and revenues obtained from a new restructure mechanism. Theultimate results of this proceeding and the potential effects on SureWestTelephone cannot yet be determined.

The Company wasinvolved in a proceeding at the CPUC that considered the continued need forcertain sharing requirements in the intrastate jurisdiction and, in connectionwith that review, also considered the issue of whether the Company overearnedin the intrastate jurisdiction in recent monitoring periods and the amount ofoverearnings that should be shared with customers. In July 2004, theCompany entered into a settlement agreement (“the settlement agreement”) withthe other parties in the proceeding, the Division of Ratepayer Advocates (“DRA”),(formerly Office of Ratepayer Advocates), 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.

In accordance withthe settlement agreement, SureWest Telephone will return approximately $6,500 (“DividendA”), plus interest at the 90-day commercial paper rate for non-financialinstitutions, which was 5.21% as of September 30, 2006, and an imputed rate of3.15%, to its end users through a consumer dividend over a period of fouryears, which began January 1, 2005. In addition, SureWest Telephone will pay aone-time consumer dividend of $2,600 (“Dividend B”), which will be returned tothe consumers to settle the monitoring periods 2000 to 2004. The consumerdividend is recorded as a reduction of the Company’s contractual shareableearnings obligations over two years, which began January 1, 2005. The consumerdividend includes an annual imputed interest rate of 3.15% (no statedcontractual interest rate). At September 30, 2006, the aggregate contractualshareable earnings obligation for these surcredits was $4,346 (which is net ofan unamortized discount pertaining to imputed interest of $146 at that date).

12

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## **3.        ESTIMATEDSHAREABLE EARNINGS OBLIGATIONS (continued)**

The followingtable summarizes the amounts returned to end users through consumer dividendsfor the quarters and nine-month periods ended September 30, 2006 and 2005:

|                | ** ** | **Quarter Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------|------------|--------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **     | ** ** | **2006**                                   | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Dividend A** |       | $                                          | 500        |                                                | $          | 423 |   | $ | 1,520 |   | $ | 1,242 |   |
| **Dividend B** |       | 293                                        |       | 310                                                 |       | 889 |   | 909 |   |
| **Total**      |       | $                                          | 793        |                                                | $          | 733 |   | $ | 2,409 |   | $ | 2,151 |   |

 

Further,commencing January 1, 2007, SureWest Telephone will implement an additionalannual consumer dividend of $1,300 to end-users receiving SureWest Telephoneservices subject to sharing on or after that date; however, this consumerdividend is subject to reduction based upon the results of other pendingregulatory proceedings, as discussed below.

During the fourthquarter of 2005, the Company filed an Advice Letter with the CPUC proposing anincrease to the consumer dividends in order to return the amounts entitled inaccordance with the settlement agreement. The change in the consumer dividendsresulted from the increase in interest rates during 2005. The increase waseffective January 1, 2006.

Prior to 2000,AT&T Inc. (“AT&T”) (formerly SBC Communications), had been payingSureWest Telephone 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 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 paymentsreceived from the CHCF should come from SureWest Telephone’s ratepayers orother regulatory recovery mechanisms.

In August 2005,the CPUC adopted a decision which (i) authorized SureWest Telephone tocontinue receiving $11,500 annually from the CHCF to offset its intrastateregulated operating expenses on an interim basis, (ii) required SureWestTelephone to prepare and submit a cost proxy model (which is used generally asa basis for CHCF-B funding) based on its current cost data, including analysesof the resulting impacts on rates, the Universal Lifeline Telephone Service (“ULTS”)fund, and the CHCF fund, to be filed by SureWest Telephone within 12 months,and (iii) authorized SureWest Telephone to file an advice letter with theCommission’s Telecommunications Division to implement reductions to itsbusiness access line rates.

In August 2006,the Company filed a Petition for Modification of D.05-08-004, the decision thatreviewed SureWest Telephone’s revenue requirement, which seeks CPUCauthorization in a graduated phase-down of its $11,500 interim draw from theCHCF-B over a period of time that is intended to assure the continuedmaintenance of good service to SureWest Telephone customers while avoidingprecipitous rate increases.  The Company’sPetition for Modification proposes a transitional phase-down over a five-to-tenyear period and requests elimination of the requirement to file its cost proxymodel.  The Company expects to recoverthe eliminated revenues through rate increases and/or operatingefficiencies.  On August 31, 2006, theDRA filed opposition to the Company’s Petition for Modification and insteadproposed the Company continue to prepare and submit a cost proxy model tocontinue receipt of CHCF-B funds. On October 30, 2006, the Company filed withthe CPUC a proposal to offset its draw from the CHCF in 2007 with the annualconsumer dividend of $1,300, which is currently scheduled to begin January 1,2007.  The DRA will respond to theCompany’s proposal November 9, 2006. The results of this proceeding and thepotential effects on SureWest Telephone could impact future funding levelsthrough the CHCF-B.

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**3.             ESTIMATED SHAREABLE EARNINGSOBLIGATIONS (continued)**

In June 2006, theCPUC instituted a rulemaking proceeding to review the CHCF-B program.  The goals of this review include, but are notlimited to, adjusting universal service rate support payments to reflectupdated operating costs, evaluating whether CHCF-B fund 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 CHCF-B rulemaking requestedcomments as to whether SureWest Telephone should continue receiving the $11,500annually from the CHCF-B and the advisability and impacts of phasing out theEAS payments gradually over a period of approximately 5 years.  Comments in the CHCF-B rulemaking were filedon September 1, 2006 with reply comments filed on October 16, 2006.  The results of this proceeding and thepotential effects on SureWest Telephone could impact future funding levels throughthe CHCF-B.

In 1996, the CPUCissued a decision that authorized SureWest Telephone to implement a NewRegulatory Framework (“NRF”) for services furnished within SureWest Telephone’sservice area in order to accommodate market and regulatory movement towardcompetition and greater pricing flexibility. Under the NRF, SureWest Telephoneis subject to ongoing monitoring and reporting requirements, and it wasinitially required to share earnings with customers through a reduction ofrevenues if its earned annual rate-of-return exceeds that authorized by theCPUC.

In April 2005, theCPUC opened a rulemaking proceeding to assess and revise the regulation oftelecommunications utilities to develop a uniform regulatory framework (“URF”)to apply to all providers of regulated telecommunications services, exceptsmall Incumbent Local Exchange Carriers(“ILECs”), to the extent that it is feasible and in the public interestto do so.  On August 24, 2006, the CPUCadopted Decision 06-08-030 (“the decision”) which revises the regulations oftelecommunications utilities, such as SureWest Telephone, which were previouslysubject to the NRF. The decision grants carriers broad pricing freedoms in theprovision of telecommunications services, bundles of services, promotions andcontracts.  The decision, among otherthings:  (i) freezes the Company’s basicresidential and lifeline rates until at least January 1, 2009 in order toaddress the subsidy levels supporting these special services, subject to reviewin the CHCF-B 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) allows bundlesand promotional packages on any telecommunication service, (iv) allocates allgains 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 withthe decision, the CPUC ordered a separate briefing cycle to consider whether todetariff altogether telecommunications services other than basic residentialservice.  The resolution of the separatebriefing cycle is expected by December 31, 2006.  Theultimate results of this proceeding and the potential effects on SureWestTelephone cannot yet be determined.

In April 2006, the CPUC released a decision in a proceeding investigatingthe continued need for the transport interconnection charge (“TIC”), which isan access charge element.  An earlierdraft decision required all ILECs operating within California to eliminate theTIC element and authorized recovery of lost revenue through end users,specifically through an increase in their local rate surcharge, and use of theCHCF-A for the small companies.  IfSureWest Telephone did not recover any lost revenues from end users, thedecision could ultimately result in a loss of revenues of up to $4,400, on aprospective basis. The Company sought modification of the draft decision on thebasis that the CPUC had indicated that it was prepared to act only with respectto larger ILECs, and thus denied SureWest Telephone due process.  In the final decision, the CPUC deferred theelimination of the TIC element for SureWest to the next phase of theproceeding, which began in May 2006.  TheCompany filed testimony in May 2006 supporting that the CPUC should noteliminate the TIC for small and mid-sized ILECs due to an impending federalintercarrier compensation restructure proceeding at the FCC.  The ultimate results of this proceeding andthe potential effects on SureWest Telephone cannot yet be determined.

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**3.             ESTIMATED SHAREABLE EARNINGSOBLIGATIONS (continued)**

On September 29,2006, the Governor of California signed into law Assembly Bill No. 2987, whichenacts the Digital Infrastructure and Video Competition Act of 2006.  This new law bypasses the local franchiseprocess and establishes a procedure for the issuance of state franchises forthe provision of video service, and promotes a more rapid entry by telephonecompanies into the video business and new competition for cable and DBSproviders.  Existing cable providers willbe able to abrogate their local franchises and opt into the state franchiseprocess beginning in January 2008. Specifically, the Company will be able to exit its current localfranchise agreements and operate under a state-issued franchise if any of thefollowing events occur:  (i) theexpiration, prior to any renewal or extension, of the Company’s localfranchise; (ii) mutual agreement between the local franchising entity and theCompany; or (iii) at the time a new video service provider initiates videoservice in all or part of the area within the local municipality’s.  This new law also prohibits ILECs thatprovide video service under a state-issued franchise from increasing****basicresidential telephone service rates until January 1, 2009.  The Company has not yet determined theeffects that this new law will have on its condensed consolidated financialstatements or results of operations.

Asof September 30, 2006, the Company’s consolidated balance sheet reflectedaggregate liabilities of $73 relating to SureWest Telephone’s estimatedinterstate shareable earnings obligations. The calculations supporting theseliabilities are very complex and involve a variety of estimates prior to theultimate settlement of such obligations. In addition, SureWest Telephone’sinterstate shareable earnings obligations lapse over time if SureWest Telephone’sinterexchange carrier and other customers do not claim the amounts ascribed tothem. Accordingly, it is reasonably possible that management’s estimates of theCompany’s liabilities for interstate shareable earnings obligations couldchange in the near term, and the amounts involved could be material.

**4.             PENSION AND OTHER POST-RETIREMENTBENEFITS**

**Components of Net Periodic Benefit Cost**

Netperiodic pension costs recognized in the condensed consolidated statements ofincome for the quarter and nine-month periods ended September 30, 2006 and 2005under the defined benefit pension plan (“Pension Plan”), Supplemental ExecutiveRetirement Plan (“SERP”) and post-retirement benefits other than pension (“OtherBenefits”) included the following components:
| ** **                                         | ** ** | **Pension Plan and SERP** | ** ** | **Other Benefits** | ** ** |
|----------------------------------------------------|------------|------------------------------------------|------------|-------------------------|------------|
| **Quarter Ended September 30,**     | ** ** | **2006**                                 | ** ** | **2005**                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Service cost-benefits  earned during the period    |       | $                                        | 1,117      |                    | $          | 1,408 |   | $ | (2 | ) | $ | 117 |   |
| Interest cost on  projected benefit obligation     |       | 1,897                                    |       | 1,866                   |       | 86 |   | 88 |   |
| Expected return on plan  assets                    |       | (2,157                                   | )          | (2,184                  | )          | (47 | ) | (38 | ) |
| Amortization of prior  service cost                |       | 23                                       |       | 86                      |       | 7 |   | 11 |   |
| Recognized net  actuarial loss                     |       | 232                                      |       | 176                     |       | (25 | ) | — |   |
| Expected disbursement  for life insurance premiums |       | —                                   |       | —                  |       | (20 | ) | (19 | ) |
| Net pension cost                                   |       | $                                        | 1,112      |                    | $          | 1,352 |   | $ | (1 | ) | $ | 159 |   |

** **

15

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**4.             PENSION AND OTHER POST-RETIREMENTBENEFITS (continued)**
| ** **                                              | ** ** | **Pension Plan and SERP** | ** ** | **Other Benefits** | ** ** |
|---------------------------------------------------------|------------|------------------------------------------|------------|-------------------------|------------|
| **Nine months ended September 30,** | ** ** | **2006**                                 | ** ** | **2005**                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Service cost-benefits  earned during the period         |       | $                                        | 3,353      |                    | $          | 4,222 |   | $ | 363 |   | $ | 352 |   |
| Interest cost on  projected benefit obligation          |       | 5,690                                    |       | 5,598                   |       | 456 |   | 263 |   |
| Expected return on plan  assets                         |       | (6,472                                   | )          | (6,550                  | )          | (207 | ) | (114 | ) |
| Amortization of prior  service cost                     |       | 70                                       |       | 259                     |       | 32 |   | 32 |   |
| Recognized net  actuarial loss                          |       | 696                                      |       | 528                     |       | — |   | — |   |
| Expected disbursement  for life insurance premiums      |       | —                                   |       | —                  |       | (52 | ) | (57 | ) |
| Special termination  benefits                           |       | —                                   |       | 51                      |       | — |   | 740 |   |
| Net pension cost                                        |       | $                                        | 3,337      |                    | $          | 4,108 |   | $ | 592 |   | $ | 1,216 |   |

 

The Company’sthird party actuary completed an experience study (the “Study”) for the PensionPlan and Other Benefits Plan utilizing historical information for purposes ofdetermining the continued appropriateness of certain assumptions used indetermining the actuarial valuation of the pension liability and relatedexpense for 2006. Based on the findings of the Study, the Company changed itsestimated costs for 2006 related to the Pension Plan and Other Benefits Planbased on revised actuarial calculations. These changes in estimates decreasedoperating expenses by $217 and $1,256 and increased net income by $131 ($0.01per share) and $758 ($0.05 per share) during the quarter and nine-month periodended September 30, 2006, respectively.

In2004, the Company initiated a voluntary enhanced early retirement program (the “REWARDprogram”). The REWARD program was offered to certain eligible employees acrossall business units.  In addition toretirement benefits, eligible employees receive enhanced medical benefits for aspecified period of time.  Prior to thecompletion of the REWARD program in February 2005, 13 employees accepted theREWARD program, and the Company recorded $791 in operating expenses during thefirst quarter of 2005.

**Employer Contributions**

The Companyexpects to contribute $3,000 and $1,300 to the Pension Plan and Other Benefits,respectively, in 2006.  As of September30, 2006, the Company has contributed $3,000 to the Pension Plan (nocontributions have been made to the Other Benefits).

## **5.       COMMITMENTSAND CONTINGENCIES**

**Credit Arrangements**

On May 1, 2006,the Company completed an unsecured Credit Agreement for a Term Loan facilityand a Revolving Loan facility (collectively “Loan Facilities”) in principalamounts up to $75,000 and $25,000, respectively.  Interest on the Loan Facilities is payablequarterly and based on a LIBOR, variable interest rate, or a fixed interestrate pricing formula, or a combination, as defined in the CreditAgreement.  Principal payments on theoutstanding amounts borrowed under the Term Loan facility as of December 31,2007 are due in equal quarterly installments commencing March 31, 2008 throughJune 30, 2016.  The Revolving Loanfacility has an expiration date of June 30, 2013.  As of September 30, 2006, $40,000 wasoutstanding under the Term Loan Facility and no amounts were outstanding underthe Revolving Loan facility.

TheCompany had a business loan agreement with a bank for a $50,000 line of credit,which was originally due to expire July 1, 2006. As of December 31, 2005, therewas $30,000 outstanding under this credit facility and the weighted averageinterest rate was 5.75%, which was based on a LIBOR-based pricing formula. Inconnection, with the completion of the Credit Agreement noted above, theCompany terminated its business loan agreement effective May 1, 2006.

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**5.             COMMITMENTSAND CONTINGENCIES (continued)**

 

Certain of theCompany’s credit arrangements contain financial and operating covenants thatrestrict, among other things, the payment of cash dividends, repurchase of theCompany’s capital stock, the making of certain other restricted payments andthe incurrence of additional indebtedness. The covenants also require theCompany to maintain certain financial ratios and minimum levels of tangible networth. At September 30, 2006 and December 31, 2005, retained earnings ofapproximately $62,950, and $28,266, respectively, were available for thepayment of cash dividends or other restricted payments under the terms of theCompany’s credit arrangements.

**Litigation,Regulatory Proceedings and Other Contingencies**

The Company issubject to certain legal and regulatory proceedings, Internal Revenue Serviceexaminations and other income tax exposures, and other claims arising in theordinary course of its business. In the opinion of management, except asotherwise noted, the ultimate outcome of these matters will not materiallyaffect the consolidated financial position, results of operations or cash flowsof the Company.

**6.       RECENT ACCOUNTING PRONOUNCEMENTS**

In September 2006,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“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 is effective for financialstatements issued for fiscal years beginning after November 15, 2007, and forinterim periods within those fiscal years. The Company is currently evaluatingthe impact, if any, the adoption of SFAS No. 157 will have on its consolidatedfinancial statements.

In September 2006,the FASB issued SFAS No. 158, *Employers’Accounting for Defined Benefit Pension and Other Postretirement Plans - anamendment of FASB Statement No.’s 87, 88, 106, and 132(R). *Effective for the fiscal yearending December 31, 2006, SFAS No. 158 requires companies to recognize thestatus of a defined benefit postretirement plan in its statement of financialposition, recognize in other comprehensive income gains or losses that ariseduring the period but are deferred under pension accounting rules and modifiesthe timing of reporting and the nature of disclosure requirements.  SFAS No.158 also requires companies tomeasure the funded status of the plan as of the date of its fiscal year-end,with limited exceptions, effective for fiscal years ending after December 15,2008. The Company is currently evaluating the impact the adoption of SFAS No.158 will have on its consolidated financial statements.

In June 2006, theFinancial Accounting Standards Board (“FASB”) issued Interpretation No. (“FIN”)48, *Accounting for Uncertainty in IncomeTaxes.*  FIN No. 48 clarifiesthe accounting for uncertainty in income taxes recognized in a company’sfinancial statements in accordance with FASB No. 109, *Accounting for 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 alsoprovides guidance on de-recognition, classification, interest and penalties,accounting in interim periods, disclosure and transition of uncertain taxpositions.  The interpretation iseffective for fiscal years beginning after December 15, 2006. The Company iscurrently evaluating the impact that FIN No. 48 will have on its consolidatedfinancial statements.

Effective January1, 2006, the Company adopted SFAS No. 154, *Accounting Changes 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 adoption of SFAS No. 154 has not had amaterial effect on the Company’s consolidated financial position, results ofoperations or cash flows.

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**ITEM 2.****                 MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.**

*(Amounts in thousands, except selected operatingmetrics and share and per share amounts)*

Certaininformation included in this quarterly report on Form 10-Q of SureWestCommunications (the “Company”), including that which relates to the impact onfuture revenue sources and potential sharing obligations of pending and futureregulatory orders, continued expansion of the telecommunications network andexpected changes in the sources of the Company’s revenue and its cost structureresulting from its entrance into new communications markets, are forwardlooking statements and are made pursuant to the safe harbor provisions of theSecurities Litigation Reform Act of 1995. Such forward looking statements aresubject to a number of risks, assumptions and uncertainties that could causethe Company’s actual results to differ from those projected in such forwardlooking statements.

Important factorsthat could cause actual results to differ from those set forth in the forwardlooking statements include, but are not limited to: advances intelecommunications technology, changes in the telecommunications regulatoryenvironment, changes in the financial stability of other telecommunicationsproviders that are customers of the Company, changes in competition in markets orbusinesses in which the Company operates, adverse circumstances affecting theeconomy in California in general, and in the Sacramento, CaliforniaMetropolitan area in particular, the availability of future financing, changesin the demand for services and products, new product and service developmentand introductions, pending and future litigation, and unanticipated changes inthe growth of the Company’s emerging businesses, including the wireless andbroadband business segments.

**Corporate Structure**

TheCompany is a holding company with wholly-owned subsidiaries operating in theTelecommunications (“Telecom”), Broadband and Wireless segments.

The Telecomsegment includes SureWest Telephone, SureWest Directories, and SureWest LongDistance, which provide landline telecommunications services, directoryadvertising, Digital Subscriber Line (“DSL”) service, long distance servicesand certain non-regulated services. SureWest Telephone, which is the principaloperating subsidiary of the Telecom segment, provides local services, tolltelephone services, network access services and certain non-regulated services.SureWest Directories publishes and distributes SureWest Telephone’s directory,including the sale of yellow pages advertising. SureWest Directories isalso engaged in the business of producing, publishing and distributingdirectories in other Northern California communities outside of SureWest Telephone’sservice area. SureWest Long Distance is a reseller of long distance services.

The Broadbandsegment includes the Company’s subsidiaries SureWest Broadband, SureWestTeleVideo and SureWest TeleVideo of Roseville (collectively referred to as “SureWestBroadband/Residential Services”) and SureWest Broadband Business Services,which is comprised, in part, of a division of SureWest Telephone operating as aCompetitive Local Exchange Carrier (“CLEC”). The Broadband segment providesvarious services, including high-speed and dial-up Internet, digital video,voice, network access, long distance and managed services in the greaterSacramento area, principally to customers residing outside of SureWestTelephone’s service area. The Company offers high-speed Internet, digitalvideo, voice and long distance phone service as a bundled package referred toas fiber-to-the-premise (“FTTP”).

The Wirelesssegment consists of the Company’s subsidiary SureWest Wireless, which provideswireless services. Wireless revenues include wireless voice services, sales ofhandsets and related accessories, long distance, roaming service and customcalling features. Wireless services are provided on a month-to-month basis andare generally billed in advance for non-contract subscribers and in arrears forcontract subscribers.

The Companyexpects that the sources of its revenues and its cost structure may bedifferent in future periods, both as a result of its entry into newcommunications markets and competitive forces in each of the markets in whichthe Company operates.

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**Resultsof Operations**

#### **Consolidated Overview**

The tables belowreflect certain financial data (on a consolidated and segment basis) andselected operating metrics for each reportable segment as of and for thequarters and nine-month periods ended September 30, 2006 and 2005.

# **FinancialData**

| ** **                  | ** ** | **Quarter Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------|------------|------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                       | ** ** | **2005**                                                | ** ** | **$  Change** | ** ** | **%  Change** | ** ** | **2006** | ** ** | **2005** | ** ** | **$  Change** | ** ** | **%  Change** | ** ** |
| **Operating revenues (1)**  |       |                                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Telecom                     |       | $                                              | 33,096     |                                                    | $          | 33,758 |   | $ | (662 | ) |   | (2 | )% |   | $ | 97,173 |   | $ | 101,179 |   | $ | (4,006 | ) |   | (4 | )% |   |
| Broadband                   |       | 15,225                                         |       | 12,979                                                  |       | 2,246 |   |   | 17 |   |   | 44,130 |   | 36,680 |   | 7,450 |   |   | 20 |   |   |
| Wireless                    |       | 8,561                                          |       | 8,832                                                   |       | (271 | ) |   | (3 | ) |   | 25,517 |   | 25,764 |   | (247 | ) |   | (1 | ) |   |
| Total operating  revenues   |       | 56,882                                         |       | 55,569                                                  |       | 1,313 |   |   | 2 |   |   | 166,820 |   | 163,623 |   | 3,197 |   |   | 2 |   |   |
|                        |       |                                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Operating income (loss)** |       |                                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Telecom                     |       | 15,413                                         |       | 13,589                                                  |       | 1,824 |   |   | 13 |   |   | 44,079 |   | 39,900 |   | 4,179 |   |   | 10 |   |   |
| Broadband                   |       | (6,254                                         | )          | (5,694                                                  | )          | (560 | ) |   | (10 | ) |   | (20,528 | ) | (17,933 | ) | (2,595 | ) |   | (14 | ) |   |
| Wireless                    |       | (3,783                                         | )          | (3,098                                                  | )          | (685 | ) |   | (22 | ) |   | (10,389 | ) | (9,704 | ) | (685 | ) |   | (7 | ) |   |
| Total operating  income     |       | 5,376                                          |       | 4,797                                                   |       | 579 |   |   | 12 |   |   | 13,162 |   | 12,263 |   | 899 |   |   | 7 |   |   |
|                        |       |                                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Net income (loss)**       |       |                                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Telecom                     |       | 9,088                                          |       | 7,954                                                   |       | 1,134 |   |   | 14 |   |   | 25,906 |   | 23,333 |   | 2,573 |   |   | 11 |   |   |
| Broadband                   |       | (4,466                                         | )          | (3,851                                                  | )          | (615 | ) |   | (16 | ) |   | (14,332 | ) | (11,834 | ) | (2,498 | ) |   | (21 | ) |   |
| Wireless                    |       | (2,465                                         | )          | (2,143                                                  | )          | (322 | ) |   | (15 | ) |   | (6,814 | ) | (6,549 | ) | (265 | ) |   | (4 | ) |   |
| Total net income            |       | $                                              | 2,157      |                                                    | $          | 1,960 |   | $ | 197 |   |   | 10 | % |   | $ | 4,760 |   | $ | 4,950 |   | $ | (190 | ) |   | (4 | )% |   |

 

(1)  External customers only

# **Selected Operating Metrics**

|                                                    | ** ** | **As of September 30,** | ** ** |
|----------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                         | ** ** | **2006**                               | ** ** | **2005** | ** ** | **Change** | ** ** | **% Change** | ** ** |
| **Telecom**                                        |       |                                   |       |   |   |   |   |   |   |
| Incumbent Local Exchange Carrier access lines      |       | 126,349                                |       | 130,000 |   | (3,651 | ) |   | (3) | % |   |
| Long distance lines                                |       | 56,774                                 |       | 51,213 |   | 5,561 |   |   | 11 |   |   |
|                                               |       |                                   |       |   |   |   |   |   |   |   |   |
| **Broadband**                                      |       |                                   |       |   |   |   |   |   |   |   |   |
| Total Subscribers (1)                              |       | 55,183                                 |       | 48,123 |   | 7,060 |   |   | 15 |   |   |
| Residential Broadband Revenue-generating units (2) |       |                                   |       |   |   |   |   |   |   |   |   |
| Data                                               |       | 52,777                                 |       | 45,354 |   | 7,423 |   |   | 16 |   |   |
| Video                                              |       | 18,578                                 |       | 15,754 |   | 2,824 |   |   | 18 |   |   |
| Voice                                              |       | 17,729                                 |       | 14,764 |   | 2,965 |   |   | 20 |   |   |
| Business Voice-grade equivalents (3)               |       | 735,500                                |       | 625,200 |   | 110,300 |   |   | 18 |   |   |
|                                               |       |                                   |       |   |   |   |   |   |   |   |   |
| **Wireless**                                       |       |                                   |       |   |   |   |   |   |   |   |   |
| Subscribers                                        |       | 52,393                                 |       | 53,818 |   | (1,425 | ) |   | (3) | % |   |

 

(1)               Totalsubscribers are customers who receive data, video or voice services fromSureWest Broadband.

(2)               TheBroadband segment can deliver multiple services to a customer. Accordingly, theCompany maintains statistical data regarding Revenue-generating units fordigital video, voice and data, in addition to the number of customers. Forexample, a single customer who purchases digital video, voice and data serviceswould be reflected as three Revenue-generating units.

(3)               BusinessVoice-grade equivalents (“VGEs”) are calculated by dividing the capacity of allcircuits in use by 64 kilobits (bandwidth representing a voice accessline).  DSL VGEs are counted as two 64kbps channels.

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Operatingrevenues from external customers in the Telecom segment decreased $662 and$4,006 during the quarter and nine-month period ended September 30, 2006,respectively, compared to thesame periods in 2005. SureWest Telephone continues toexperience decreases in local and network access revenues due to competitionfrom wireless (including SureWest Wireless) and wireline competitors, which hasresulted in an approximate 3% decline in access lines.  In addition, network access revenuesdecreased due to a decline in the rate base, which affects the interstate poolsettlements from the National Exchange Carrier Association (“NECA”) (see *Regulatory Matters* within the *Telecom Segment Results of Operations and CriticalAccounting Policies and Estimates* sections below).  SureWest Telephone’s revenues are alsoimpacted by shareable earnings obligations, which are also discussed below inthe *Telecom Segment Results of Operations.*

Whilethe Telecom segment steadily continues to generate a majority of the Company’srevenues, cash flows and net income, the Company believes that the results ofthe Telecom segment in recent years (reflected in declining revenues and accesslines) support, in part, the Company’s efforts to continue to develop its otherbusiness segments.

Broadbandoperating revenues increased $2,246 and $7,450 during the quarter andnine-month period ended September 30, 2006, respectively, compared to the sameperiods in 2005.  During the nine-monthperiod ended September 30, 2006, the Broadband segment experienced a 15%increase in the number of subscribers compared to the prior year period. Alsoduring the same period, broadband business services realized an 18% increase inVGEs. While continuing to produce significant revenue increases, the expansionof the broadband residential services has and will continue to requiresignificant capital and expense commitments.

Operatingrevenues from external customers in the Wireless segment for the quarter andnine-month period ended September 30, 2006 decreased $271 and $247,respectively, compared to the same periods in 2005.  As the Company deemphasizes the prepaidmarket and migrates toward contract subscribers, the number of wirelesssubscribers decreased to 52,393 at September 30, 2006, a 3% decline fromSeptember 30, 2005.  In addition, theaverage revenue per subscriber declined by 3% during the nine-month periodended September 30, 2006 compared to the same prior year period due in part toa decrease in roaming revenues as a result of a reduction in roaming rates, andthe implementation of new Travel Plans during the quarter ended June 30, 2006to provide subscribers with competitive roaming packages and lower pricedcalling options.

TheCompany’s consolidated operating expenses, excluding depreciation andamortization, decreased $820 and $2,656 during the quarter and nine-monthperiod ended September 30, 2006, respectively, compared to the same periods in2005. During the quarter and nine month period ended September 30, 2006, theCompany changed its estimated costs for 2006 related to its non-contributorydefined benefit pension plan (the “Pension Plan”) and Postretirement WelfarePlan based on revised actuarial calculations. In addition, the Company alsorevised its 2006 estimate of certain employee compensation incentives. Thecombined effect of these changes in estimates decreased operating expenses byapproximately $679 and $1,718 and increased net income by $409 ($0.03 pershare) and $1,036 ($0.07 per share) during the quarter and nine month periodended September 30, 2006, respectively.

Inlate 2004, the Company initiated a voluntary enhanced early retirement program(the “REWARD program”). The REWARD program was offered to certain eligibleemployees across all business units.  Inaddition to retirement benefits, eligible employees receive enhanced medicalbenefits for a specified period of time. During the quarter ended March 31, 2005, the Company recorded $791 inoperating expenses attributed to 13 employees that accepted the REWARD programin 2005.

During2005, the Company implemented a strategy for driving efficiency and long-termgrowth through cost reduction and workforce consolidation. This strategic planentailed a reduction of operating expenses through a realignment oforganizational structure in order to focus on primary customer segments. Theongoing corporate restructuring has involved a reorganization of stand-alonesegment functions in order to gain operating efficiencies through aconsolidated organizational structure. As a result of this effort, overalllabor costs decreased approximately $2,700 during the nine-month period endedSeptember 30, 2006 compared to the prior year period. The Company also expectsto continue to identify and eliminate additional functional redundancies,combine duplicate or overlapping work areas, and further reduce overall laborcosts.

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Costof services and products expense decreased $153 and $635 for the quarter and nine-monthperiod ended September 30, 2006, respectively, compared to the same periods in2005 due primarily to a decline in expenses for network operations as a resultof the cost reduction and workforce consolidation.  The decrease in network operations expensewas largely offset by an increase in (i) video license fees as the number ofsubscribers within the Broadband segment continued to grow and (ii) cost ofequipment sales due to increases in the average cost and quantity of wirelesshandsets sold.

Customeroperations and selling expense increased $260 and $712 for the quarter andnine-month period ended September 30, 2006, respectively, compared to the sameperiods in 2005 due primarily to an increase in sales and advertising costs topromote new product offerings within the Broadband segment.  General and administrative expenses decreased$927 and $2,733, for the quarter and nine-month period ended September 30,2006, respectively, compared to the same periods in 2005 primarily as a resultof a decline in consulting and audit fees related to Sarbanes-Oxley Actimplementation and compliance completed in prior years, and as a result of thecost reduction and workforce consolidation.

TheCompany’s consolidated depreciation and amortization expense increased $1,554and $4,954 during the quarter and nine-month period ended September 30, 2006,respectively, compared to the same periods in 2005 primarily due to thecontinued network build-out and success-based capital projects undertakenwithin the residential broadband service territories.

*Reclassifications*

Certain amounts inthe Company’s 2005 condensed consolidated financial statements have beenreclassified to conform to the presentation of the Company’s 2006 condensedconsolidated financial statements.

**Segment Results of Operations**

**Telecom**
| ** **                                        | ** ** | **Quarter Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------------------------|------------|------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                        | ** ** | **2006**                                       | ** ** | **2005**                                                | ** ** | **$  Change** | ** ** | **%  Change** | ** ** | **2006** | ** ** | **2005** | ** ** | **$  Change** | ** ** | **%  Change** | ** ** |
|                                              |       |                                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Local service                                     |       | $                                              | 15,606     |                                                    | $          | 15,870 |   | $ | (264 | ) |   | (2 | )% |   | $ | 47,278 |   | $ | 47,831 |   | $ | (553 | ) |   | (1 | )% |   |
| Network access  service                           |       | 10,661                                         |       | 11,048                                                  |       | (387 | ) |   | (4 | ) |   | 30,034 |   | 32,993 |   | (2,959 | ) |   | (9 | ) |   |
| Directory  advertising                            |       | 4,555                                          |       | 4,409                                                   |       | 146 |   |   | 3 |   |   | 13,460 |   | 13,045 |   | 415 |   |   | 3 |   |   |
| Long distance  service                            |       | 1,493                                          |       | 1,607                                                   |       | (114 | ) |   | (7 | ) |   | 4,211 |   | 4,503 |   | (292 | ) |   | (6 | ) |   |
| Other                                             |       | 781                                            |       | 824                                                     |       | (43 | ) |   | (5 | ) |   | 2,190 |   | 2,807 |   | (617 | ) |   | (22 | ) |   |
| Total operating  revenues from external customers |       | 33,096                                         |       | 33,758                                                  |       | (662 | ) |   | (2 | ) |   | 97,173 |   | 101,179 |   | (4,006 | ) |   | (4 | ) |   |
| Intersegment  revenues                            |       | 7,392                                          |       | 7,660                                                   |       | (268 | ) |   | (4 | ) |   | 22,170 |   | 22,133 |   | 37 |   |   | — |   |   |
| Operating  expenses*                              |       | 18,752                                         |       | 21,277                                                  |       | (2,525 | ) |   | (12 | ) |   | 56,300 |   | 64,502 |   | (8,202 | ) |   | (13 | ) |   |
| Depreciation and  amortization                    |       | 6,323                                          |       | 6,552                                                   |       | (229 | ) |   | (4 | ) |   | 18,964 |   | 18,910 |   | 54 |   |   | — |   |   |
| Operating income                                  |       | 15,413                                         |       | 13,589                                                  |       | 1,824 |   |   | 13 |   |   | 44,079 |   | 39,900 |   | 4,179 |   |   | 10 |   |   |
| Net income                                        |       | $                                              | 9,088      |                                                    | $          | 7,954 |   | $ | 1,134 |   |   | 14 | % |   | $ | 25,906 |   | $ | 23,333 |   | $ | 2,573 |   |   | 11 | % |   |

*Exclusive of depreciation and amortization

*Operating Revenues*

Operatingrevenues from external customers in the Telecom segment decreased $662 and$4,006 for the quarter and nine-month period ended September 30, 2006,respectively, compared to the same periods in 2005. SureWest Telephonecontinues to experience decreases in local and network access revenues due tocompetition from wireless (including SureWest Wireless) and wirelinecompetitors, which has resulted in an approximate 3% decline in accesslines.  In addition, network accessrevenues decreased due to a decline in the rate base, which affects theinterstate pool settlements from the NECA (see *RegulatoryMatters* and *Critical AccountingPolicies and Estimates* sections below).  SureWest Telephone’s revenues are alsoimpacted by shareable earnings obligations, which are discussed below in the *Telecom Segment Results of Operations*.

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*OperatingExpenses*

Operating expenses for theTelecom segment decreased $2,525 and $8,202 for the quarter and nine-monthperiod ended September 30, 2006, respectively, compared to the same periods in2005.  The decreases in operatingexpenses were due in large part to labor savings realized through the costcontainment and workforce consolidation plan and the inclusion during thequarter ended March 31, 2005 of approximately $640 related to the REWARDprogram, as described in the *ConsolidatedOverview* section above.  Thedecreases in operating expenses were also attributable in part to a change inestimated costs during 2006 related to employee compensation and benefits, alsodescribed in the *Consolidated Overview*section above, which resulted in a $361 and $914 reduction to operatingexpenses during the quarter and nine period ended September 30, 2006,respectively.

Cost of services andproducts (exclusive of depreciation and amortization) decreased $1,230 and$4,290 for the quarter and nine-month period ended September 30, 2006,respectively, compared to the same periods in 2005.  As described above, the decreases wereattributable to the labor savings realized through the cost containment andworkforce consolidation plan and the inclusion in 2005 of costs related to theREWARD program.  In addition, the changein estimated costs during 2006 related to employee compensation and benefitsresulted in a $104 and $412 decrease in expense during the quarter andnine-month period ended September 30, 2006, respectively.

Customer operations andselling expense decreased $194 and $822 for the quarter and nine-month periodended September 30, 2006, respectively, compared to the same periods in 2005,due primarily to decreases in labor costs as a result of a reduction inemployee headcount and internal efficiencies resulting from integrated customersupport systems and productivity gains.

General andadministrative expense decreased $1,101 and $3,090 for the quarter andnine-month period ended September 30, 2006, respectively, compared to the sameperiods in 2005 due to decreased labor costs resulting from efficiencies gainedthrough the workforce consolidation plan and a decline in audit and consultingfees primarily related to the occurrence in prior years of Sarbanes-Oxley Actimplementation and compliance efforts.

*Regulatory Matters*

Revenues fromservices subject to regulation constituted approximately 46% of the Company’stotal operating revenues for the quarter and nine-month period ended September30, 2006.  For the prior year periods,the revenues constituted approximately 48% and 49% of the Company’s totaloperating revenues, respectively.  Localservice, network access service and toll service are included in revenues fromservices subject to regulation, and are derived from various sources including:

·               business andresidential subscribers, for basic exchange services;

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

·               long distancecarriers, for network access service;

·               competitive accessproviders and subscribers, for network access services;

·               interstate poolsettlements from NECA;

·               support paymentsfrom federal or state programs; and

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

Revenues fromcertain telephone services are affected by rates authorized by variousregulatory agencies. Intrastate service rates are subject to regulation by theCPUC. With respect to toll calls initiated by interexchange carriers’customers, the interexchange carriers are assessed access charges based ontariffs filed by SureWest Telephone. Interstate access rates and resultantearnings are subject to regulation by the Federal Communications Commission (“FCC”).With respect to interstate services, SureWest Telephone has detariffed its DSLservices and files its own tariff with the FCC for switched and special accessservices.  For interstate common line (“CL”)charges, SureWest Telephone concurs with tariffs filed by NECA.

TheFCC monitors SureWest Telephone’s interstate earnings through the use of annualcost separation studies prepared by SureWest Telephone, which utilize estimatedcost information and projected demand usage. The FCC

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establishesrules that carriers must follow in the preparation of the annual studies.Additionally, under current FCC rules governing rate making, SureWestTelephone is required to establish interstate rates based on projected demandusage for its various services and determine the actual earnings from theserates once actual volumes and costs are known. Based on preliminary coststudies, the Company recognized liabilities relating to SureWest Telephone’sestimated interstate shareable earnings obligations of $87 and $167 for thequarter and nine-month period ended September 30, 2005, respectively, throughreductions of revenues (none in 2006).

Asa result of periodic cost separation studies, SureWest Telephone changed itsestimates for a portion of its interstate shareable earnings obligations andcertain NECA CL accounts receivable balances. For the quarter and nine-month period ended September 30, 2006, thesechanges in estimates increased the Company’s consolidated revenues by $185 and$499 and net income by $112 ($0.01 per share) and $301 ($0.02 per share),respectively.  For the comparable prioryear periods, these changes in estimates increased the Company’s consolidatedrevenues by $175 and $989 and net income by $107 ($0.01 per share) and $604($0.04 per share), respectively.

Duringthe quarter ended September 30, 2005, SureWest Telephone made a payment of $100to a certain carrier customer in full settlement of an interstate overearningsdispute for the monitoring period 2001-2002. The limitations period applicable to this monitoring period expiredduring the quarter.  Therefore, SureWestTelephone released all other amounts reserved in connection with the potentialoverearnings claims for the 2001-2002 monitoring period, which increased the Company’srevenues and net income by $125 and $76 ($0.01 per share), respectively, duringthe quarter ended September 30, 2005.

TheFCC has a pending rulemaking proceeding to re-examine all regulated forms ofintercarrier compensation and develop a more unified mechanism to govern thepayment flows among telecommunications carriers.  Intercarrier compensation is the regulatedfees that service providers charge each other to carry and terminatetraffic.  Reform has been suggested dueto the changing nature of the industry with increasing competition from newtechnologies, such as Internet and Internet-based services and wirelessservices.  Various plans have beensubmitted to the FCC with divergent approaches to handle intercarriercompensation that may reduce per-minute access and reciprocal compensationcharges and replace these revenues with a combination of increases to thesubscriber line charge and revenues obtained from a new restructuremechanism.  The ultimate results of thisproceeding and the potential effects on SureWest Telephone cannot yet bedetermined.

The Company wasinvolved in a proceeding at the CPUC that considered the continued need forcertain sharing requirements in the intrastate jurisdiction and, in connectionwith that review, also considered the issue of whether the Company overearnedin the intrastate jurisdiction in recent monitoring periods and the amount ofoverearnings that should be shared with customers. In July 2004, theCompany entered into a settlement agreement (“the settlement agreement”) withthe other parties in the proceeding, the Division of Ratepayer Advocates (“DRA”),(formerly Office of Ratepayer Advocates), 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.

In accordance withthe settlement agreement, SureWest Telephone will return approximately $6,500 (“DividendA”), plus interest at the 90-day commercial paper rate for non-financialinstitutions, which was 5.21% as of September 30, 2006, and an imputed rate of3.15%, to its end users through a consumer dividend over a period of fouryears, which began January 1, 2005. In addition, SureWest Telephone will pay aone-time consumer dividend of $2,600 (“Dividend B”), which will be returned tothe consumers to settle the monitoring periods 2000 to 2004.  The consumer dividend is recorded as areduction of the Company’s contractual shareable earnings obligations over twoyears, which began January 1, 2005. The consumer dividend includes an annualimputed interest rate of 3.15% (no stated contractual interest rate).  At September 30, 2006, the aggregatecontractual shareable earnings obligation for these surcredits was $4,346 (whichis net of an unamortized discount pertaining to imputed interest of $146 atthat date).

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The followingtable summarizes the amounts returned to end users through consumer dividendsfor the quarters and nine-month periods ended September 30, 2006 and 2005:

|                 | ** ** | **Quarter Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------|------------|--------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **      | ** ** | **2006**                                   | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Dividend  A** |       | $                                          | 500        |                                                | $          | 423 |   | $ | 1,520 |   | $ | 1,242 |   |
| **Dividend  B** |       | 293                                        |       | 310                                                 |       | 889 |   | 909 |   |
| **Total**       |       | $                                          | 793        |                                                | $          | 733 |   | $ | 2,409 |   | $ | 2,151 |   |

 

Further, commencingJanuary 1, 2007, SureWest Telephone will implement an additional annualconsumer dividend of $1,300 to end-users receiving SureWest Telephone servicessubject to sharing on or after that date; however, this consumer dividend issubject to reduction based upon the results of other pending regulatoryproceedings, as described below.

During the fourthquarter of 2005, the Company filed an Advice Letter with the CPUC proposing anincrease to the consumer dividends in order to return the amounts entitled inaccordance with the settlement agreement. The change in the consumer dividendsresulted from the increase in interest rates during 2005. The increase waseffective January 1, 2006.

Prior to 2000,AT&T Inc. (“AT&T”) (formerly SBC Communications), had been payingSureWest Telephone approximately $11,500 per year for EAS pursuant to aSettlement Transition Agreement. In November 2000, the CPUC authorized AT&Tto terminate its annual EAS payments to SureWest Telephone effectiveNovember 30, 2000. The CPUC authorized replacement funding to SureWestTelephone on an interim basis using funds from the CHCF. The CHCF is a programdesigned by the CPUC to establish a fair and equitable local rate structure andto reduce any disparity in the rates charged by telephone companies servinghigh-cost areas. The CHCF is scheduled to expire January 1, 2009. Inaddition, the CPUC opened an Order Instituting Investigation (“OII”) for thepurpose of determining whether future recovery of all, none, or a portion ofthe approximate $11,500 annual payments received from the CHCF should come fromSureWest Telephone’s ratepayers or other regulatory recovery mechanisms.

In August 2005,the CPUC adopted a decision which (i) authorized SureWest Telephone tocontinue receiving $11,500 annually from the CHCF to offset its intrastateregulated operating expenses on an interim basis, (ii) required SureWestTelephone to prepare and submit a cost proxy model (which is used generally asa basis for CHCF-B funding) based on its current cost data, including analysesof the resulting impacts on rates, the Universal Lifeline Telephone Service (“ULTS”)fund, and the CHCF fund, to be filed by SureWest Telephone within 12 months,and (iii) authorized SureWest Telephone to file an advice letter with theCommission’s Telecommunications Division to implement reductions to itsbusiness access line rates.

In August 2006,the Company filed a Petition for Modification of D.05-08-004, the decision thatreviewed SureWest Telephone’s revenue requirement, which seeks CPUCauthorization in a graduated phase-down of its $11,500 interim draw from theCHCF-B over a period of time that is intended to assure the continuedmaintenance of good service to SureWest Telephone customers while avoidingprecipitous rate increases.  The Company’sPetition for Modification proposes a transitional phase-down over a five-to-tenyear period and requests elimination of the requirement to file its cost proxymodel.  The Company expects to recoverthe eliminated revenues through rate increases and/or operatingefficiencies.  On August 31, 2006, theDRA filed opposition to the Company’s Petition for Modification and insteadproposed the Company continue to prepare and submit a cost proxy model tocontinue receipt of CHCF-B funds. On October 30, 2006, the Company filed withthe CPUC a proposal to offset its draw from the CHCF in 2007 with the annualconsumer dividend of $1,300, which is currently scheduled to begin January 1,2007.  The DRA will respond to theCompany’s proposal November 9, 2006. The results of this proceeding and thepotential effects on SureWest Telephone could impact future funding levelsthrough the CHCF-B.

In June 2006, theCPUC instituted a rulemaking proceeding to review the CHCF-B program.  The goals of this review include, but are notlimited to, adjusting universal service rate support payments to reflectupdated operating costs, evaluating whether CHCF-B fund 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

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service betweenurban and rural areas in the state, and making the current administration ofthe program more efficient.  In addition,the CHCF-B rulemaking requested comments as to whether SureWest Telephoneshould continue receiving the $11,500 annually from the CHCF-B and theadvisability and impacts of phasing out the EAS payments gradually over aperiod of approximately 5 years.  Commentsin the CHCF-B rulemaking were filed on September 1, 2006 with reply commentsfiled on October 16, 2006.  The resultsof this proceeding and the potential effects on SureWest Telephone could impactfuture funding levels through the CHCF-B.

In 1996, the CPUCissued a decision that authorized SureWest Telephone to implement a NewRegulatory Framework (“NRF”) for services furnished within SureWest Telephone’sservice area in order to accommodate market and regulatory movement towardcompetition and greater pricing flexibility. Under the NRF, SureWest Telephoneis subject to ongoing monitoring and reporting requirements, and it wasinitially required to share earnings with customers through a reduction ofrevenues if its earned annual rate-of-return exceeds that authorized by theCPUC.

In April 2005, theCPUC opened a rulemaking proceeding to assess and revise the regulation oftelecommunications utilities to develop a uniform regulatory framework (“URF”)to apply to all providers of regulated telecommunications services, exceptsmall Incumbent Local Exchange Carriers(“ILECs”), to the extent that it is feasible and in the public interestto do so.  On August 24, 2006, the CPUCadopted Decision 06-08-030 (“the decision”) which revises the regulations oftelecommunications utilities, such as SureWest Telephone, which were previouslysubject to the NRF. The decision grants carriers broad pricing freedoms in theprovision of telecommunications services, bundles of services, promotions andcontracts.  The decision, among otherthings:  (i) freezes the Company’s basicresidential and lifeline rates until at least January 1, 2009 in order toaddress the subsidy levels supporting these special services, subject to reviewin the CHCF-B 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) allows bundlesand promotional packages on any telecommunication service, (iv) allocates allgains and losses from the sale of assets to shareholders and (iv) 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 withthe decision, the CPUC ordered a separate briefing cycle to consider whether todetariff altogether telecommunications services other than basic residentialservice.  The resolution of the separatebriefing cycle is expected by December 31, 2006.  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 decision required all ILECsoperating within California to eliminate the TIC element and authorizedrecovery of lost revenue through end users, specifically through an increase intheir local rate surcharge, and use of the CHCF-A for the small companies.  If SureWest Telephone did not recover anylost revenues from end users, the decision could ultimately result in a loss ofrevenues of up to $4,400, on a prospective basis. The Company sought modificationof the draft decision on the basis that the CPUC had indicated that it wasprepared to act only with respect to larger ILECs, and thus denied SureWestTelephone due process.  In the finaldecision, the CPUC deferred the elimination of the TIC element for SureWest tothe next phase of the proceeding, which began in May 2006.  The Company filed testimony in May 2006supporting that the CPUC should not eliminate the TIC for small and mid-sizedILECs due to an impending federal intercarrier compensation restructureproceeding at the FCC.  The ultimateresults of this proceeding and the potential effects on SureWest Telephonecannot yet be determined.

On September 29,2006, the Governor of California signed into law Assembly Bill No. 2987, whichenacts the Digital Infrastructure and Video Competition Act of 2006.  This new law bypasses the local franchiseprocess and establishes a procedure for the issuance of state franchises forthe provision of video service, and promotes a more rapid entry by telephonecompanies into the video business and new competition for cable and DBSproviders.  Existing cable providers willbe able to abrogate their local franchises and opt into the state franchiseprocess beginning in January 2008. Specifically, the Company will be able to exit its current local franchiseagreements and operate under a state-issued franchise if any of the followingevents occur:  (i) the expiration, priorto any renewal or extension, of the Company’s local franchise; (ii) mutualagreement between the local franchising entity and the Company; or (iii) at thetime a new video service provider initiates video service in all or part of thearea within the local municipality’s. This new law also prohibits ILECs that provide video service under astate-issued franchise from increasing****basic residential telephoneservice rates until January 1, 2009.  TheCompany has not yet

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determined theeffects that this new law will have on its condensed consolidated financialstatements or results of operations.

As of September30, 2006, the Company’s consolidated balance sheet reflected aggregateliabilities of $73 relating to SureWest Telephone’s estimated interstateshareable earnings obligations. The calculations supporting these liabilitiesare very complex and involve a variety of estimates prior to the ultimatesettlement of such obligations. In addition, SureWest Telephone’s interstateshareable earnings obligations lapse over time if SureWest Telephone’sinterexchange carrier and other customers do not claim the amounts ascribed tothem. Accordingly, it is reasonably possible that management’s estimates of theCompany’s liabilities for interstate shareable earnings obligations couldchange in the near term, and the amounts involved could be material.

# **Broadband**

| ** **                                        | ** ** | **Quarter Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------------------------|------------|------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                        | ** ** | **2006**                                       | ** ** | **2005**                                                | ** ** | **$  Change** | ** ** | **%  Change** | ** ** | **2006** | ** ** | **2005** | ** ** | **$  Change** | ** ** | **%  Change** | ** ** |
|                                              |       |                                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Data                                              |       | $                                              | 7,319      |                                                    | $          | 6,518 |   | $ | 801 |   |   | 12 | % |   | $ | 21,464 |   | $ | 19,157 |   | $ | 2,307 |   |   | 12 | % |   |
| Video                                             |       | 3,184                                          |       | 2,438                                                   |       | 746 |   |   | 31 |   |   | 9,033 |   | 7,095 |   | 1,938 |   |   | 27 |   |   |
| Voice                                             |       | 1,885                                          |       | 1,483                                                   |       | 402 |   |   | 27 |   |   | 5,470 |   | 4,101 |   | 1,369 |   |   | 33 |   |   |
| Network access                                    |       | 2,295                                          |       | 1,929                                                   |       | 366 |   |   | 19 |   |   | 6,668 |   | 4,628 |   | 2,040 |   |   | 44 |   |   |
| Other                                             |       | 542                                            |       | 611                                                     |       | (69 | ) |   | (11 | ) |   | 1,495 |   | 1,699 |   | (204 | ) |   | (12 | ) |   |
| Total operating  revenues from external customers |       | 15,225                                         |       | 12,979                                                  |       | 2,246 |   |   | 17 |   |   | 44,130 |   | 36,680 |   | 7,450 |   |   | 20 |   |   |
| Intersegment  revenues                            |       | 387                                            |       | 428                                                     |       | (41 | ) |   | (10 | ) |   | 1,123 |   | 1,269 |   | (146 | ) |   | (12 | ) |   |
| Operating  expenses*                              |       | 15,880                                         |       | 14,886                                                  |       | 994 |   |   | 7 |   |   | 48,877 |   | 44,036 |   | 4,841 |   |   | 11 |   |   |
| Depreciation and  amortization                    |       | 5,986                                          |       | 4,215                                                   |       | 1,771 |   |   | 42 |   |   | 16,904 |   | 11,846 |   | 5,058 |   |   | 43 |   |   |
| Operating loss                                    |       | (6,254                                         | )          | (5,694                                                  | )          | (560 | ) |   | (10 | ) |   | (20,528 | ) | (17,933 | ) | (2,595 | ) |   | (14 | ) |   |
| Net loss                                          |       | $                                              | (4,466     | )                                                       | $          | (3,851 | ) | $ | (615 | ) |   | (16 | )% |   | $ | (14,332 | ) | $ | (11,834 | ) | $ | (2,498 | ) |   | (21 | )% |   |

*Exclusive of depreciation and amortization

*OperatingRevenues*

Operating revenues fromexternal customers in the Broadband segment increased $2,246 and $7,450 for thequarter and nine-month period ended September 30, 2006, respectively, comparedto the same periods in 2005. The increase in Broadband revenues was due to thecombined effects of (i) a 15% increase in total subscribers, and (ii) thecontinued expansion of business broadband services as evidenced by an 18%increase in VGEs.

*Operating Expenses*

Total operating expensesin the Broadband segment increased $994 and $4,841 for the quarter andnine-month period ended September 30, 2006, respectively, compared to the sameperiods in 2005.  Cost of services and products(exclusive of depreciation and amortization) increased $423 and $2,767 for thequarter and nine-month period ended September 30, 2006, respectively, comparedto the same periods in 2005, due primarily to (i) an increase in programmingand transport costs related to the growth in Broadband subscribers andresidential broadband Revenue-generating units, (ii) an increase in accessexpense and general support costs corresponding to the increased subscribercount, as well as the expanded network footprint and (iii) an increase inproperty taxes predominantly due to the increase in property, plant andequipment as the network has expanded. The increase in cost of services and products was offset in part bylabor savings realized through the cost containment and workforce consolidationplan, as described in the *ConsolidatedOverview* section above.

Customer operationsexpense increased $418 and $1,549 for the quarter and nine-month period endedSeptember 30, 2006, respectively, compared to the same periods in 2005.  The increase was attributable to an increase insales and advertising costs to promote new product offerings within theBroadband segment.

General andadministrative expense increased $153 and $525 for the quarter and nine-monthperiod ended September 30, 2006, respectively, compared to the same periods in2005, primarily due to (i) increased corporate overhead costs charged to theBroadband segment resulting from the growth in the customer base and (ii)increased

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taxes andsurcharges.  These increases were offsetin part by a decline in audit and consulting fees primarily related to the occurrencein prior years of Sarbanes-Oxley Act implementation and compliance efforts.

The increase in operatingexpenses was offset in part by the change in estimated costs for 2006 relatedto employee compensation and benefits, described in the *Consolidated Overview* section above, whichresulted in an approximate $237 and $561 reduction to operating expenses forthe quarter and nine-month period ended September 30, 2006, respectively.

Depreciation andamortization increased $1,771 and $5,058 for the quarter and nine-month periodended September 30, 2006, respectively, compared to the same periods in 2005,primarily due to continued network build-out within the residential broadbandservice territories.

# **Wireless**

|                                            | ** ** | **Quarter Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------|------------|------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                 | ** ** | **2006**                                       | ** ** | **2005**                                                | ** ** | **$  Change** | ** ** | **%  Change** | ** ** | **2006** | ** ** | **2005** | ** ** | **$  Change** | ** ** | **%  Change** | ** ** |
|                                       | ** ** | ** **                                     | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Wireless  revenues from external customers |       | $                                              | 8,561      |                                                    | $          | 8,832 |   | $ | (271 | ) |   | (3 | )% |   | $ | 25,517 |   | $ | 25,764 |   | $ | (247 | ) |   | (1 | )% |   |
| Intersegment  revenues                     |       | 727                                            |       | 667                                                     |       | 60 |   |   | 9 |   |   | 2,102 |   | 1,908 |   | 194 |   |   | 10 |   |   |
| Operating  expenses*                       |       | 10,074                                         |       | 9,612                                                   |       | 462 |   |   | 5 |   |   | 29,071 |   | 28,281 |   | 790 |   |   | 3 |   |   |
| Depreciation and  amortization             |       | 2,997                                          |       | 2,985                                                   |       | 12 |   |   | — |   |   | 8,937 |   | 9,095 |   | (158 | ) |   | (2 | ) |   |
| Operating loss                             |       | (3,783                                         | )          | (3,098                                                  | )          | (685 | ) |   | (22 | ) |   | (10,389 | ) | (9,704 | ) | (685 | ) |   | (7 | ) |   |
| Net loss                                   |       | $                                              | (2,465     | )                                                       | $          | (2,143 | ) | $ | (322 | ) |   | (15 | )% |   | $ | (6,814 | ) | $ | (6,549 | ) | $ | (265 | ) |   | (4 | )% |   |

*Exclusive of depreciation and amortization

*OperatingRevenues*

Operating revenuesfrom external customers in the Wireless segment decreased $271 and $247 for thequarter and nine-month period ended September 30, 2006, respectively, comparedto the same periods in 2005.  Thedecrease in revenue was attributable to (i) a 3% decline in subscribers due inpart to a de-emphasis on the prepaid market and (ii) a decline in the averagerevenue per subscriber primarily as a result of a decrease in roaming revenuesfrom a reduction in roaming rates and the implementation of Travel Plans, whichprovide subscribers with flat-rate roaming packages and lower priced callingoptions.  The declines in revenues wereoffset in part by increases in equipment revenues resulting from an increase inthe quantity of handsets sold.

*OperatingExpenses*

Total operating expensesfor the Wireless segment increased $462 and $790 for the quarter and nine-monthperiod ended September 30, 2006, respectively, compared to the same periods in2005.  Although the Wireless segmentexperienced increases in operating expenses efficiencies gained through thecost containment and workforce consolidation plan, as described in the *Consolidated Overview* section above,helped to reduce the increases.

Cost of services andproducts (exclusive of depreciation and amortization) increased $309 and $873for the quarter and nine-month period ended September 30, 2006, respectively,compared to the same periods in 2005, primarily due to increases in (i) theaverage cost and quantity of handsets sold, (ii) long distance expense due toan increase in the minutes of use and (iii) costs associated with additionalfeatures introduced in 2006. These increases were partially offset by decreasesin (i) labor costs in network operations through the corporate restructuringand (ii) roaming costs as a result of a reduction in contracted rates.

Customer operationsexpense increased $150 and $102 for the quarter and nine-month period endedSeptember 30, 2006, respectively, compared to the same periods in 2005 dueprimarily to an increase in sales and advertising expense as a result ofincreased promotional campaigns in the current quarter.

General andadministrative expense decreased $185 for the nine-month period ended September30, 2006 compared to the same period in 2005 primarily due to decreased laborcosts resulting from efficiencies gained through the

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corporate restructuringand a decline in audit and consulting fees primarily related to the occurrencein prior years of Sarbanes-Oxley Act implementation and compliance efforts.

Operating expenses werealso impacted by the change in estimated costs for 2006 related to employeecompensation and benefits, described in the *ConsolidatedOverview* section above, which resulted in an approximate $81and $243reduction to operating expenses for the quarter and nine-month period endedSeptember 30, 2006, respectively.

Depreciation andamortization decreased $158 for the nine-month period ended September 30, 2006compared to the same period in 2005 primarily due to reduced capitalexpenditures and fully depreciated property, plant and equipment.

**Non-operating Items**

*OtherIncome and Expense, Net*

Interestexpense increased $338 and $1,023 during the quarter and nine-monthperiod ended September 30, 2006, respectively, compared to the sameperiods in 2005.  The increase ininterest expense was primarily a result of an increase in long-term debt and acorresponding increase in the weighted average cost of debt in the current yearas the Company borrowed under the Term Loan Facility described in Liquidity andCapital Resources below.

*Income Taxes*

Income tax expense increased$203 and decreased $33 for the quarter and nine-monthperiod ended September 30, 2006, respectively, compared to the sameperiods in 2005, due primarily to corresponding fluctuations in income subjectto tax. The effective federal and state income tax rates were approximately39.7% and 39.0% for the nine-month periods ended September 30, 2006 and 2005,respectively.

## **Liquidityand Capital Resources**

Asreflected in the Condensed Consolidated Statements of Cash Flow, net cashprovided by the Company’s operating activities was $46,457 for the nine-monthperiod ended September 30, 2006 primarily due to (i) net income of $4,760, (ii)non-cash charges of $44,805 consisting of depreciation and amortization due tocapital investments principally in the Broadband segment and (iii) othernon-cash charges of $869 primarily for stock based compensation expense.  These amounts were offset by (i) a decreasein accounts payable and accrued liabilities of approximately $1,753 primarilydue to a decrease in outstanding obligations related to accrued compensationand capital project expenditures and (ii) an approximate $2,500 decrease in theCompany’s estimated and contractual shareable earnings obligations dueprimarily to the amounts returned to end users through consumer dividendsresulting from the intrastate settlement agreement (see *Regulatory Matters* within the TelecomSegment Results of Operations).

Net cash used inthe Company’s investing activities for the nine-month period ended September30, 2006 was $37,413 for capital expenditures pertaining to ongoing plantconstruction projects.

Net cash used inthe Company’s financing activities was $4,469 for the nine-month period endedSeptember 30, 2006 due primarily to dividend payments of $10,962 and $3,477 forthe repurchase of the Company’s common stock offset by a $10,000 net increasein short and long-term borrowings.

The Company’sworking capital was $14,776 at September 30, 2006.  The increase in working capital during thenine-month period ended September 30, 2006 was due primarily to the retirementof short-term borrowings and an increase in cash resulting from the incurrenceof long-term debt, as described below. In addition, the increase was also due in part to decreases in accountspayable, other accrued liabilities and accrued income taxes. The increase inworking capital was partially offset by a decrease in net accounts receivable.  As discussed below, the Company believes thatits working capital position, operating cash flows and borrowing capacity aresufficient to satisfy its liquidity requirements in the next twelve months.

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TheCompany’s most significant use of funds during the remainder of 2006 isexpected to be for (i) budgeted capital expenditures of approximately $23,000,(ii) scheduled payments of long-term debt of $3,636, (iii) support of theoperations of SureWest Broadband/Residential Services up to an anticipated$1,991 and (iv) support of the operations of SureWest Wireless up to ananticipated $924.  In addition, during2006 the payment of additional dividends, which is at the discretion of theCompany’s Board of Directors, could be as much as $3,700 based on the Company’smost recent dividend payments. A substantial portion of the 2006 budgetedcapital expenditures is at the discretion of the Company, and dependent uponthe Company’s working capital position, operating cash flows and ability toborrow, as described below. The Company is required to comply with its cablefranchise agreements to continue its build-out in the franchise areas.

The Companycurrently receives funding of $11,500 annually from the CHCF, a programdesigned by the CPUC to establish a fair and equitable local rate structure andto reduce any disparity in the rates charged by certain telephone companiesserving high-cost areas. In June 2006, the CPUC instituted a rulemakingproceeding to review the CHCF-B program. Among other things, the CHCF-B rulemaking requests comments as towhether SureWest Telephone should continue receiving the $11,500 annually fromthe CHCF-B and the advisability and impacts of phasing out the EAS paymentsgradually over a period of approximately 5 years.  Comments in the CHCF-B rulemaking were dueSeptember 1, 2006 with reply comments due October 16, 2006.  In August 2006, the Company filed a Petitionfor Modification of D.05-08-004, the decision that reviewed SureWest Telephone’srevenue requirement, which seeks CPUC authorization in a graduated phase-downof its $11,500 interim draw from the CHCF-B 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’s Petition for Modificationproposes a transitional phase-down over a five-to-ten year period and requestselimination of the requirement to file its cost proxy model.  The Company expects to recover the eliminatedrevenues through rate increases and/or operating efficiencies. For a moredetailed discussion, see *Regulatory Matters*within the Telecom Segment Results of Operations.

On May 1, 2006,the Company completed an unsecured Credit Agreement for a Term Loan facilityand a Revolving Loan facility (collectively “Loan Facilities”) in principalamounts up to $75,000 and $25,000, respectively.  Interest on the Loan Facilities is payablequarterly and based on a LIBOR, variable interest rate, or a fixed interestrate pricing formula, or a combination, as defined in the CreditAgreement.  Principal payments on theoutstanding amounts borrowed under the Term Loan facility as of December 31,2007 are due in equal quarterly installments commencing March 31, 2008 throughJune 30, 2016.  The Revolving Loanfacility has an expiration date of June 30, 2013.  As of September 30, 2006, $40,000 wasoutstanding under the Term Loan Facility and no amounts were outstanding underthe Revolving Loan facility.

TheCompany had a business loan agreement with a bank for a $50,000 unsecured lineof credit, which was originally due to expire July 1, 2006. As of December 31,2005, there was $30,000 outstanding under this credit facility, and theweighted average interest rate was 5.75%, which was based on a LIBOR-basedpricing formula.  As a result of theavailability of the Loan Facilities the Company terminated its business loanagreement effective May 1, 2006.

TheCompany’s Board of Directors has previously authorized the repurchase of up to1.5 million shares of the Company’s common stock. The shares are purchased fromtime to time in the open market or through privately negotiated transactions,subject to overall financial and market conditions. Through September 30, 2006,approximately 1.2 million shares of common stock had been repurchased. TheCompany has remaining authorization from the Board of Directors to repurchaseapproximately an additional 300 thousand outstanding shares. The purchase ofcommon shares did not have a substantive effect on the average number of commonshares outstanding and had no effect on the calculation of basic and dilutedearnings per share.

TheCompany had cash and cash equivalents at September 30, 2006, of $12,208. TheCompany believes that its working capital position, additional available fundsfrom the Credit Agreement, operating cash flows and borrowing capacity aresufficient to satisfy its liquidity requirements in the next twelve months. TheCompany’s forecast indicates it is likely that the Company will continue todraw on available funds during the next twelve months to fund operations andplanned capital expenditures, including capital expenditures as required by theCompany’s cable franchise agreements, while maintaining adequate cash and cashequivalents. Such draws might be undertaken under

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theCredit Agreement using the Revolving Credit facility or the available Term Loanfacility, or a combination of the two facilities. The Company believes, givenits financial position and debt-to-equity position, it has substantialadditional short-and long-term borrowing capacity. As indicated above, asubstantial portion of the Company’s 2006 budgeted capital expenditures andcash dividend payments are at the discretion of the Company. Accordingly, theCompany believes that it can modify its planned construction commitments andcash dividend payments if the results of operations or available capital sorequire.

Dividends aredeclared at the discretion of the Company’s Board of Directors. However, theNote Purchase Agreement under which the Company issued its Series A and SeriesB Senior 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. Under the Company’s Note Purchase Agreement and the newCredit Agreement, retained earnings of approximately $62,950 would have beenavailable for the payments described immediately above.

## **CriticalAccounting Policies and Estimates**

Belowis a summary of the Company’s critical accounting policies and estimates.Management has discussed development and selection of critical accountingpolicies and estimates with the Company’s Audit Committee.

·                                          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 2005, the Company obtained an independent valuationof the Company’s goodwill using a discounted cash flow model. Assumptions usedin this model include the following:

·                  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);

·                  a14.5% weighted average cost of capital based on industry weighted average costof capital; and

·                  noterminal growth rate.

The carrying value of the Company’s goodwill was$2,171 as of December 31, 2005. When determining the fair value of the Company’sgoodwill, the use of different estimates or assumptions within the discountedcash flow model could result in a different fair value. For example, theCompany used a discount rate of 14.5% and no terminal growth rate in itsassessment of fair value in 2005. If the discount rate were to increase 2%, thefair value of the goodwill would decrease by $40, but would not result in animpairment of goodwill.

The Company’s wireless licenses include PersonalCommunications Services (“PCS”) and Local Multipoint Distribution Service (“LMDS”)licenses. The carrying value at December 31, 2005 of the PCS and LMDS licenseswas $8,925 and $4,641, respectively. In assessing the recoverability of theCompany’s PCS licenses, the Company obtained an independent valuation in 2005,which reviewed transactions involving sales of comparable wireless licenses inthe aftermarket, using characteristics of the license and the related market,including geographic location, market size, megahertz frequency and populationdensity.

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 estimates fair value ofthe Company’s LMDS licenses using a discounted cash flow model. Assumptionsused in this model include the following:

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·                  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 average cost ofcapital adjusted to reflect the inherent risks associated with the introductionof a new service offering; and

·                  a4% 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 4% in itsassessment of fair value in 2005. If the discount rate were to increase 1%, thefair value of the LMDS licenses would decrease by $700, which would result inan impairment charge of approximately $324 based on the carrying value of theLMDS licenses as of December 31, 2005. In addition, the Company’s LMDSlicenses may be impaired in the near future if the estimates and assumptionsused in the 2005 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 2005, no impairment of either goodwill or PCSor LMDS licenses was indicated. During the nine-month period ended September 30,2006, the Company was unaware of any events or changes in circumstance thatwould require a test of impairment that may potentially reduce the fair valuebelow the carrying value.

·                                          Totalrevenues from telephone services are affected by rates authorized by variousregulatory agencies. The FCC monitors SureWest Telephone’s interstate earningsthrough the use of annual cost separation studies prepared by SureWestTelephone. The FCC establishes rules that carriers must follow in thepreparation 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 its participation in theNECA pool can also be impacted by the earnings and data of other carriers whoparticipate in the pool.

In accordance with the NRF, SureWest Telephone wassubject to ongoing monitoring and reporting requirements by the CPUC, and wasinitially required to share earnings with customers based on its earned annualrate-of-return. The Company utilized models, which relied on estimatesregarding the jurisdictional separation of financial data and operational datainto the interstate jurisdictions as discussed previously for the purposes ofcalculating its earned annual rate-of-return. However, as discussed more fullyin Note 3, in August 2006, the CPUC adopted a Decision that revised theregulations of telecommunications utilities, such as SureWest Telephone, whichwere previously subject to the NRF. The decision, among other things eliminatesprice caps, the annual price cap filing, the productivity factor, and allresidual elements of rate of return regulation, including the calculation ofshareable earnings.

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.

·                                          The Company recognizes revenue when(i) persuasive evidence of an arrangement between the Company and the customerexists, (ii) delivery of the product to the customer has occurred or servicehas been provided to the customer, (iii) the price to the customer is fixed ordeterminable and (iv) collectibility of the sales price is reasonably assured.

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·                                          The Company maintains allowances for doubtfulaccounts for estimated losses resulting from the potential inability of itscustomers to make required payments. In evaluating the collectibility of itsaccounts receivable, the Company assesses a number of factors including aspecific customer’s or carrier’s ability to meet its financial obligations tothe Company, the length of time the receivable has been past due and historicaland future expectations of conditions that may impact the Company’s ability tocollect its accounts receivable. If circumstances change or economic conditionsworsen such that the Company’s past collection experience is no longer relevant,the Company’s estimate of the recoverability of its accounts receivable couldbe further reduced from the levels reflected in the Company’s consolidatedbalance sheet. If uncollectibility of the Company’s billed revenue changes by1%, the Company would expect an annual increase in uncollectible expense ofapproximately $2,300. As of September 30, 2006, the Company had three customersthat accounted for 7% of consolidated accounts receivable. Although managementbelieves that these customers are creditworthy, a severe adverse impact ontheir business operations could have a corresponding material effect on theirability to pay timely and, therefore, on the Company’s results of operations,cash flows and financial condition. In addition, certain revenues are subjectto refund if the customer terminates services or returns equipment within astipulated time period, or if certain performance criteria are not met.Accordingly, the Company maintains accounts receivable allowances andrecognizes certain customer refund liabilities, through charges to revenues,based on the Company’s best estimates of the resolution of these contingencies,which are based on historical experience.

·                                          The Company states its inventoriesheld for sale at lower of cost or market. In assessing the ultimaterecoverability of inventories, the Company is required to make estimatesregarding future customer demand and technological advances of equipment.

·                                          Property, plant and equipment arerecorded at cost. Retirements and other reductions of regulated telephone plantand equipment are charged against accumulated depreciation with no gain or lossrecognized in accordance with the composite group remaining life methodologyutilized for telephone plant assets. When property applicable to non-telephoneoperations is sold or retired, the asset and related accumulated depreciationare removed from the accounts and the associated gain or loss is recognized.Property, plant and equipment is depreciated or amortized using thestraight-line method over their estimated economic lives. The economic livesare estimated at the time the assets are acquired and are based on historicalexperience with similar assets, as well as anticipated technological or otherchanges. If technological changes were to occur more rapidly than anticipatedor differently than anticipated, the economic lives assigned to these assetsmay need to be shortened, resulting in the recognition of increaseddepreciation and amortization expense in future periods. Likewise, if theanticipated technological or other changes occur more slowly than anticipated,the life of the asset group could be extended based on the life assigned to newassets added to the group. This could result in a reduction of depreciation andamortization expense in future periods. The Company reviews the estimateduseful lives of its property, plant and equipment once every three years, orwhen events or circumstances indicate that the carrying amount may not berecoverable over the remaining lives of the assets. In assessing therecoverability of the Company’s property, plant and equipment, the Company mustmake assumptions regarding estimated future cash flows and other factors todetermine the fair value of the respective assets.

·                                          TheCompany accounts for asset retirement obligations in accordance with SFAS No.143, *Accounting for Asset RetirementObligations*and Financial Accounting Standards Board Interpretation(“FIN”) No. 47, *Accounting for Conditional RetirementObligations*, which requires the Company to recognize a retirementobligation when a legal obligation exists to remove an asset at some point inthe future or if legislation exists that requires special disposal proceduresof the asset. The Company believes it may have potential retirement obligationsrelating to its wireless cell sites and disposal obligations relating tocertain building materials containing asbestos. Based on terms outlined in itstower leases, the Company is obligated to return the land or facilities totheir 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. 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

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is 2025. The Company has also used aprobability-weighted assessment to address the uncertainty regarding the timingof future cash flows to settle the potential liability. The Company believesthat utilizing probabilities for its wireless towers of less than 100% isappropriate because the Company believes the likelihood of incurring materialasset retirement expenditures is remote. The Company used a 100% probabilityfactor of its building materials containing asbestos. The Company monitors theestimates and assumptions used in determining its potential asset retirementobligations for its cell sites and buildings containing asbestos. However, theCompany believes it is remote that any future adjustment to its assetretirement liability for obligations existing as of September 30, 2006 will bematerial to the Company’s consolidated financial statements.

·                                          The Company accounts for incometaxes using the liability method. Under this method, deferred tax assets andliabilities are determined based on differences between the financial reportingand tax bases of assets and liabilities and are measured using the enacted taxrates and laws that are expected to be in effect when the differences areexpected to reverse. The Company does not have a valuation allowance on itsdeferred tax asset as of September 30, 2006 and December 31, 2005 because itbelieves it is more likely than not that such deferred tax asset will berealized. Should the Company determine that it would not be able to realize allor part of its deferred tax asset in the future, an adjustment to the deferredtax asset would be charged to income in the period in which the determinationwas made.

·                                          The Company has pension andpost-retirement benefit costs and obligations. The Company’s pension andpost-retirement benefit obligations are actuarially determined based onestimates of discount rates, long-term rates of return on plan assets andincreases in future compensation levels. Changes in these estimates and otherfactors could significantly impact the Company’s pension and post-retirementbenefit costs and obligations. Assumed health care cost trend rates have asignificant effect on the amounts reported for the health care plans. Aone-percentage-point change in assumed health care cost trend rates would havethe following effects:
|                                                                     | ** ** | **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 January 1, 2006 |       | $                                      | 401        |                                   | $          | (356 | ) |

 

For 2006, the discount rates used for the Company’spension and post-retirement benefit obligations were 5.75% and 5.50%,respectively. The discount rates were determined based on current yields onhigh quality corporate fixed-income investments with maturities correspondingto the expected duration of the benefit obligations. The rate used for thepost-retirement benefit obligation reflects heavier weighting for retiredparticipants of shorter durations.

The expected return on assets (“EROA”) rate isdetermined based on the current and projected investment portfolio mix and estimatedlong-term investment returns for each asset class. In 2005, the Company used anEROA of 8.5%. The Company evaluated the appropriateness of the EROA rate for2006 by analyzing the long-term returns for domestic and internationalequities, as well as domestic fixed income instruments. Based on theevaluation, the Company decreased the EROA for 2006 to 8.0% to better reflectthe current economic environment. The 0.5% decrease in the EROA rate willincrease the Company’s 2006 pension expense approximately $550, or 9.0%.

During 2006, the Company’s third party actuarycompleted an experience study (the “Study”) for the Pension Plan and OtherBenefits Plan utilizing historical information for purposes of determining thecontinued appropriateness of certain assumptions used in determining theactuarial valuation of the pension liability and related expense. Based on theresults of the Study, certain assumptions, including both demographic andbenefit assumptions, used in the actuarial valuation of the Company’s pensionand postretirement costs were revised resulting in estimated costs for pensionand other benefits expense for 2006 of $4,998, which is $2,939 lower than theprevious estimate.

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·                                          The Company is a party to a varietyof litigation, regulatory proceedings and other contingencies that arise in theordinary course of business. The Company is required to assess the likelihoodof any adverse judgments or outcomes to these matters, as well as potentialranges of probable losses for certain of these matters. The determination ofthe liabilities required, if any, for loss contingencies is made after carefulanalysis of each individual issue. In the opinion of management, the ultimateoutcome of these matters will not materially affect the Company’s consolidatedfinancial position and results of operations.

·                                          TheCompany currently sponsors two Equity Incentive Plans (the “Plans”) for certainemployees, outside directors and consultants of the Company, which wereapproved by the Company’s shareholders. The Plans permit issuance by the Company of awards in the form ofrestricted shares, stock units, performance shares, stock options and stockappreciation rights.

Effective January 1, 2006, the Company adopted SFASNo. 123(R), *Share-Based Payment*,using the modified-prospective-transition method.  Since the fair value recognition provisionsof SFAS No. 123, *Accounting for Stock-BasedCompensation* and SFAS No. 123(R) were materially consistent underthe Company’s Plans, the adoption of SFAS No. 123(R) did not have a significantimpact on the Company’s financial position or results of operations.  The Company has not made any stock optiongrants since 2003 and consequently the compensation expense resulting fromstock option grants prior to 2003 was either fully expensed as of January 1,2006, or not material to the Company’s financial statements.

Prior to January 1, 2006, the Company accounted forthe Plans under the fair value recognition provisions of SFAS No. 123.  Under the provisions of SFAS No. 148, *Accounting for Stock-Based Compensation — Transitionand Disclosure*, the fair value method of accounting was applied toall employee awards granted, modified, or settled after January 1, 2003.

Asof September 30, 2006, total unrecognized compensation cost related tononvested restricted stock was $1,026 and will be recognized over aweighted-average period of approximately three years.  The total fair value of the restricted commonstock and restricted common stock units that vested for the quarter andnine-month period ended September 30, 2006 was $261 and $773, respectively.

Stockbased compensation for restricted stock reflects the cost of restricted stockthat is expected to vest.  The Companycalculated an estimated forfeiture rate based on historic forfeiture experienceto date.  If actual forfeitures are notconsistent with the Company’s estimated forfeiture rate, it will be required torecord adjustments to compensation expense.

TheBlack-Scholes-Merton option-pricing model used to value stock option grantsincludes assumptions regarding dividend yields, expected volatility, expectedlives and risk-free interest rates. These assumptions reflect management’s bestestimates, but these items involve inherent uncertainties based on marketconditions generally outside of the control of the Company.

## **Recent Accounting Pronouncements**

In September 2006,the Financial Accounting Standards Board (“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 effectivefor 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 will haveon its consolidated financial statements.

In September 2006,the FASB issued SFAS No. 158, *Employers’Accounting for Defined Benefit Pension and Other Postretirement Plans - anamendment of FASB Statement No.’s 87, 88, 106, and 132(R). *Effective for the fiscal yearending December 31, 2006, SFAS No. 158 requires companies to recognize thestatus of a defined benefit postretirement plan in its statement of financialposition, recognize in other comprehensive income gains or losses that ariseduring the period but are deferred under pension accounting rules and modifiesthe timing of reporting and the nature of disclosure requirements.  SFAS No.158 also requires companies tomeasure the funded status of the plan as of the date of its fiscal year-end,with limited exceptions, effective for fiscal years ending after December 15,

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2008. The Companyis currently evaluating the impact the adoption of SFAS No. 158 will have onits consolidated financial statements.

In June 2006, theFASB issued FIN No. 48, *Accounting forUncertainty in Income Taxes.* FIN No. 48 clarifies the accounting for uncertainty in income taxesrecognized in a company’s financial statements in accordance with FASB No. 109,*Accounting for 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 alsoprovides guidance on de-recognition, classification, interest and penalties,accounting in interim periods, disclosure and transition of uncertain taxpositions.  The interpretation iseffective for fiscal years beginning after December 15, 2006. The Company is currentlyevaluating the impact that FIN No. 48 will have on its consolidated financialstatements.

Effective January 1,2006, the Company adopted SFAS No. 154, *AccountingChanges and Error Corrections. *TheStatement applies to all voluntary changes in accounting principle, and changesthe requirements for accounting for and reporting of a change in accountingprinciple.  The adoption of SFAS No. 154has not had a material effect on the Company’s consolidated financial position,results of operations or cash flows.

## **Factors That CouldAffect 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.

Representativeexamples 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.*   The telecommunications industry is highlycompetitive. We face actual or potential competition from many existing andemerging companies, including other incumbent and competitive local telephonecompanies, long-distance carriers and resellers, wireless telephone companies,Internet service providers, satellite companies and cable television companies.We may not be able to successfully anticipate and respond to variouscompetitive factors affecting the industry, including regulatory changes thatmay affect our competitors and us differently, new technologies and servicesthat may be introduced, changes in consumer preferences, demographic trends anddiscount pricing strategies by competitors. As the incumbent carrier inSacramento, AT&T Inc. enjoys certain business advantages, including itssize, financial resources, favorable regulatory position, brand recognition andconnection to virtually all of our customers and potential customers there. Asthe largest cable operator in Sacramento and Placer County, Comcast enjoyscertain business advantages, including its size, financial resources, ownershipor superior access to programming and other content, brand recognition, andfirst-in-the-field advantages with a customer base that generates positive cashflow for its operations. We face intense competition in our markets forlong-distance, Internet access and other ancillary services that are importantto our business and to our growth strategy.

*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.**  *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.

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*Our operations haveundergone material changes, and our actual operating results can be expected todiffer from the results indicated in our historical financial statements.*   As a result of our 2002 acquisition ofassets, which launched our residential broadband business, and the subsequentexpansion of our video business, our mix of operating assets differs from thoseoperations upon which our historical financial statements are based.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.*   Our growth strategy will continue to requireus to invest significant capital in facilities and services that may notachieve the desired returns. Our future success depends, in part, upon ourability to manage our growth, including our ability to build network andrelated 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 fromvarious funds established under federal and state law and the continued receiptof that support is not assured.*   While we do not receive any supportfrom the rural or non-rural Federal Universal Service high cost loop fund, wedo receive payments from various other federal or state programs. These includeinterstate common line support, CHCF—B and the Lifeline, Education andLibraries programs. These governmental programs are reviewed and amended fromtime to time, and are likely to change in the near future. As described in *Regulatory Matters* within the TelecomSegment Results of Operations, the Company currently receives funding of$11,500 annually from the CHCF-B, 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-B is the subject of pending regulatoryproceedings, and its continuation is dependent upon many factors. The statelegislative authorization for the CHCF is scheduled to expire January 1,2009.  In June 2006, the CPUC instituteda rulemaking proceeding to review the CHCF-B program.  The goals of this review include, but are notlimited to, adjusting universal service rate support payments to reflectupdated operating costs, evaluating whether CHCF-B fund 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 CHCF-B rulemaking requestscomments as to whether SureWest Telephone should continue receiving the $11,500annually from the CHCF-B and the advisability and impacts of phasing out theEAS payments gradually over a period of approximately 5 years.  The outcome and impact on the Company’soperations resulting from future changes to these governmental programs cannotbe determined at this time.

*We could be harmed by therecent developments affecting other communications companies.*   There have been numerous bankruptciesand other financial difficulties experienced by other carriers and suppliers inthe telecommunications and Internet sectors. Similar situations with oursuppliers, some of whom provide products and services for which there are fewsubstitutes, could cause us to experience delays, service interruptions oradditional expenses. Situations with carrier and other customers could affectour ability to collect services that have been provided.

*We depend on thirdparties, over whom we have no control, to deliver our services.*   Because of the interconnected nature ofthe telecommunications industry, we depend heavily on other local telephonecompanies, long-distance carriers, and numerous other third parties to deliverour services. In addition, we are dependent on easements, franchises andlicenses from various private parties such as established telephone companiesand other utilities, railroads, long-distance companies, and from state highwayauthorities, local governments and transit authorities for access to aerialpole space, underground conduits and other rights-of-way in order to constructand operate our networks. The failure to maintain in effect the necessary thirdparty arrangements on acceptable terms would have an adverse effect on ourability to conduct our business.

*We are subject tocorporate governance and internal control reporting requirements, and ourfailure to comply with existing and future requirements could adversely affectour business.*   Pursuant to Section 404of the Sarbanes-Oxley Act of 2002 (“Section 404”) and related Securitiesand Exchange Commission (“SEC”) rules, we have issued a report of management’sassessment of the effectiveness of our internal controls at December 31,2005. In addition, our Independent Registered Public Accounting Firm auditedand reported on management’s assessment.

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Managementconcluded that the Company’s internal controls over financial reporting wereeffective at December 31, 2005. If we are unable to maintain effectiveinternal controls or if future deficiencies are not adequately addressed, wecould experience accounting errors that could result in misstatements of ourfinancial position and results of operations, potential restatements of ourfinancial statements or otherwise adversely affect our business, reputation andresults of operations. Inferior internal controls could also cause investors tolose confidence in our reported financial information, which could have anegative effect on the trading price of our securities.

##### **Regulatory and Legal Matters**

SureWest Telephoneis subject 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.

Due to the ongoingactions taken by the FCC to promulgate rules and regulations oninterconnection access 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.

The Company’sfinancial condition and results of operations have been and will be affected byrecent and future proceedings before the CPUC and FCC. Pending before the FCCand 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 to thenetwork capabilities of local exchange carriers; and

·               The regulated rates and earnings ofSureWest Telephone.

There are a numberof pending and anticipated other regulatory proceedings occurring at the federaland state levels that may have a material impact on SureWest Telephone. Theseregulatory proceedings include, but are not limited to, consideration ofchanges to the interstate universal service fund, intercarrier compensation,reform and the regulation of local exchange carriers and their competitors, andregulation of IP-enabled services. The outcomes and impact on SureWestTelephone’s operations of these proceedings and related court matters cannot bedetermined at this time.

Theeventual impact on the Company of the effect of all the proceedings describedabove cannot presently be determined.

**ITEM 3.  QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.**

TheCompany’s 2005 Annual Report on Form 10-K contains certain disclosures aboutthe Company’s limited exposure to market risk for changes in interestrates.  There have been no materialchanges to the information provided which would require additional disclosuresas of the date of this filing.

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**ITEM4.  CONTROLS AND PROCEDURES.**

As of the end of the period covered by this report,the Company carried out an evaluation, under the supervision and with theparticipation of our management, including the Chief Executive Officer andChief Financial Officer, of the effectiveness of the design and operation ofour disclosure controls and procedures (as defined in Rule 13a-15(e) underthe Securities Exchange Act of 1934, as amended). Based upon, and as of thedate of this evaluation, the Chief Executive Officer and Chief FinancialOfficer have concluded that, the Company’s disclosure controls and procedureswere effective, at the reasonable assurance level, to ensure that informationrequired to be disclosed by the Company in reports that it files or submitsunder the Securities Exchange Act is authorized, recorded, processed,summarized and reported within the time periods specified in SEC rules andforms.

The Company’smanagement is responsible for establishing and maintaining adequate internalcontrol over financial reporting. The Company’s internal control system wasdesigned to provide reasonable assurance to the Company’s management, Board ofDirectors and Audit Committee regarding the reliability of financial reportingand the preparation of published financial statements in accordance withgenerally accepted accounting principles.

##### **Change in Internal Control over FinancialReporting**

In October 2006,the Company completed a version upgrade to its integrated Enterprise ResourcePlanning (“ERP”) system for both the human resources and financial modules.  During the implementation period, the Companyhas reassessed, tested and updated, as necessary, the various processes oraccounting procedures, which may be affected by the upgrade.  Based on Management’s assessment and testingof the upgrade, it appears that the upgrade did not adversely impact theCompany’s internal controls.

EffectiveJune 1, 2006, the Company’s Vice President, Sales entered into a SeparationAgreement with the Company.  Othermembers of the Company’s management have assumed the responsibilities of theformer Vice President, Sales.  On May 9,2006, the Company hired a Vice President, Treasurer with oversightresponsibilities related to the treasury, human resources and investorrelations functions.  Based on theCompany’s interim control testing and management’s continual assessment of theCompany’s internal control environment to date, it appears the changes in theCompany’s management have not adversely impacted the Company’s internalcontrols or control environment.

Asreported in the Company’s previous periodic reports, in February 2005 theCompany announced that it began a search for a President and CEO as a result ofthe indication by Brian H. Strom of his desire to ultimately retire from thosepositions. The Company conducted a search for a successor that would allow thenew President and CEO to serve with Mr. Strom prior to his formalretirement to assure an effective and smooth transition. Effective January 1,2006, Steven C. Oldham was elected President and CEO while Mr. Strom remainedan employee until March 31, 2006.  Basedon the Company’s interim control testing and management’s continual assessmentof the Company’s internal control environment to date, it appears that thetransition of the officer has not adversely impacted the Company’s internalcontrols or control environment.

Exceptfor the items discussed above, there has been no change in the Company’sinternal control over financial reporting during the period ended September 30,2006 that has materially affected, or is reasonably likely to materiallyaffect, the Company’s control over financial reporting.

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**PART II–OTHER INFORMATION**

**ITEM 1.****                 LEGALPROCEEDINGS. ***(Dollars in thousands)*

Except for theproceedings described below, the Company is not aware of any material pendinglegal proceedings, other than ordinary routine litigation incidental to itsbusiness, to which it is a party or to which any of its property is subject.

Prior to 2000,AT&T Inc. (“AT&T”) (formerly SBC Communications) had been payingSureWest Telephone approximately $11,500 per year for EAS pursuant to aSettlement Transition Agreement. In November 2000, the CPUC authorized AT&Tto terminate its annual EAS payments to SureWest Telephone effectiveNovember 30, 2000. The CPUC authorized replacement funding to SureWestTelephone on an interim basis using funds from the CHCF. The CHCF is a programdesigned by the CPUC to establish a fair and equitable local rate structure andto reduce any disparity in the rates charged by telephone companies servinghigh-cost areas. The CHCF is scheduled to expire January 1, 2009. Inaddition, the CPUC opened an Order Instituting Investigation (“OII”) for thepurpose of determining whether future recovery of all, none, or a portion ofthe approximate $11,500 annual payments received from the CHCF should come fromSureWest Telephone’s ratepayers or other regulatory recovery mechanisms.

In August 2005,the CPUC adopted a decision which (i) authorized SureWest Telephone tocontinue receiving $11,500 annually from the CHCF to offset its intrastateregulated operating expenses on an interim basis, (ii) required SureWestTelephone to prepare and submit a cost proxy model (which is used generally asa basis for CHCF-B funding) based on its current cost data, including analysesof the resulting impacts on rates, the Universal Lifeline Telephone Service (“ULTS”)fund, and the CHCF fund, to be filed by SureWest Telephone within 12 months,and (iii) authorized SureWest Telephone to file an advice letter with theCommission’s Telecommunications Division to implement reductions to itsbusiness access line rates.

In August 2006, theCompany filed a Petition for Modification of D.05-08-004, the decision thatreviewed SureWest Telephone’s revenue requirement, which seeks CPUCauthorization in a graduated phase-down of its $11,500 interim draw from theCHCF-B over a period of time that is intended to assure the continuedmaintenance of good service to SureWest Telephone customers while avoidingprecipitous rate increases.  The Company’sPetition for Modification proposes a transitional phase-down over a five-to-tenyear period and requests elimination of the requirement to file its cost proxymodel.  The Company expects to recoverthe eliminated revenues through rate increases and/or operatingefficiencies.  On August 31, 2006 the DRAfiled opposition to the Company’s Petition for Modification and insteadproposed the Company continue to prepare and submit a cost proxy model tocontinue receipt of CHCF-B funds. On October 30, 2006, the Company filed withthe CPUC a proposal to offset its draw from the CHCF in 2007 with the annualconsumer dividend of $1,300, which is currently scheduled to begin January 1,2007.  The DRA will respond to theCompany’s proposal November 9, 2006. The results of this proceeding and thepotential effects on SureWest Telephone could impact future funding levelsthrough the CHCF-B.

In June 2006, theCPUC instituted a rulemaking proceeding to review the CHCF-B program.  The goals of this review include, but are notlimited to, adjusting universal service rate support payments to reflectupdated operating costs, evaluating whether CHCF-B fund 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 CHCF-B rulemaking requestscomments as to whether SureWest Telephone should continue receiving the $11,500annually from the CHCF-B and the advisability and impacts of phasing out theEAS payments gradually over a period of approximately 5 years.  Comments in the CHCF-B rulemaking were filedon September 1, 2006 with reply comments filed on October 16, 2006.  The results of this proceeding and thepotential effects on SureWest Telephone could impact future funding levelsthrough the CHCF-B.

In 1996, the CPUCissued a decision that authorized SureWest Telephone to implement a NewRegulatory Framework (“NRF”) for services furnished within SureWest Telephone’sservice area in order to accommodate market and regulatory movement towardcompetition and greater pricing flexibility. Under the NRF, SureWest Telephoneis subject to ongoing monitoring and reporting requirements, and it wasinitially required to share earnings with customers through a reduction ofrevenues if its earned annual rate-of-return exceeds that authorized by theCPUC.

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In accordance withthe requirements of its general rate case order, SureWest Telephone filed anapplication for review of its NRF in 1999. In connection with this proceeding,the CPUC’s Division of Ratepayer Advocates (“DRA”), (formerly Office ofRatepayer Advocates), undertook a verification audit of SureWest Telephone’snon-regulated and affiliated transactions pursuant to the general rate case andother CPUC orders. In June 2001, the CPUC adopted its decision in thismatter (the “Decision”). The Decision did not suspend the sharing mechanism asSureWest Telephone had requested, and further provided that SureWest Telephonemust change the method used to allocate costs for services provided by SureWestTelephone to its affiliates, the treatment of certain directory revenues andthe treatment of internal-use software costs. Additionally, in accordance withthe provisions of the Decision, the Company recorded certain liabilities andreductions of revenues relating to estimated intrastate shareable earningsobligations.

In April 2005, theCPUC opened a rulemaking proceeding to assess and revise the regulation oftelecommunications utilities to develop a uniform regulatory framework (“URF”)to apply to all providers of regulated telecommunications services, exceptsmall Incumbent Local Exchange Carriers(“ILECs”), to the extent that it is feasible and in the public interestto do so.  On August 24, 2006, the CPUCadopted Decision 06-08-030 (“the decision”) which revises the regulations oftelecommunications utilities, such as SureWest Telephone, which were previouslysubject to the NRF. The decision grants carriers broad pricing freedoms in theprovision of telecommunications services, bundles of services, promotions andcontracts.  The decision, among otherthings:  (i) freezes the Company’s basicresidential and lifeline rates until at least January 1, 2009 in order toaddress the subsidy levels supporting these special services, subject to reviewin the CHCF-B 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) allows bundlesand promotional packages on any telecommunication service, (iv) allocates allgains and losses from the sale of assets to shareholders and (iv) 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 withthe decision, the CPUC ordered a separate briefing cycle to consider whether todetariff altogether telecommunications services other than basic residentialservice.  The resolution of the separatebriefing cycle is expected by December 31, 2006. The ultimate results of this proceeding and the potential effects onSureWest Telephone cannot yet be determined.

In April 2006, the CPUC released a decision in a proceeding investigatingthe continued need for the transport interconnection charge (“TIC”), which isan access charge element.  An earlierdraft decision required all ILECs operating within California to eliminate theTIC element and authorized recovery of lost revenue through end users,specifically through an increase in their local rate surcharge, and use of theCHCF-A for the small companies.  IfSureWest Telephone did not recover any lost revenues from end users, thedecision could ultimately result in a loss of revenues of up to $4,400, on aprospective basis. The Company sought modification of the draft decision on thebasis that the CPUC had indicated that it was prepared to act only with respectto larger ILECs, and thus denied SureWest Telephone due process.  In the final decision, the CPUC deferred theelimination of the TIC element for SureWest to the next phase of theproceeding, which began in May 2006.  TheCompany filed testimony in May 2006 supporting that the CPUC should noteliminate the TIC for small and mid-sized ILECs due to an impending federalintercarrier compensation restructure proceeding at the FCC.  The ultimate results of this proceeding andthe potential effects on SureWest Telephone cannot yet be determined.

SureWest Telephone’soperations may also be impacted by the Telecommunications Act of 1996 (the “Act”).The Act significantly changed the regulatory environment for telecommunicationscompanies. Beginning in 1996, the Federal Communications Commission (“FCC”)conducted proceedings and adopted orders implementing the Act’s provisions toopen local exchange service markets, such as the market of SureWest Telephone,to competition. These proceedings and orders address the regulation ofcompeting telecommunications companies, interconnection, access charges anduniversal service.

Given the ongoingactivities of the FCC to promulgate rules and regulations on competition,interconnection, access charges, and universal service reform, and the variouson-going legal challenges considering the validity of these FCC orders, it isnot yet possible to determine fully the impact of the Act and related FCCregulations on SureWest Telephone’s operations.

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Thereare a number of 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 thejurisdictional separations process, the interstate universal service fund, intercarriercompensation access charge reform and the regulation of local exchange carriersand their competitors, including providers of Internet protocol (“IP”) enabledservices. The outcomes and impact on SureWest Telephone’s operations of theseproceedings and related court matters cannot be determined at this time.

Theregulatory proceedings occurring at the state and federal levels describedabove may also broaden the scope of competition in the provision of regulatedservices and change the rates and rate structure for regulated servicesfurnished by SureWest Telephone, the effects of which on SureWest Telephonecannot yet be determined.

##### **ITEM 1A.       RISK FACTORS.**

There have been nomaterial changes from risk factors disclosed in the Company’s Annual Report onForm 10-K for the year ended December 31, 2005, identified in Item 1A of Part Iof the Form 10-K.

**ITEM 2.         UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.**

The followingtable summarizes the Company’s common stock repurchase activity during thequarter ended September 30, 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** | ** ** |
|----------------------------------------|------------|-----------------------------------------------------|------------|-------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| July 1, — July  31, 2006          |       | —                                              |       | —                                                |       | 1,034,614                                                                                                            |       | 465,386                                                                     |       |
| August 1, 2006 —  August 31, 2006 |       | 62,508                                              |       | $                                                     | 18.27      |                                                                                                                 | 1,097,122  |                                                                        | 402,878    |   |
| September 1,  2006-September 30, 2006  |       | 117,554                                             |       | $                                                     | 19.46      |                                                                                                                 | 1,214,676  |                                                                        | 285,324    |   |

 

**ITEM 3.          DEFAULTS UPON SENIOR SECURITIES.**

Not applicable.

**ITEM 4.          SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.**

Not applicable.

**ITEM 5.         OTHER INFORMATION.**

Not applicable.

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**ITEM 6.  EXHIBITS.**

(a)          Index to Exhibits.
| 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 May 1, 2006, between CoBank,  ACB and Registrant (Filed as Exhibit 99.1 to Form 8-K filed May 2, 2006)                                                                                                                                                                                                                       |                  | Incorporated by  reference |
| 10           | .4         |            | 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           | .5         |            | 2000 Equity Incentive Plan, as amended (Filed as  Exhibit 10.9 to Form 10-Q Quarterly Report for the quarter  ended June 30, 2005)                                                                                                                                                                                                   |                  | Incorporated by  reference |
| 10           | .6         |            | SureWest KSOP (Filed as Exhibit 4.1 to  Registration Statement on Form S-8 [No. 333-87222])                                                                                                                                                                                                                                               |                  | Incorporated by  reference |
| 10           | .7         |            | Letter agreement dated January 16, 2001 between  Registrant and Brian H. Strom (Filed as Exhibit 10(g) to Form 10-K  Annual Report of Registrant for the year ended December 31, 2000)                                                                                                                                                         |                  | Incorporated by  reference |
| 10           | .8         |            | Letter agreement dated January 16, 2001 between  Registrant and Jay B. Kinder (Filed as Exhibit 10(i) to Form 10-K  Annual Report of Registrant for the year ended December 31, 2000)                                                                                                                                                               |                  | Incorporated by  reference |
| 10           | .9         |            | 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 |
| 10           | .10        |            | 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           | .11        |            | 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           | .12        |            | 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           | .13        |            | Letter agreement dated December 15, 2005 between  Registrant and Brian H. Strom (Filed as Exhibit 99.2 to Form 8-K filed  December 16, 2005)                                                                                                                                                                                                        |                  | Incorporated by  reference |
| 10           | .14        |            | Letter agreement dated December 15, 2005 between  Registrant and Jay B. Kinder (Filed as Exhibit 99.3 to Form 8-K filed  December 16, 2005)                                                                                                                                                                                                         |                  | Incorporated by  reference |
| 10           | .15        |            | 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           | .16        |            | Letter agreement dated October 4, 2004 between  Registrant and Philip A. Grybas (Filed as Exhibit 10.23 to Form 10-K Annual  Report of Registrant for the year ended December 31, 2005)                                                                                                                                                             |                  | Incorporated by  reference |

 

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| Exhibit  No. | ** ** | **Description** | ** **                                                                                                                                                                                                                                                                       | **Method  of Filing** |
|--------------|------------|-----------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------|
| 10           | .17        |            | Summary of Board of Directors’ Compensation (Filed  as Exhibit 99.1 to Form 8-K filed January 26, 2006)                                                                                                                                                                     |                  | Incorporated by  reference |
| 10           | .18        |            | 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           | .19        |            | 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           | .20        |            | Form of Restricted Stock Unit Award, dated February  23, 2005, between Registrant and Brian H. Strom (Filed as Exhibit 10.17 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, dated  January 26, 2006, 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           | .22        |            | 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           | .23        |            | 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 |
| 10           | .24        |            | 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 |
| 3            | 1.1        |            | 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 |
| 3            | 1.2        |            | 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 |
| 3            | 2.1        |            | 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 |
| 3            | 2.2        |            | 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 |

 

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.
|                    |   | SUREWEST COMMUNICATIONS    |   |
|-------------------------|--------|----------------------------|--------|
|                    |   | (Registrant)               |   |
|                    |   |                       |   |
|                    |   |                       |   |
|                    | By:    | /s/ STEVEN C. OLDHAM       |   |
|                    |   | Steven C. Oldham,          |   |
|                    |   | President and Chief        |   |
|                    |   | Executive Officer          |   |
|                    |   |                       |   |
|                    |   |                       |   |
|                    | By:    | /s/ PHILIP A. GRYBAS       |   |
|                    |   | Philip A. Grybas,          |   |
|                    |   | Senior Vice President  and |   |
|                    |   | Chief Financial Officer    |   |
|                    |   |                       |   |
|                    |   |                       |   |
| Date: October  30, 2006 |   |                       |   |

 

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