** **

**UNITEDSTATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

## ***FORM 10-Q***

 
| **(Mark  One)** |
|-----------------|
|            |
| **ý**      | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|            |   |
|            | **For  the quarterly period ended June 30, 2005** |
|            | ** ** |
|            | **or** |
|            |   |
| ** ̈**      | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|            |   |
|            | **For  the transition period  from               to               ** |

 

**Commission File Number: 1-32362**

 

# **OTELCO INC.**

(Exact name of registrant as specified in itscharter)

 

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

 

**(205) 625-3574**

(Registrant’s telephone number, including areacode)

 

**N/A**

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

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.

 

Yes   ý          No    ̈

 

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

 

Yes   o          No   ý

 

**APPLICABLE ONLY TO CORPORATEUSERS:**

 

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

 

| **Class**                                              | ** ** | **Outstanding at August 9, 2005** |
|--------------------------------------------------------|------------|----------------------------------------|
| Class A Common Stock ($0.01 par value per  share) |       | 9,676,733                              |
| Class B Common Stock ($0.01 par value per  share) |       | 544,671                                |

 

 

----

 

**OTELCO INC.**

**FORM 10-Q**

**For the three and six month period ended June 30,2005**

**TABLE OF CONTENTS**

 
| **PART I FINANCIAL INFORMATION** |                                                                                               |
|---------------------------------------|----------------------------------------------------------------------------------------------------|
| Item 1.                               | Financial Statements                                                                               |   |
|                                  | Consolidated  Balance Sheets as of December 31, 2004 and June 30, 2005                   |   |
|                                  | Consolidated  Statements of Income for the three and six months ended June 30, 2004  and 2005 |   |
|                                  | Consolidated  Statements of Cash Flows for the six months ended June 30, 2004 and 2005        |   |
|                                  | Notes to Consolidated Financial  Statements                                                        |   |
| Item 2.                               | Management’s Discussion and Analysis of Financial  Condition and Results of Operations        |   |
| Item 3.                               | Quantitative and Qualitative Disclosures About Market  Risk                                        |   |
| Item 4.                               | Controls and Procedures                                                                            |   |
|                                  |                                                                                               |   |
| **PART II OTHER INFORMATION**    |                                                                                               |
| Item 4.                               | Submission of Matters to a vote of Security Holders                                                |   |
| Item 6.                               | Exhibits                                                                                           |   |

 

2

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*Unless the contextotherwise requires, the words “we”, “us”, “our”, “the company” and “Otelco”refer to Otelco Inc., a Delaware corporation.*

 

# **FORWARD-LOOKING STATEMENTS**

# ** **

The report containsforward-looking statements that are subject to risks and uncertainties.  Forward-looking statements give our currentexpectations relating to our financial condition, results of operations, plans,objectives, future performance and business. These statements may include words such as “anticipate,” “estimate,” “expect,”“project,” “plan,” “intend,” “believe” and other words and terms of similarmeaning in connection with any discussion of the timing or nature of futureoperating or financial performance or other events.  These forward-looking statements are based onassumptions that we have made in light of our experience in the industry inwhich we operate, as well as our perceptions of historical trends, currentconditions, expected future developments and other factors we believe areappropriate under the circumstances. Although we believe that these forward-looking statements are based onreasonable assumptions, you should be aware that many factors could affect ouractual financial condition or results of operations and cause actual results todiffer materially from those in the forward-looking statements.

 

3

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**PART I**

**FINANCIAL INFORMATION**

 

**Item 1. *Financial Statements***

 

**OTELCO INC.**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                       | ** ** | **December 31,  2004** | ** **  | **June 30  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|-------------|------------------------|------------|
| ** **                                                                                                       | ** ** | ** **                  | ** **  | **(unaudited)**        | ** ** |
| **Assets**                                                                                                       |       |                        |        |                   |       |
| Current assets                                                                                                   |       |                        |        |                   |       |
| Cash and cash equivalents                                                                                        |       | $                           | 5,406,545   |                   | $          | 5,231,715 |   |
| Accounts receivable:                                                                                             |       |                        |        |                   |       |
| Due from subscribers, net of allowance for  doubtful accounts of $170,515 and $163,993, respectively.            |       | 1,179,074                   |        | 1,185,584              |       |
| Unbilled receivables                                                                                             |       | 1,884,405                   |        | 1,805,661              |       |
| Other                                                                                                            |       | 1,522,945                   |        | 1,410,512              |       |
| Materials and supplies                                                                                           |       | 1,039,910                   |        | 1,006,614              |       |
| Prepaid expenses                                                                                                 |       | 537,784                     |        | 469,636                |       |
| Deferred income taxes                                                                                            |       | 652,625                     |        | 652,625                |       |
| Total current assets                                                                                             |       | 12,223,288                  |        | 11,762,347             |       |
|                                                                                                             |       |                        |        |                   |       |
| Property and equipment, net                                                                                      |       | 48,195,568                  |        | 46,723,783             |       |
| Goodwill                                                                                                         |       | 119,714,094                 |        | 119,714,094            |       |
| Intangible assets, net                                                                                           |       | 2,050,943                   |        | 1,819,511              |       |
| Investments                                                                                                      |       | 1,298,852                   |        | 1,205,251              |       |
| Deferred financing costs                                                                                         |       | 8,020,743                   |        | 7,423,264              |       |
| Interest rate cap                                                                                                |       | 4,723,135                   |        | 3,921,098              |       |
| Total assets                                                                                                     |       | $                           | 196,226,623 |                   | $          | 192,569,348 |   |
|                                                                                                             |       |                        |        |                   |       |
| **Liabilities  and Stockholders’ Equity**                                                                   | ** ** | ** **                  | ** **  | ** **             | ** ** |
| Current liabilities                                                                                              |       |                        |        |                   |       |
| Accounts payable                                                                                                 |       | $                           | 2,690,351   |                   | $          | 1,433,021 |   |
| Accrued expenses                                                                                                 |       | 1,862,604                   |        | 2,553,098              |       |
| Advance billings and payments                                                                                    |       | 1,141,013                   |        | 1,159,093              |       |
| Customer deposits                                                                                                |       | 220,209                     |        | 233,864                |       |
| Total Current Liabilities                                                                                        |       | 5,914,177                   |        | 5,379,076              |       |
|                                                                                                             |       |                        |        |                   |       |
| Deferred income taxes                                                                                            |       | 13,053,226                  |        | 13,053,226             |       |
| Other liabilities                                                                                                |       | 196,644                     |        | 185,284                |       |
| Total deferred tax and other liabilities                                                                         |       | 13,249,870                  |        | 13,238,510             |       |
|                                                                                                             |       |                        |        |                   |       |
| Long-term notes payable                                                                                          |       | 161,075,498                 |        | 161,075,498            |       |
| Derivative liability                                                                                             |       | 2,788,716                   |        | 2,173,237              |       |
| Class B common convertible to senior  subordinated notes                                                    |       | 3,212,528                   |        | 3,433,991              |       |
|                                                                                                             |       |                        |        |                   |       |
| Stockholders’ Equity                                                                                        |       |                        |        |                   |       |
| Class A Common Stock, $.01 par  value-authorized 20,000,000 shares; issued and outstanding 9,676,733 shares |       | 96,767                      |        | 96,767                 |       |
| Class B Common Stock, $.01 par  value-authorized 800,000 shares; issued and outstanding 544,671 shares      |       | 5,447                       |        | 5,447                  |       |
| Additional paid in capital                                                                                       |       | 12,435,800                  |        | 9,024,752              |       |
| Retained deficit                                                                                                 |       | (2,597,315                  | )           | (1,151,744             | )          |
| Accumulated other comprehensive income  (loss)                                                                   |       | 45,135                      |        | (706,186               | )          |
| Total stockholders’ equity                                                                                  |       | 9,985,834                   |        | 7,269,036              |       |
|                                                                                                             |       |                        |        |                   |       |
| Total liabilities and stockholders’ equity                                                                  |       | $                           | 196,226,623 |                   | $          | 192,569,348 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

4

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**OTELCO INC.**

**CONSOLIDATED STATEMENTS OF INCOME**

(Unaudited)

 
| ** **                                                                 | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                 | ** ** | **2004**                              | ** ** | **2005**                            | ** ** | **2004** | ** ** | **2005** | ** ** |
| Revenues                                                                   |       |                                  |       |                                |       |   |   |   |   |
| Local service                                                              |       | $                                     | 3,511,668  |                                | $          | 3,561,731 |   | $ | 6,929,055 |   | $ | 7,205,376 |   |
| Network access                                                             |       | 3,888,914                             |       | 5,235,327                           |       | 8,001,836 |   | 10,964,633 |   |
| Long distance and other telephone services                                 |       | 673,905                               |       | 779,294                             |       | 1,352,574 |   | 1,564,274 |   |
| Cable television                                                           |       | 435,483                               |       | 516,060                             |       | 873,413 |   | 1,012,178 |   |
| Internet                                                                   |       | 519,033                               |       | 1,350,112                           |       | 999,364 |   | 2,723,158 |   |
| Total revenues                                                             |       | 9,029,003                             |       | 11,442,524                          |       | 18,156,242 |   | 23,469,619 |   |
| Operating expenses                                                         |       |                                  |       |                                |       |   |   |   |   |
| Cost of services and products                                              |       | 1,992,032                             |       | 3,020,050                           |       | 3,961,424 |   | 6,073,594 |   |
| Selling, general and administrative  expenses                              |       | 1,588,107                             |       | 1,512,050                           |       | 3,218,619 |   | 3,326,999 |   |
| Depreciation and amortization                                              |       | 1,493,491                             |       | 2,370,986                           |       | 3,047,182 |   | 4,736,193 |   |
| Total operating expenses                                                   |       | 5,073,630                             |       | 6,903,086                           |       | 10,227,225 |   | 14,136,786 |   |
|                                                                       |       |                                  |       |                                |       |   |   |   |   |
| Income from operations                                                     |       | 3,955,373                             |       | 4,539,438                           |       | 7,929,017 |   | 9,332,833 |   |
|                                                                       |       |                                  |       |                                |       |   |   |   |   |
| Other income (expense)                                                     |       |                                  |       |                                |       |   |   |   |   |
| Interest expense                                                           |       | (792,413                              | )          | (4,057,957                          | )          | (1,630,234 | ) | (8,035,748 | ) |
| Change in fair value of derivative                                         |       | —                                |       | 337,696                             |       | — |   | 615,479 |   |
| Other income                                                               |       | 6,637                                 |       | 47,215                              |       | 54,276 |   | 320,691 |   |
| Total other expense                                                        |       | (785,776                              | )          | (3,673,046                          | )          | (1,575,958 | ) | (7,099,578 | ) |
|                                                                       |       |                                  |       |                                |       |   |   |   |   |
| Income before income tax and accretion  expense                            |       | 3,169,597                             |       | 866,392                             |       | 6,353,059 |   | 2,233,255 |   |
|                                                                       |       |                                  |       |                                |       |   |   |   |   |
| Income tax expense                                                         |       | (1,122,038                            | )          | (139,301                            | )          | (2,248,984 | ) | (566,221 | ) |
|                                                                       |       |                                  |       |                                |       |   |   |   |   |
| Income before accretion expense                                            |       | 2,047,559                             |       | 727,091                             |       | 4,104,075 |   | 1,667,034 |   |
|                                                                       |       |                                  |       |                                |       |   |   |   |   |
| Accretion of Class B common  convertible to senior subordinated notes |       | —                                |       | (110,732                            | )          | — |   | (221,463 | ) |
| Net income available to common stockholders                                |       | $                                     | 2,047,559  |                                | $          | 616,359 |   | $ | 4,104,075 |   | $ | 1,445,571 |   |
|                                                                       |       |                                  |       |                                |       |   |   |   |   |
| Weighted average shares outstanding:                                       |       |                                  |       |                                |       |   |   |   |   |
| Basic                                                                      |       | 8,054,841                             |       | 9,676,733                           |       | 8,054,841 |   | 9,676,733 |   |
| Diluted                                                                    |       | 8,557,304                             |       | 10,221,404                          |       | 8,557,304 |   | 10,221,404 |   |
|                                                                       |       |                                  |       |                                |       |   |   |   |   |
| Net income per share                                                       |       |                                  |       |                                |       |   |   |   |   |
| Basic                                                                      |       | $                                     | 0.25       |                                | $          | 0.06 |   | $ | 0.51 |   | $ | 0.15 |   |
| Diluted                                                                    |       | $                                     | 0.24       |                                | $          | 0.04 |   | $ | 0.48 |   | $ | 0.10 |   |
|                                                                       |       |                                  |       |                                |       |   |   |   |   |
| Dividends declared per share                                               |       | $                                     | —     |                                | $          | 0.18 |   | $ | — |   | $ | 0.35 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

5

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**OTELCO INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(Unaudited)

 
| ** **                                                                    | ** ** | **Six months ended  June 30,** | ** ** |
|-------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                    | ** ** | **2004**                            | ** ** | **2005** | ** ** |
| Cash flows from operating activities:                                         |       |                                |       |   |   |
| Net income                                                                    |       | $                                   | 4,104,075  |   | $ | 1,445,571 |   |
| Adjustments to reconcile net income to cash  flows from operating activities: |       |                                |       |   |   |
| Depreciation                                                                  |       | 2,848,300                           |       | 3,844,022 |   |
| Amortization                                                                  |       | 198,882                             |       | 892,171 |   |
| Interest rate caplet                                                          |       | —                              |       | 50,716 |   |
| Accretion expense                                                             |       | —                              |       | 221,463 |   |
| Change in fair value of derivative  liability                                 |       | —                              |       | (615,479 | ) |
| Provision for uncollectible revenue                                           |       | 34,014                              |       | 42,249 |   |
| Changes in assets and liabilities, net of  assets and liabilities acquired:   |       |                                |       |   |   |
| Accounts receivables                                                          |       | 128,321                             |       | 142,418 |   |
| Material and supplies                                                         |       | 179,330                             |       | 33,296 |   |
| Prepaid expenses and other assets                                             |       | 239,955                             |       | 68,151 |   |
| Accounts payable and accrued liabilities                                      |       | 2,961,437                           |       | (566,838 | ) |
| Advance billings and payments                                                 |       | 38,701                              |       | 18,080 |   |
| Other liabilities                                                             |       | (11,000                             | )          | 2,295 |   |
| Net cash from operating activities                                            |       | 10,722,015                          |       | 5,578,115 |   |
|                                                                          |       |                                |       |   |   |
| Cash flows from investing activities:                                         |       |                                |       |   |   |
| Acquisition and construction of property  and equipment                       |       | (1,914,215                          | )          | (2,359,481 | ) |
| Proceeds from retirement of investment                                        |       | 38,778                              |       | 80,846 |   |
| Capitalized transaction costs                                                 |       | (479,314                            | )          | — |   |
| Net cash from investing activities                                            |       | (2,354,751                          | )          | (2,278,635 | ) |
|                                                                          |       |                                |       |   |   |
| Cash flows from financing activities:                                         |       |                                |       |   |   |
| Cash dividends paid                                                           |       | —                              |       | (3,411,048 | ) |
| Loan origination cost and transaction cost                                    |       | —                              |       | (63,262 | ) |
| Repayment of long-term notes payable                                          |       | (3,811,113                          | )          | — |   |
| Net cash from financing activities                                            |       | (3,811,113                          | )          | (3,474,310 | ) |
|                                                                          |       |                                |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                         |       | 4,556,151                           |       | (174,830 | ) |
| Cash and cash equivalents, beginning of  period                               |       | 1,650,307                           |       | 5,406,545 |   |
|                                                                          |       |                                |       |   |   |
| Cash and cash equivalents, end of period                                      |       | $                                   | 6,206,458  |   | $ | 5,231,715 |   |
|                                                                          |       |                                |       |   |   |
| Supplemental disclosures of cash flow  information:                           |       |                                |       |   |   |
|                                                                          |       |                                |       |   |   |
| Interest paid                                                                 |       | $                                   | 1,393,200  |   | $ | 8,337,834 |   |
|                                                                          |       |                                |       |   |   |
| Income taxes paid (received)                                                  |       | $                                   | 452,000    |   | $ | (350,000 | ) |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

6

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**(Unaudited)

 

**1.****                                      Organizationand Basis of Financial Reporting**

 

# ***Basis of Presentation and Principles of Consolidation***

# ** **

Theconsolidated financial statements include the accounts of Otelco Inc. (the “Company”),its wholly owned subsidiaries Otelco Telecommunications LLC (“OTC”), OtelcoTelephone LLC (“OTP”), Hopper Holding Company, Inc. (“HHC”), Brindlee HoldingsLLC (“BH”), Page & Kiser Communications, Inc. (“PKC”), andMid-Missouri Holding Corporation (“MMH”). HHC’s wholly owned subsidiary is Hopper Telecommunications Company, Inc.(“HTC”).  BH’s owned subsidiary isBrindlee Mountain Telephone Company, Inc. (“BMTC”).  PKC’s wholly owned subsidiary is BlountsvilleTelephone Company, Inc. (“BTC”).  OnDecember 21, 2004, the Company acquired MMH.  MMH’s wholly owned subsidiary is Mid-MissouriTelephone Company (“MMT”).  MMT is thesole stockholder of Imagination, Inc., which provides internet services incertain locations in Missouri.  Theaccompanying consolidated financial statements include the accounts of theCompany and all of its subsidiaries after elimination of all materialintercompany balances and transactions.

 

The consolidated financial statements and footnotes included in this Form 10-Qshould be read in conjunction with the consolidated financial statements andnotes thereto included in the Company’s annual report on Form 10-K for theyear ended December 31, 2004.  Theinterim Consolidated Financial information herein is unaudited.  The information reflects all adjustments(which include only normal recurring adjustments), which are, in the opinion ofmanagement, necessary for a fair presentation of the financial position andresults of operations for the periods included in the report.

 

**2.****                                     ****Commitmentand Contingencies**

 

From time to time, we may be involved in various claims, legal actionsand regulatory proceedings incidental to and in the ordinary course ofbusiness, including administrative hearings of the Alabama and Missouri PublicService Commission related primarily to rate making.  Currently, none of the legal proceedings areexpected to have a material adverse effect on our business.

 

**3.****                                      Acquisitions**

 

On December 21, 2004, the Company acquired 100% of the outstandingcommon stock of MMH.  MMH owns 100% ofMMT.  MMT is a local exchange carrier incentral Missouri.  The implicit purchaseprice of the acquisition was $30,540,774 including assumed notes payable.  The excess of the total purchase price overthe assigned value of the identifiable net assets is reflected as goodwill andintangible assets in the amount of $17,858,806 and $1,800,000, respectively.  The goodwill related to the acquisition isnot deductible for tax purposes.

 

The allocation of the net purchase price for the MMH acquisition is asfollows:

 

7

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| ** **             | ** ** | **2004**    | ** ** |
|------------------------|------------|-------------|------------|
|                   |       |        |       |
| Current Assets         |       | $           | 1,158,957  |   |
| Property and equipment |       | 12,900,823  |       |
| Intangible assets      |       | 1,800,000   |       |
| Goodwill               |       | 17,858,806  |       |
| Other assets           |       | 422,680     |       |
| Current liabilities    |       | (1,144,674  | )          |
| Notes payable          |       | (16,714,140 | )          |
| Other liabilities      |       | (2,455,818  | )          |
|                   |       |        |       |
| Net purchase price     |       | $           | 13,826,634 |   |

 

TheCompany issued 856,234 shares of Class A common stock ($8,562 par value)underlying the 856,234 IDSs and 53,413 shares of Class B common stock($534 par value) in connection with the acquisition of MMHC based on anexchange ratio of 0.14126 IDSs and 0.00881 shares of Class B common stockfor each share of MMHC.  The issuance of Class Acommon stock represented by Income Deposit Securities (“IDSs”), Class Bcommon stock and Class A common stock associated with the conversion ofoptions resulted in an increase in paid-in capital of $7,222,120.  Each IDS represents one share of Class Acommon stock and a 13.0% senior subordinated note with a $7.50 principalamount.  The number of IDSs and shares ofClass B common stock to be received upon exchange of each outstandingoption to acquire shares of Mid-Missouri Holding were equal to the number ofIDSs and shares of Class B common stock that a holder would have receivedin the exchange had the holder exercised the option on a “cashless basis.”  The embedded exchange feature of the Class Bcommon stock is accounted for separately as a derivative liability.

 

Thefollowing unaudited pro forma information presents the combined results ofoperations of the Company as though the acquisition of MMH completed in 2004occurred at the beginning of the year.   The results include certain adjustments,including increased interest expense on notes payable related to theacquisition.  The pro forma financialinformation does not necessarily reflect the results of operations had theacquisition been completed at the beginning of 2004 or those which may beobtained in the future. The impacts of accounting for the change in fair valueof derivative and accretion expense have not been included in the results.

 
| ** **                   | ** ** | **Unaudited  For the three months ended  June 30, 2004** | ** ** | **Unaudited  For the six months ended  June 30, 2004** | ** ** |
|------------------------------|------------|---------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
|                         |       |                                                          |       |                                                        |       |
| Revenues                     |       | $                                                             | 11,693,475 |                                                        | $          | 23,508,187 |   |
| Income from operations       |       | 4,684,876                                                     |       | 9,413,142                                                   |       |
| Net income                   |       | 2,230,659                                                     |       | 4,502,523                                                   |       |
|                         |       |                                                          |       |                                                        |       |
| Basic net income per share   |       | $                                                             | 0.28       |                                                        | $          | 0.56 |   |
| Diluted net income per share |       | $                                                             | 0.26       |                                                        | $          | 0.53 |   |

 

Theacquisition was accounted for using the purchase method of accounting andaccordingly, the accompanying financial statements include the financialposition and results of operation from the date of acquisition.

 

8

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**4.****             Derivativeand Hedge Activities**

 

The interest rate cap was purchased on December 21,2004, coincident with the closing of our initial public offering and therecapitalization of our senior notes payable. The interest rate cap was purchased to mitigate the risk of risinginterest rates to limit or cap the rate at 7%. It is considered an effective hedge as all critical terms of theinterest rate cap are identical to the underlying debt it hedges.  Changes in the fair value of the interestrate cap are not included in earnings but are reported as a component ofaccumulated other comprehensive income. For the three months and six months ended June 30, 2005 the changein the fair value of the interest rate cap was $(1,554,453) and $(751,321)respectively.  The cost of the interestrate cap is expensed as interest over the effective life of the hedge inaccordance with the quarterly value of the caplets as determined at the date ofinception.  For the three months and sixmonths ended June 30, 2005 the cost of the interest rate cap was $29,619and $50,716, respectively.

 

**5.****            ****Income per Common Share and Potential Common Share**

 

Basicincome per common share is computed by dividing net income by theweighted-average number of shares outstanding for the period.  Diluted income per common share reflects thepotential dilution that could occur if the Class B common stock wereexercised into IDSs.  Class B commonstock is convertible on a one-for-one basis into IDSs, each of which includes aClass A common share.  For periodsprior to our conversion, membership units were treated on an as if convertedbasis into Class A and Class B common shares.

 

Areconciliation of the common shares and net income for the Company’s basic anddiluted income per common share calculation is as follows:

 
| ** **                                                                                                                                                        | ** ** | **For the three months  ended June 30,** | ** ** | **For the six months  ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                                        | ** ** | **2004**                                      | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2005** | ** ** |
|                                                                                                                                                              |       |                                          |       |                                        |       |   |   |   |   |
| Weighted average common shares at  conversion                                                                                                                     |       | 8,054,841                                     |       | 8,054,841                                   |       | 8,054,841 |   | 8,054,841 |   |
| Purchase of Mid-Missouri Holding Corp.,  sale of common shares by Company, and buy-back of common shares by Company  (12/21/04)                                   |       | —                                        |       | 1,621,892                                   |       | — |   | 1,621,892 |   |
| Weighted average common shares-basic                                                                                                                              |       | 8,054,841                                     |       | 9,676,733                                   |       | 8,054,841 |   | 9,676,733 |   |
|                                                                                                                                                              |       |                                          |       |                                        |       |   |   |   |   |
| Effect of Class B shares at conversion                                                                                                                       |       | 502,463                                       |       | 502,463                                     |       | 502,463 |   | 502,463 |   |
| Effect on Class B shares from purchse  of Mid Missouri-Holding Corp., sale of common shares by Company, and buy-back  of common shares by Company (12/21/04) |       | —                                        |       | 42,208                                      |       | — |   | 42,208 |   |
| Effect of dilutive securities                                                                                                                                     |       | 502,463                                       |       | 544,671                                     |       | 502,463 |   | 544,671 |   |
|                                                                                                                                                              |       |                                          |       |                                        |       |   |   |   |   |
| Weighted-average common shares and  potential common shares-diluted                                                                                               |       | 8,557,304                                     |       | 10,221,404                                  |       | 8,557,304 |   | 10,221,404 |   |
|                                                                                                                                                              |       |                                          |       |                                        |       |   |   |   |   |
| Net income available to common stockholders                                                                                                                       |       | $                                             | 2,047,559  |                                        | $          | 616,359 |   | $ | 4,104,075 |   | $ | 1,445,571 |   |
|                                                                                                                                                              |       |                                          |       |                                        |       |   |   |   |   |
| Net income per basic share                                                                                                                                        |       | $                                             | 0.25       |                                        | $          | 0.06 |   | $ | 0.51 |   | $ | 0.15 |   |
|                                                                                                                                                              |       |                                          |       |                                        |       |   |   |   |   |
| Net income available to common stockholders                                                                                                                       |       | $                                             | 2,047,559  |                                        | $          | 616,359 |   | $ | 4,104,075 |   | $ | 1,445,571 |   |
| Plus: Accretion expense of Class B  common convertible to senior subordinated notes                                                                          |       | —                                        |       | 110,732                                     |       | — |   | 221,463 |   |
| Less: Change in fair value of derivative                                                                                                                          |       | —                                        |       | (337,696                                    | )          | — |   | (615,479 | ) |
| Net income available for diluted shares                                                                                                                           |       | $                                             | 2,047,559  |                                        | $          | 389,395 |   | $ | 4,104,075 |   | $ | 1,051,555 |   |
|                                                                                                                                                              |       |                                          |       |                                        |       |   |   |   |   |
| Net income per diluted share                                                                                                                                      |       | $                                             | 0.24       |                                        | $          | 0.04 |   | $ | 0.48 |   | $ | 0.10 |   |
|                                                                                                                                                                   |            |                                               |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

9

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**6.****            ****Other Comprehensive Income (Loss)**

 

The components of othercomprehensive income (loss) consist of:

 
| ** **                        | ** ** | **For the three months  ended June 30,** | ** ** | **For the six months  ended June 30,** | ** ** |
|-----------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                        | ** ** | **2004**                                      | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2005** | ** ** |
|                              |       |                                          |       |                                        |       |   |   |   |   |
| Net income                        |       | $                                             | 2,047,559  |                                        | $          | 616,359 |   | $ | 4,104,075 |   | $ | 1,445,571 |   |
|                              |       |                                          |       |                                        |       |   |   |   |   |
| Hedge accounting                  |       | —                                        |       | (1,554,453                                  | )          | — |   | (751,321 | ) |
|                              |       |                                          |       |                                        |       |   |   |   |   |
| Total comprehensive income (loss) |       | $                                             | 2,047,559  |                                        | $          | (938,094 | ) | $ | 4,104,075 |   | $ | 694,250 |   |

 

10

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**Item2.  *Management’sDiscussion and Analysis of Financial Condition and Results of Operations***

 

**Overview**

 

***General***

 

Since1999, we have acquired and operate five rural local exchange carriers servingtwenty exchanges through four central offices and thirteen remote switches inapproximately 1,540 square miles of north central Alabama and centralMissouri.  We are the sole wirelinetelephone services provider in the rural communities we serve.  Our services include local telephone, networkaccess, long distance and other telephone related services, cable televisionand Internet access.  We view, manage andevaluate the results of operations from the various telephony products andservices as one company and therefore have identified one reporting segment asit relates to providing segment information. As of June 30, 2005, we operated approximately 37,400 access lineequivalents.

 

Ourcore businesses are local telephone service and the provision of network accessto other wireline, long distance and wireless carriers for calls originated orterminated on our network.  Our corebusinesses generated approximately 76.9% of our total revenues in the secondquarter of 2005.  We also provide longdistance and other telephone related services, cable television and dial-up andhigh-speed Internet access.

 

Thefollowing discussion and analysis should be read in conjunction with ourfinancial statements and the related notes included in Item 1 of Part 1and other financial information appearing elsewhere in this report.  The following discussion and analysisdiscusses our financial condition and results of operations on a consolidatedbasis, including the acquisition (the “Mid-Missouri Acquisition”) ofMid-Missouri Holding Corp. (“MMH”) as of December 21, 2004.

 

***Revenue Sources***

 

Wederive our revenues from five sources:

 

•                  *Local services.*  Wereceive revenues from providing local exchange telephone services.  These revenues include monthly subscriptioncharges for basic service, calling to adjacent communities on a per minutebasis, local private line services and enhanced calling features, such asvoicemail, caller identification, call waiting and call forwarding.

•                  *Network access services.*  Wereceive revenues from charges established to compensate us for the origination,transport and termination of calls of long distance and other interexchangecarriers.  These include subscriber linecharges imposed on end users and switched and special access charges paid bycarriers.  Switched access charges forlong distance services within Alabama and Missouri are based on rates approvedby the Alabama Public Service Commission and Missouri Public Service Commissionrespectively.  Switched and specialaccess charges for interstate and international services are based on ratesapproved by the Federal Communications Commission.

•                  *Long distance and othertelephone services*.  We receive revenues for providing longdistance services to our customers.  Wealso provide billing and collections services for other carriers under contractand receive revenues from directory advertising.

•                  *Cable television services.*  Weoffer basic, digital and pay per view cable television services to a portion ofour telephone service territory in both Alabama and Missouri.

•                  *Internet services.*  Wereceive revenues from monthly recurring charges for dial-up and high-speed Internetaccess.

 

***Access Line and Customer Trends***

 

Thenumber of access lines served is a fundamental factor in determining revenuestability for a telecommunications provider. Reflecting a general trend in the rural local exchange carrier industry,the number of access lines we serve has been decreasing gradually whennormalized for territory acquisitions. We expect this trend to continue for the industry and ourterritory.  In addition to the impact ofthe

 

11

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economyon our customers, the growth of our high-speed Internet access services willcontinue to have an impact on residential and small business customers’requirements for second access lines. Our response to this trend will have an important impact on our futurerevenues.  Our primary strategy consistsof leveraging our strong incumbent market position to increase revenue peraccess line by selling additional services to our customer base.

 
| ** **                                  | ** ** | **Year Ended December 31,** | ** ** | **March 31,** | ** ** | **June 30,** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|--------------------|------------|-------------------|------------|
| ** **                                  | ** ** | **2002**                         | ** ** | **2003**           | ** ** | **2004**          | ** ** | **2005** | ** ** | **2005** | ** ** |
| Access line equivalents (1):                |       |                             |       |               |       |              |       |   |   |   |   |
| Residential access lines                    |       | 19,343                           |       | 22,100             |       | 25,237            |       | 25,314 |   | 25,013 |   |
| Business access lines                       |       | 6,654                            |       | 7,355              |       | 8,414             |       | 8,310 |   | 8,006 |   |
| Total access lines                          |       | 25,997                           |       | 29,455             |       | 33,651            |       | 33,624 |   | 33,019 |   |
| High-speed lines                            |       | 1,361                            |       | 2,185              |       | 3,488             |       | 4,014 |   | 4,407 |   |
| Total access line equivalents               |       | 27,358                           |       | 31,640             |       | 37,139            |       | 37,638 |   | 37,426 |   |
|                                        |       |                             |       |               |       |              |       |   |   |   |   |
| Long distance customers                     |       | 8,183                            |       | 11,374             |       | 13,641            |       | 14,039 |   | 14,061 |   |
| Cable television customers                  |       | 3,442                            |       | 3,628              |       | 3,959             |       | 4,023 |   | 4,163 |   |
| Dial-up Internet customers                  |       | 2,463                            |       | 2,331              |       | 15,348            |       | 14,693 |   | 13,831 |   |
|                                        |       |                             |       |               |       |              |       |   |   |   |   |
| Average monthly revenue per access line (2) |       | $                                | 94.40      |               | $          | 101.45            |       | $ | 105.88 |   | $ | 112.66 |   | $ | 108.52 |   |
|                                             |            |                                  |            |                    |            |                   |            |  |  |  |  |  |  |  |  |  |

 

----

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

 

(2)          We calculate average monthly revenue peraccess line as equal to (A) our average revenues for the period within ourtelephone territory divided by (B) the average of the number of accesslines on the first day and the last day of the period. Year-to-date averagerevenue per access line is $111.08.

 

Wewill continue our strategy of increasing revenues by cross-selling to ourexisting customer base, in the form of bundled service packages and individualadditional services as they become available. Our high-speed Internet customers continue to grow from 4,014 customersat March 31, 2005, to 4,407 at June 30, 2005. We expect continuedrevenue growth in this area of our business. This growth in our high-speed Internet customers is expected to have anegative effect on our dial-up Internet customers as some customers migrate tohigh-speed Internet access.  In addition,we expect the growth in our high-speed Internet access customers will have anegative effect on our access lines as some customers will no longer have aneed for second lines for purposes of dial-up Internet access.  During second quarter 2005, residential andbusiness access lines and business data circuits declined 1.8% while high-speedInternet customers grew 9.8% during the same period.

 

Ourlong distance customers increased to 14,061 from March 31, 2005 to June 30,2005 and now represent 42.6% of our access lines.  Our cable television customers grew 140 to4,163 from March 31, 2005 to June 30, 2005.  While we have experienced annual increases inour cable television programming costs, and expect this trend to continue inthe future, we expect these increases will be offset by a correspondingincrease in the price that we charge our cable television customers for cabletelevision service offerings.  Dial-upinternet customers declined to 13,831 on June 30, 2005 from 14,693 on March 31,2005, including the subscribers we service outside of our telephone servicearea, reflecting the shift to high-speed Internet services.

 

Ouraverage revenue per access line for the second fiscal quarter decreased 3.7%from the first fiscal quarter of 2005. The primary contributor was a non-recurring reduction in access revenueassociated with the industry process of truing-up prior period rates, offset byincreases in high-speed Internet, cable and long distance revenues. With theMid-Missouri Acquisition on December 21, 2004, there was an increase inaverage revenue per access line associated with the proportionately largercontribution from High Cost Loop support. On a year-to-date basis, averagerevenue per access line is $111.08 for an increase of 4.9% over 2004. Coupledwith the increase in high-speed access, long distance and cable subscribers, wecontinue to provide an increasingly valuable basket of services to oursubscribers.

 

12

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***Categories of Operating Expenses***

 

Ouroperating expenses are categorized as cost of services; selling, general andadministrative expenses; and depreciation and amortization.

 

*Cost of services. *This includesexpense for salaries, wages and benefits relating to plant operation,maintenance and customer service; other plant operations, maintenance andadministrative costs; network access costs; and costs of sales for longdistance, cable television, Internet and directory services.

 

*Selling, general and administrative expenses. *This includes expenses for salaries, wages and benefits and contract servicepayments (e.g., legal fees) relating to engineering, financial, human resourcesand corporate operations; information management expenses, including billing;allowance for uncollectibles; expenses for travel, lodging and meals; internaland external communications costs; stock option compensation expense; insurancepremiums; stock exchange and banking fees; and postage.  Included in selling, general andadministrative expenses historically are annual management fees ofapproximately $1.0 million in 2004 payable to Seaport Capital Partners II, L.P.and its affiliates, or Seaport Capital. These fees were terminated on December 21, 2004 in conjunction withour initial public offering.  Theincremental selling, general and administrative expenses associated with beinga public company replace these fees.

 

*Depreciation and amortization. *This includes depreciation of our telecommunications, cable andInternet networks and equipment, and amortization of intangible assets.

 

***Our Ability to Control Operating Expenses***

 

Westrive to control expenses in order to maintain our strong operatingmargins.  As our revenue shifts tonon-regulated services, operating margins decrease reflecting the lower marginsassociated with these more competitive services.  We expect to control expenses while wecontinue to grow our business.

 

***Results of Operations***

 

Thefollowing table sets forth our results of operations as a percentage of totalrevenues for the periods indicated.

 

13

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| ** **                                                                 | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                 | ** ** | **2004**                             | ** ** | **2005**                           | ** ** | **2004** | ** ** | **2005** | ** ** |
| Revenues                                                                   |       |                                 |       |                               |       |   |   |   |   |
| Local service                                                              |       | 38.9                                 | %          | 31.1                               | %          | 38.2 | % | 30.7 | % |
| Network access                                                             |       | 43.1                                 |       | 45.8                               |       | 44.1 |   | 46.7 |   |
| Long distance and other telephone services                                 |       | 7.5                                  |       | 6.8                                |       | 7.4 |   | 6.7 |   |
| Cable television                                                           |       | 4.8                                  |       | 4.5                                |       | 4.8 |   | 4.3 |   |
| Internet                                                                   |       | 5.7                                  |       | 11.8                               |       | 5.5 |   | 11.6 |   |
| Total revenues                                                             |       | 100.0                                | %          | 100.0                              | %          | 100.0 | % | 100.0 | % |
| Operating expenses                                                         |       |                                 |       |                               |       |   |   |   |   |
| Cost of services and products                                              |       | 22.1                                 | %          | 26.4                               | %          | 21.8 |   | 25.9 |   |
| Selling, general and administrative  expenses                              |       | 17.6                                 |       | 13.2                               |       | 17.7 |   | 14.1 |   |
| Depreciation and amortization                                              |       | 16.5                                 |       | 20.7                               |       | 16.8 |   | 20.2 |   |
| Total operating expenses                                                   |       | 56.2                                 |       | 60.3                               |       | 56.3 |   | 60.2 |   |
|                                                                       |       |                                 |       |                               |       |   |   |   |   |
| Income from operations                                                     |       | 43.8                                 |       | 39.7                               |       | 43.7 |   | 39.8 |   |
|                                                                       |       |                                 |       |                               |       |   |   |   |   |
| Other income (expense)                                                     |       |                                 |       |                               |       |   |   |   |   |
| Interest expense                                                           |       | (8.8                                 | )          | (35.5                              | )          | (9.0 | ) | (34.2 | ) |
| Change in fair value of derivative                                         |       | —                               |       | 3.0                                |       | — |   | 2.6 |   |
| Other income                                                               |       | 0.1                                  |       | 0.4                                |       | 0.3 |   | 1.3 |   |
| Total other expense                                                        |       | (8.7                                 | )          | (32.1                              | )          | (8.7 | ) | (30.3 | ) |
|                                                                       |       |                                 |       |                               |       |   |   |   |   |
| Income before income taxes                                                 |       | 35.1                                 |       | 7.6                                |       | 35.0 |   | 9.5 |   |
|                                                                       |       |                                 |       |                               |       |   |   |   |   |
| Income tax expense                                                         |       | (12.4                                | )          | (1.2                               | )          | (12.4 | ) | (2.4 | ) |
|                                                                       |       |                                 |       |                               |       |   |   |   |   |
| Income before accretion expense                                            |       | 22.7                                 |       | 6.4                                |       | 22.6 |   | 7.1 |   |
|                                                                       |       |                                 |       |                               |       |   |   |   |   |
| Accretion of Class B common  convertible to senior subordinated notes |       | —                               |       | (1.0                               | )          | — |   | (0.9 | ) |
|                                                                       |       |                                 |       |                               |       |   |   |   |   |
| Net income available to common stockholders                                |       | 22.7                                 | %          | 5.4                                | %          | 22.6 | % | 6.2 | % |

 

***Three months and six months ended June 30,2005 compared to three months and six months ended June 30, 2004***

 

*Total Revenues. *Total revenuesgrew 26.7% in the three months ended June 30, 2005 to $11.4 million from$9.0 million in the three months ended June 30, 2004.  Total revenues grew 29.3% in the six monthsended June 30, 2005 to $23.5 million from $18.2 million in the six monthsended June 30, 2004.  The tablesbelow provide the components of our revenues for the three months and six monthof 2005 compared to the three months and six months of 2004.

 

*For the three months ended June 30, 2005 and 2004*

 
| ** **                                 | ** ** | **Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|--------------------------------------------|------------|--------------------------------------|------------|------------|------------|
| ** **                                 | ** ** | **2004**                             | ** ** | **2005**   | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                                 | ** ** | **(dollars in thousands)**           | ** ** |
| Local service                              |       | $                                    | 3,512      |       | $          | 3,562 |   | $ | 50 |   | 1.4 | % |
| Network access                             |       | 3,889                                |       | 5,235      |       | 1,346 |   | 34.6 |   |
| Long distance and other telephone services |       | 674                                  |       | 779        |       | 105 |   | 15.6 |   |
| Cable television                           |       | 435                                  |       | 516        |       | 81 |   | 18.6 |   |
| Internet                                   |       | 519                                  |       | 1,350      |       | 831 |   | 160.1 |   |
| Total                                      |       | $                                    | 9,029      |       | $          | 11,442 |   | $ | 2,413 |   | 26.7 |   |

 

Local service.  Local service revenue in the three monthsended June 30, 2005 grew 1.4% to $3.6 million from $3.5 million in thethree months ended June 30, 2004.  Thisgrowth was attributable to an increase of $0.2 million from the Mid-MissouriAcquisition offset by $0.1 million from a decrease in minutes of use on ourvarious local calling arrangements and customer attrition.  Access lines

 

14

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increased3,720 primarily from the acquisition of Mid-Missouri, partially offset bycontinued growth of the Company’s high-speed Internet service which resulted inthe loss of some second access lines used by customers for dial-up Internetaccess and wireline customer attrition.

 

Network access.  Network access revenue in the three monthsended June 30, 2005 grew 34.6% to $5.2 million from $3.9 million in thefirst three months ended June 30, 2004. This growth was primarily attributable to the increase of $1.4 millionassociated with the Mid-Missouri Acquisition offset by a decrease of $0.1million in interstate access revenue after netting a small increase in federaluniversal service charges.

 

Long distance and other telephone services.  Longdistance and other telephone services revenue in the three months ended June 30,2005 increased 15.6% to $0.8 million from $0.7 million in the three monthsended June 30, 2004.  TheMid-Missouri Acquisition increased revenue by $0.2 million, offset by areduction of $0.1 in other carrier billing and collection agreements andproperty rental income.

 

Cable television.  Cable television revenue in the three monthsended June 30, 2005 increased 18.6% to $0.5 million from $0.4 million inthe three months ended June 30, 2004. The increase was due to the impact of a $2.00 per month increase inbasic cable prices, the addition of 370 customers associated with theMid-Missouri Acquisition and growth of 214 customers in Alabama.

 

Internet.  Internet revenue in the three months ended June 30,2005 increased 160.1% to $1.3 million from $0.5 million in the three monthsended June 30, 2004.  Of thisincrease, $0.1 million was attributable to the addition of almost 1,400 newhigh-speed Internet customers in Alabama and $0.7 million was attributable tothe addition of high-speed and dial-up Internet customers associated with theMid-Missouri Acquisition.

 

*For the six months ended June 30, 2005 and 2004*

 
| ** **                                 | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|--------------------------------------------|------------|------------------------------------|------------|------------|------------|
| ** **                                 | ** ** | **2004**                           | ** ** | **2005**   | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                                 | ** ** | **(dollars in thousands)**         | ** ** |
| Local service                              |       | $                                  | 6,929      |       | $          | 7,206 |   | $ | 277 |   | 4.0 | % |
| Network access                             |       | 8,002                              |       | 10,965     |       | 2,963 |   | 37.0 |   |
| Long distance and other telephone services |       | 1,353                              |       | 1,564      |       | 211 |   | 15.6 |   |
| Cable television                           |       | 873                                |       | 1,012      |       | 139 |   | 15.9 |   |
| Internet                                   |       | 999                                |       | 2,723      |       | 1,724 |   | 172.6 |   |
| Total                                      |       | $                                  | 18,156     |       | $          | 23,470 |   | $ | 5,314 |   | 29.3 |   |

 

Local service.  Local service revenue in the six months endedJune 30, 2005 grew 4.0% to $7.2 million from $6.9 million in the sixmonths ended June 30, 2004.  Thisgrowth was attributable to an increase of $0.3 million from the Mid-MissouriAcquisition.

 

Network access.  Network access revenue in the six monthsended June 30, 2005 grew 37.0% to $11.0 million from $8.0 million in thefirst six months ended June 30, 2004. This growth was primarily attributable to the Mid-Missouri Acquisition.

 

Long distance and other telephone services.  Longdistance and other telephone services revenue in the six months ended June 30,2005 increased 15.6% to $1.6 million from $1.4 million in the six months ended June 30,2004.  The Mid-Missouri Acquisitionincreased revenue by $0.3 million, offset by a reduction of $0.1 in othercarrier billing and collection agreements and property rental income.

 

Cable television. Cable television revenue in the sixmonths ended June 30, 2005 increased 15.9% to $1.0 million from $0.9million in the six months ended June 30, 2004.  The increase was due to the

 

15

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impactof a $2.00 per month increase in basic cable prices, the addition of 370customers associated with the Mid-Missouri Acquisition and growth of 214customers in Alabama.

 

Internet.  Internet revenue in the six months ended June 30,2005 increased 172.6% to $2.7 million from $1.0 million in the six months endedJune 30, 2004.  Of this increase,$0.3 million was attributable to the addition of almost 1,300 new high-speedInternet customers in Alabama and $1.4 million was attributable to the additionof high-speed and dial-up Internet customers associated with the Mid-MissouriAcquisition.

 

*Operating expenses. *Operatingexpenses in the three months ended June 30, 2005 increased 36.0% to $6.9million from $5.1 million the three months ended June 30, 2004.  Operating expenses in the six months ended June 30,2005 increased 38.2% to $14.1 million from $10.2 million the six months ended June 30,2004.  The increase was primarilyattributable to the Mid-Missouri Acquisition, amortization of loan costsassociated with our initial public offering and public company costs.

 

*For the three months ended June 30, 2005 and 2004*

 
| ** **                                    | ** ** | **Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|-----------------------------------------------|------------|--------------------------------------|------------|------------|------------|
| ** **                                    | ** ** | **2004**                             | ** ** | **2005**   | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                                    | ** ** | **(dollars in thousands)**           | ** ** |
| Cost of services                              |       | $                                    | 1,992      |       | $          | 3,020 |   | $ | 1,028 |   | 51.6 | % |
| Selling, general and administrative  expenses |       | 1,588                                |       | 1,512      |       | (76 | ) | (4.8 | ) |
| Depreciation and amortization                 |       | 1,494                                |       | 2,371      |       | 877 |   | 58.7 |   |
| Total                                         |       | $                                    | 5,074      |       | $          | 6,903 |   | $ | 1,829 |   | 36.0 |   |

 

Cost of services.  The cost of services increased 51.6% to $3.0million in the three months ended June 30, 2005 from $2.0 million in thethree months ended June 30, 2004. The Mid-Missouri Acquisition accounted for $0.9 million of thisincrease.  The balance of the increasewas attributable to the higher installation and service costs associated withthe increase in Internet customers and higher cable programming fees.

 

Selling, general and administrative expenses. Selling, general and administrative expenses decreased 4.8% to $1.5million in the three months ended June 30, 2005 from $1.6 million in thethree months ended June 30, 2004. The costs associated with the Mid-Missouri Acquisition and our publiccompany costs in the period were slightly less than the elimination ofmanagement fees paid to a related party and stock option expense in theprevious year.

 

Depreciation and amortization.  Depreciation and amortizationincreased 58.7% to $2.4 million in the three months ended June 30, 2005from $1.5 million in three months ended June 30, 2004.  The Mid-Missouri Acquisition accounted for$0.5 million and the amortization of loan costs associated with our initialpublic offering accounted for $0.3 million. The balance of the increase wasassociated with increased high-speed Internet equipment and amortization ofintangibles.

 

*For the six months ended June 30, 2005 and 2004*

 
| ** **                                    | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|-----------------------------------------------|------------|------------------------------------|------------|------------|------------|
| ** **                                    | ** ** | **2004**                           | ** ** | **2005**   | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                                    | ** ** | **(dollars in thousands)**         | ** ** |
| Cost of services                              |       | $                                  | 3,961      |       | $          | 6,074 |   | $ | 2,113 |   | 53.3 | % |
| Selling, general and administrative  expenses |       | 3,219                              |       | 3,327      |       | 108 |   | 3.4 |   |
| Depreciation and amortization                 |       | 3,047                              |       | 4,736      |       | 1,689 |   | 55.4 |   |
| Total                                         |       | $                                  | 10,227     |       | $          | 14,137 |   | $ | 3,910 |   | 38.2 |   |

 

16

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Cost of services.  The cost of services increased 53.3% to $6.1million in the six months ended June 30, 2005 from $4.0 million in the sixmonths ended June 30, 2004.  TheMid-Missouri Acquisition accounted for $1.8 million of this increase.  The balance of the increase was attributableto the higher installation and service costs associated with the increase inInternet customers and higher cable programming fees.

 

Selling, general and administrative expenses. Selling, general and administrative expenses increased 3.4% to $3.3million in the six months ended June 30, 2005 from $3.2 million in the sixmonths ended June 30, 2004.  Thecosts associated with the Mid-Missouri Acquisition and our public company costsin the period were slightly higher than the elimination of management fees paidto a related party and stock option expense in the previous year.

 

Depreciation and amortization.  Depreciation and amortizationincreased 55.4% to $4.7 million in the six months ended June 30, 2005 from$3.0 million in six months ended June 30, 2004.  The Mid-Missouri Acquisition accounted for$0.9 million and the amortization of loan costs associated with our initialpublic offering accounted for $0.6 million. The balance of the increase wasassociated with increased high-speed Internet equipment and amortization ofintangibles.

 

*For the three months and six months ended June 30, 2005and 2004*

 

*Interest expense. *Interestexpense increased 412.1% to $4.1 million in the three months ended June 30,2005 from $0.8 million in the three months ended June 30, 2004.  Interest expense increased 392.9% to $8.0 millionin the six months ended June 30, 2005 from $1.6 million in the six months endedJune 30, 2004.  The new creditfacility and the senior subordinated notes associated with our initial publicoffering in December 2004 replaced existing variable rate term debt.Interest on the new credit facility is capped at 7% for the five year termending December 20, 2009. Interest on the senior subordinate notes is 13%for the 15 year term ending December 30, 2019.

 

*Change in fair value of derivative associated with Class Bcommon convertible to Class A common. *The derivativevalue associated with the conversion option for our Class B common stockmust be fair valued each quarter until conversion occurs, not later than December 21,2009. The reduction in maximum time to conversion and the increase in the priceof IDSs and the underlying Class A common stock since the initial publicoffering combined to reduce the fair value of this liability by $0.6 million atthe end of the first six months of 2005, including $0.3 million in the threemonths ended June 30, 2005.

 

*Other income. *Other income was less than $0.1 million inthe three months ended June 30, 2005 and 2004. Other income increased490.9% to $0.3 million in the six months ended June 30, 2005 from $0.1million in the six months ended June 30, 2004.  The increase was attributable to theincreased annual patronage dividend income from CoBank received in firstquarter 2005.

 

*Income taxes. *Provision for income taxes in the threemonths ended June 30, 2005 declined 87.6% to $0.1 million from $1.1million in the three months ended June 30, 2004.  Provision for income taxes in the six monthsended June 30, 2005 declined 74.8% to $0.6 million from $2.2 million inthe six months ended June 30, 2004. This reflects the expected lower income generated from the capitalstructure associated with our initial public offering in December 2004 andthe estimated lower tax rate for the full year. In calculating the effectivetax rate, the change in the fair value of the derivative associated with the Class Bcommon convertible to Class A common is excluded as a permanentdifference. As a result, the effective rate will vary from period to period.

 

*Accretion of Class B common convertible tosenior subordinated notes. *Our Class B common stock was issued tothe existing equity holders coincident with our initial public offering on December 21,2004.  These shares represent theirretained interest in the company.  Theydo not receive any dividends and will convert into IDSs not later than December 21,2009.  For the first two years aftertheir issuance, the present value discount on the portion of the shares relatedto the conversion to senior subordinated notes is being accreted as a non-cashexpense to the Company. For the three months and six months ended June 30,2005, this accretion expense was $0.1 million and $0.2 million respectively.

 

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*Net income. *As a result of the foregoing, net incomeavailable to common stockholders in the three months ended June 30, 2005decreased 69.9% to $0.6 million from $2.0 million in the three months ended June 30,2004 and net income in the six months ended June 30, 2005 decreased 64.8%to $1.4 million from $4.1 million in the six months ended June 30, 2004.

 

**Liquidityand Capital Resources**

 

Havingcompleted the transactions associated with our initial public offering, ourliquidity needs will arise primarily from: (i) interest payments relatedto our credit facility and our senior subordinated notes; (ii) capitalexpenditures, (iii) working capital requirements; (iv) dividendpayments on our Class A common stock; and (v) potential acquisitions.

 

Cashflows from operating activities for the first six months of 2005 amounted to$5.6 million compared to $10.7 million for the first six months of 2004.  The changes are primarily the result ofhigher interest associated with the capital structure of the Company since itsinitial public offering, the payment of accrued expenses associated with theinitial public offering, and advance payments for dial-up Internet customersoutside of our telephone service territory.

 

Cashflows from investing activities for the first six months of 2005 amounted to$2.3 million compared to $2.4 million for the first six months of 2004.  The capital expenditures for the acquisitionand construction of property and equipment associated with the Mid-MissouriAcquisition accounted for the increase, offset by the absence of anycapitalized transaction costs in 2005.

 

Cashflows from financing activities for the first six months of 2005 reflected thechange in equity and debt structure of the company associated with our initialpublic offering.  The company distributed$3.4 million in cash dividends to stockholders in the first six months of 2005compared to $3.8 million for repayment of long-term notes payable in the firstsix months of 2004, accounting for the change between periods.

 

Weanticipate that operating cash flow, together with borrowings under our creditfacility, will be adequate to meet our currently anticipated operating andcapital expenditure requirements for at least the next 12 months.

 

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**Item3.   *Quantitativeand Qualitative Disclosures About Market Risk***

 

Our short-term excess cash balance is invested in short-term commercialpaper.  We do not invest in anyspeculative derivative or commodity type instruments.  Accordingly, we are subject to minimal marketrisk on our investments.

 

We have the ability to borrow up to $15.0 million under a revolvingloan facility.  The interest rate isvariable and, accordingly, we are exposed to interest rate risk, primarily fromthe change in LIBOR or a base rate. Currently, we have no loans drawn under this facility.

 

**Item 4.*  Controls andProcedures***

 

With the participation of the Chief Executive Officer and the ChiefFinancial Officer, management has evaluated the effectiveness of our disclosurecontrols and procedures (as defined in Rule 13a-15(e) under theSecurities Exchange Act of 1934).  Basedon that evaluation, the Chief Executive Officer and Chief Financial Officerconcluded that our disclosure controls and procedures were effective as of June 30,2005.

 

With the completion of our initial public offering on December 21,2004, we are subject to the reporting requirements under Regulation S-K for thefirst time and anticipate being classified as an accelerated filer for the yearending December 31, 2005.

 

There were no changes in our internal control over financial reporting(as defined in Rule 13a-15(f) under the Securities Exchange Act of1934) during the first and second quarter of fiscal 2005 that materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

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**PART II   OTHERINFORMATION**

 

**Item4.  *Submissionof Matters to a Vote of Security Holders***

 

OtelcoInc. held its Annual Meeting of Stockholders on May 26, 2005. At thatmeeting, stockholders elected William Bak and Michael D. Weaver as Directors ofthe Company for a term to expire at the 2008 Annual Meeting of Stockholders.The results of the voting are as follows:

 
| ** **        | ** ** | **Votes For** | ** ** | **Votes  Withheld** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------|------------|---------------|------------|---------------------|------------|------------|------------|------------|------------|
|              |       |          |       |                |       |       |       |       |       |
| William Bak       |       | 8,267,653     |       | 42,602              |       |       |       |       |       |
| Michael D. Weaver |       | 8,198,528     |       | 111,727             |       |       |       |       |       |

 

Thefollowing directors also have terms in office that continue after the AnnualMeeting of Stockholders: Howard Haug, John P. Kunz, Stephen P. McCall, AndrewMeyers, and William F. Reddersen.

 

Inaddition, stockholders ratified the appointment of BDO Seidman, LLP as ourIndependent Registered Public Accounting Firm for the fiscal year ending December 31,2005. The result of the voting is as follows:

 
| ** **                                                                    | ** ** | **Votes For** | ** ** | **Votes Against** | ** ** | **Abstain** | ** ** | **Broker Non-Vote** | ** ** |
|-------------------------------------------------------------------------------|------------|---------------|------------|-------------------|------------|-------------|------------|---------------------|------------|
|                                                                          |       |          |       |              |       |        |       |                |       |
| Ratification of appointment of independent  registered public accounting firm |       | 8,278,701     |       | 7,468             |       | 24,086      |       | 0                   |       |

 

**Item.6.  *Exhibits***

 

Exhibits

 

SeeExhibit Index.

 

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**Signatures**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 
| Date:  August 10, 2005 | **OTELCO  INC.** |
|-----------------------------|------------------|
|                        |             |
|                        |             |
|                        | By:              | /s/  Michael D. Weaver |
|                        |             | Michael  D. Weaver |
|                        |             | President  and Chief Executive Officer |
|                        |             |
|                        |             |
| Date:  August 10, 2005 |             |
|                        |             |
|                        |             |
|                        | By:              | /s/  Curtis L. Garner, Jr. |
|                        |             | Curtis  L. Garner, Jr. |
|                        |             | Chief  Financial Officer |

 

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**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                  |
|----------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |                                                                                                                                                             |
| 10.4                 |       | Long-term Incentive Compensation Plan approved May 12, 2005                                                                                                 |
|                 |       |                                                                                                                                                             |
| 31.1                 |       | Certificate pursuant to Rule 13A-14(a) or Rule 15d-14(a) of  the Securities Exchange Act of 1934 of the Chief Executive Officer              |
|                 |       |                                                                                                                                                             |
| 31.2                 |       | Certificate pursuant to Rule 13A-14(a) or Rule 15d-14(a) of  the Securities Exchange Act of 1934 of the Chief Financial Officer              |
|                 |       |                                                                                                                                                             |
| 32.1                 |       | Certificate pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of the Chief  Executive Officer |
|                 |       |                                                                                                                                                             |
| 32.2                 |       | Certificate pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of the Chief  Financial Officer |

 

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