**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-Q**





(Mark
                One)x
            QUARTERLY
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934For
                the quarterly period ended September 30, 2008Or ̈
            TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934For
                the transition period from to




Commission
      File Number: 1-32362




**OTELCO
      INC.**


(Exact
      name of registrant as specified in its charter)





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




(205)
      625-3574


(Registrant’s
      telephone number, including area code)




N/A


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




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




Yes
x No ̈




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




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




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




Yes  ̈ No x




**APPLICABLE
      ONLY TO CORPORATE ISSUERS:**




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




**Class**
            
            **Outstanding at November 6, 2008**Class
                A Common Stock ($0.01 par value per share)
            
            
            12,676,733Class
                B Common Stock ($0.01 par value per share)
            
            
            544,671









**OTELCO
      INC.**


**FORM
      10-Q**


**For
      the three month period ended September 30, 200** **8**


**TABLE
      OF CONTENTS**


**Page****PART
                  I FINANCIAL INFORMATION**Item
                  1.
              Condensed
                  Financial Statements
              
              2Consolidated
                  Balance Sheets as of December 31, 2007 and September 30,
                  2008
              
              2Consolidated
                  Statements of Operations for the Three Months and Nine Months Ended
                  September 30, 2007 and 2008
              
              3Consolidated
                  Statements of Cash Flows for the Nine Months Ended September 30,
                  2007 and
                  2008
              
              4Notes
                  to Consolidated Financial Statements
              
              5Item
                  2.
              Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              
              15Item
                  3.
              Quantitative
                  and Qualitative Disclosures about Market Risk
              
              25Item
                  4.
              Controls
                  and Procedures
              
              25**PART
                  II OTHER INFORMATION**Item
                  6.
              Exhibits
              
              25




i




*Unless
      the context otherwise requires, the words “we,” “us,” “our,” “the
      Company* *”
and
      “Otelco” refer to Otelco Inc., a Delaware corporation, and its consolidated
      subsidiaries as of September 30, 2008.*




**FORWARD-LOOKING
      STATEMENTS**




This
      report contains forward-looking statements that are subject to risks and
      uncertainties. Forward-looking statements give our current expectations relating
      to our financial condition, results of operations, plans, objectives, future
      performance and business. These statements may include words such as
“anticipate,” “estimate,” “expect,” “project,” “plan,” “intend,” “believe” and
      other words and terms of similar meaning in connection with any discussion
      of
      the timing or nature of future operating or financial performance or other
      events. These forward-looking statements are based on assumptions that we have
      made in light of our experience in the industry in which we operate, as well
      as
      our perceptions of historical trends, current conditions, expected future
      developments and other factors we believe are appropriate under the
      circumstances. Although we believe that these forward-looking statements are
      based on reasonable assumptions, you should be aware that many factors could
      affect our actual financial condition or results of operations and cause actual
      results to differ materially from those in the forward-looking
      statements.




1




**PART
      I  FINANCIAL INFORMATION**




**Item
      1. Financial Statements**




**OTELCO
        INC.**
 **CONSOLIDATED
        BALANCE SHEETS**




**December 31,**
              **2007**
            
            **September 30,**
              **2008******
            
            
            
            **(unaudited)****Assets**Current
                assetsCash
                and cash equivalents
            
            $
            12,810,497
            
            $
            13,160,898Accounts
                receivable:Due
                from subscribers, net of allowance for doubtful accounts of $257,862
                and
                $165,078, respectively
            
            
            2,753,451
            
            
            2,899,519Unbilled
                receivables
            
            
            2,616,867
            
            
            2,649,775Other
            
            
            1,760,207
            
            
            1,934,355Materials
                and supplies
            
            
            1,991,724
            
            
            2,259,937Prepaid
                expenses
            
            
            1,149,180
            
            
            548,079Income
                tax receivable
            
            
            469,546
            
            
            214,440Deferred
                income taxes
            
            
            1,486,439
            
            
            1,486,439Total
                current assets
            
            
            25,037,911
            
            
            25,153,442Property
                and equipment, net
            
            
            54,610,355
            
            
            52,786,133Goodwill
            
            
            134,570,435
            
            
            134,570,435Intangible
                assets, net
            
            
            9,514,772
            
            
            8,462,790Investments
            
            
            1,207,183
            
            
            1,188,051Deferred
                financing costs
            
            
            5,878,943
            
            
            4,760,463Interest
                rate cap
            
            
            1,510,951
            
            
            479,152Deferred
                charges
            
            
            155,573
            
            
            650,228Total
                assets
            
            $
            232,486,123
            
            $
            228,050,694**Liabilities
                and Stockholders’ Equity**Current
                liabilitiesAccounts
                payable
            
            $
            2,058,989
            
            $
            1,867,564Accrued
                expenses
            
            
            3,716,880
            
            
            5,210,931Advance
                billings and payments
            
            
            2,077,713
            
            
            1,944,115Customer
                deposits
            
            
            185,147
            
            
            194,531Total
                current liabilities
            
            
            8,038,729
            
            
            9,217,141Deferred
                income taxes
            
            
            25,223,656
            
            
            25,223,656Advance
                billings and payments
            
            
            797,498
            
            
            750,081Other
                liabilities
            
            
            183,756
            
            
            179,911Long-term
                notes payable
            
            
            170,019,705
            
            
            169,965,588Total
                liabilities
            
            
            204,263,344
            
            
            205,336,377Derivative
                liability
            
            
            814,005
            
            
            516,112Class
                B common convertible to senior subordinated notes
            
            
            4,085,033
            
            
            4,085,033Stockholders’
                equityClass
                A Common Stock, $.01 par value-authorized 20,000,000 shares; issued
                and
                outstanding 12,676,733 shares
            
            
            126,767
            
            
            126,767Class
                B Common Stock, $.01 par value-authorized 800,000 shares; issued
                and
                outstanding 544,671 shares
            
            
            5,447
            
            
            5,447Additional
                paid in capital
            
            
            28,215,056
            
            
            21,512,233Retained
                deficit
            
            
            (4,084,797
            )
            
            (2,481,378
            )Accumulated
                other comprehensive loss
            
            
            (938,732
            )
            
            (1,049,897
            )Total
                stockholders’ equity
            
            
            23,323,741
            
            
            18,113,172Total
                liabilities and stockholders’ equity
            
            $
            232,486,123
            
            $
            228,050,694




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




2




**OTELCO
        INC.**
 **CONSOLIDATED
        STATEMENTS OF OPERATIONS**
 **(unaudited)**


**Three months ended**
                **September 30,**
              
              **Nine months ended**
                **September 30,****2007**
              
              **2008**
              
              **2007**
              
              **2008**RevenuesLocal
                  services
              
              $
              6,502,105
              
              $
              6,678,826
              
              $
              19,381,216
              
              $
              20,116,902Network
                  access
              
              
              6,612,250
              
              
              6,694,486
              
              
              19,190,669
              
              
              19,237,269Cable
                  television
              
              
              547,044
              
              
              601,025
              
              
              1,642,985
              
              
              1,713,457Internet
              
              
              2,867,381
              
              
              3,028,963
              
              
              8,547,085
              
              
              9,060,822Transport
                  services
              
              
              1,065,521
              
              
              1,234,274
              
              
              3,122,940
              
              
              3,637,276Total
                  revenues
              
              
              17,594,301
              
              
              18,237,574
              
              
              51,884,895
              
              
              53,765,726Operating
                  expensesCost
                  of services and products
              
              
              6,326,014
              
              
              6,654,860
              
              
              19,131,470
              
              
              20,052,583Selling,
                  general and administrative expenses
              
              
              2,676,515
              
              
              2,777,411
              
              
              7,597,843
              
              
              7,998,818Depreciation
                  and amortization
              
              
              3,474,799
              
              
              3,140,688
              
              
              10,879,513
              
              
              9,903,702Total
                  operating expenses
              
              
              12,477,328
              
              
              12,572,959
              
              
              37,608,826
              
              
              37,955,103Income
                  from operations
              
              
              5,116,973
              
              
              5,664,615
              
              
              14,276,069
              
              
              15,810,623Other
                  income (expense)Interest
                  expense
              
              
              (5,844,898
              )
              
              (4,773,647
              )
              
              (16,633,507
              )
              
              (14,229,727
              )Change
                  in fair value of derivative
              
              
              186,055
              
              
              173,842
              
              
              654,472
              
              
              99,787Other
                  income
              
              
              268,356
              
              
              188,160
              
              
              715,389
              
              
              618,785Total
                  other expense
              
              
              (5,390,487
              )
              
              (4,411,645
              )
              
              (15,263,646
              )
              
              (13,511,155
              )Income
                  (loss) before income tax expense
              
              
              (273,514
              )
              
              1,252,970
              
              
              (987,577
              )
              
              2,299,468Income
                  tax (expense) benefit
              
              
              (394,197
              )
              
              (463,727
              )
              
              97,079
              
              
              (696,049
              )Net
                  income (loss) available to common stockholders
              
              $
              (667,711
              )
              $
              789,243
              
              $
              (890,498
              )
              $
              1,603,419Weighted
                  average shares outstanding:Basic
              
              
              12,546,298
              
              
              12,676,733
              
              
              10,643,766
              
              
              12,676,733Diluted
              
              
              13,090,969
              
              
              13,221,404
              
              
              11,188,437
              
              
              13,221,404Net
                  income (loss) per shareBasic
              
              $
              (0.05
              )
              $
              0.06
              
              $
              (0.08
              )
              $
              0.13Diluted
              
              $
              (0.07
              )
              $
              0.04
              
              $
              (0.14
              )
              $
              0.10Dividends
                  declared per share
              
              $
              0.18
              
              $
              0.18
              
              $
              0.53
              
              $
              0.53





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




3


**OTELCO
        INC.**
 CONSOLIDATED
        STATEMENTS OF CASH FLOWS
 (unaudited)


**Nine
                  months ended**
                **September
                  30,****2007**
              
              **2008**Cash
                  flows from operating activities:Net
                  income (loss)
              
              $
              (890,498
              )
              $
              1,603,419Adjustments
                  to reconcile net income to cash flows from operating
                  activities:Depreciation
              
              
              8,933,812
              
              
              8,275,580Amortization
              
              
              1,945,696
              
              
              1,628,122Interest
                  rate caplet
              
              
              673,425
              
              
              722,527Amortization
                  of debt premium
              
              
              (16,533
              )
              
              (54,117
              )Amortization
                  of loan cost
              
              
              2,233,495
              
              
              1,118,481Change
                  in fair value of derivative
              
              
              (654,472
              )
              
              (99,787
              )Provision
                  for uncollectible revenue
              
              
              114,979
              
              
              229,404Gain
                  on early lease termination
              
              
              -
              
              
              (121,124
              )Changes
                  in assets and liabilities; net of assets and liabilities
                  acquired:Accounts
                  receivables
              
              
              (642,120
              )
              
              (582,528
              )Material
                  and supplies
              
              
              (117,903
              )
              
              (268,213
              )Prepaid
                  expenses and other assets
              
              
              496,527
              
              
              601,101Income
                  tax receivable
              
              
              -
              
              
              255,106Accounts
                  payable and accrued liabilities
              
              
              1,231,277
              
              
              1,302,625Advance
                  billings and payments
              
              
              (33,971
              )
              
              (181,015
              )Other
                  liabilities
              
              
              4,174
              
              
              5,539Net
                  cash from operating activities
              
              
              13,277,888
              
              
              14,435,120Cash
                  flows from investing activities:Acquisition
                  and construction of property and equipment
              
              
              (4,386,579
              )
              
              (6,848,799
              )Proceeds
                  from retirement of investment
              
              
              7,871
              
              
              -Deferred
                  charges
              
              
              (2,033
              )
              
              (533,098
              )Net
                  cash from investing activities
              
              
              (4,380,741
              )
              
              (7,381,897
              )Cash
                  flows from financing activities:Cash
                  dividends paid
              
              
              (5,645,322
              )
              
              (6,702,822
              )Direct
                  cost of subsequent public offering
              
              
              (2,307,686
              )
              
              -Repayment
                  of long-term debt
              
              
              (55,353,032
              )
              
              -Loan
                  origination costs
              
              
              (1,827,903
              )
              
              -Proceeds
                  from issuance IDS
              
              
              59,400,000
              
              
              -Net
                  cash from financing activities
              
              
              (5,733,943
              )
              
              (6,702,822
              )Net
                  increase in cash and cash equivalents
              
              
              3,163,204
              
              
              350,401Cash
                  and cash equivalents, beginning of period
              
              
              14,401,849
              
              
              12,810,497Cash
                  and cash equivalents, end of period
              
              $
              17,565,053
              
              $
              13,160,898Supplemental
                  disclosures of cash flow information:Interest
                  paid
              
              $
              13,878,086
              
              $
              12,705,214Income
                  taxes paid
              
              $
              (133,218
              )
              $
              (122,606
              )Non-cash
                  gain on early lease termination
              
              $
              -
              
              $
              (121,124
              )




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




4




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**(unaudited)**


**1.** **Organization
            and Basis of Financial Reporting**
 
 **Basis
        of Presentation and Principles of Consolidation**
 
 The
        condensed consolidated financial statements include the accounts of Otelco
        Inc.
        (the “Company”), its wholly owned subsidiaries Otelco Telecommunications LLC,
        Otelco Telephone LLC, Hopper Holding Company, Inc. (“HHC”), Brindlee Holdings
        LLC (“BH”), Page & Kiser Communications, Inc. (“PKC”), Mid-Missouri Holding
        Corporation (“MMH”), and Mid-Maine Communications, Inc. (“Mid-Maine”). HHC’s
        wholly owned subsidiary is Hopper Telecommunications Company, Inc. BH’s wholly
        owned subsidiary is Brindlee Mountain Telephone Company, Inc. PKC’s wholly owned
        subsidiary is Blountsville Telephone Company, Inc. MMH’s wholly owned subsidiary
        is Mid-Missouri Telephone Company (“MMT”). MMT is the sole stockholder of
        Imagination, Inc. Mid-Maine’s wholly owned subsidiaries are Mid-Maine Telecom,
        Inc. (“MMTI”) and Mid-Maine TelPlus (“MMTP”). The Company and its subsidiaries
        are located and conduct business in Alabama, Maine and Missouri. The
        accompanying consolidated financial statements include the accounts of the
        Company and all of the aforesaid subsidiaries after elimination of all material
        intercompany balances and transactions. The unaudited operating results for
        the
        three months and nine months ended September 30, 2008 are not necessarily
        indicative of the results that may be expected for the year ending December
        31,
        2008.
  The
        consolidated financial statements and notes included in this Form 10-Q should
        be
        read in conjunction with the consolidated financial statements and notes
        thereto
        included in the Company’s annual report on Form 10-K for the year ended December
        31, 2007. The interim consolidated financial information herein is unaudited.
        The information reflects all adjustments (which include only normal recurring
        adjustments), which are, in the opinion of management, necessary for a fair
        presentation of the financial position and results of operations for the
        periods
        included in the report. The unaudited condensed consolidated financial
        statements have been prepared in accordance with the rules and regulations
        of
        the SEC applicable to interim financial information. Certain information
        and
        note disclosures included in financial statements prepared in accordance
        with
        generally accepted accounting principles in the United States of America
        (“GAAP”) have been omitted in these interim statements, as allowed by such SEC
        rules and regulations. The condensed consolidated balance sheet as of December
        31, 2007, has been derived from audited financial statements, but it does
        not
        include all disclosures required by GAAP. However, we believe the disclosures
        are adequate to make the information presented not misleading.
  Certain
        prior year amounts have been reclassified to conform with the current year
        presentation.
  **Recent
        Accounting Pronouncements**
 
 Effective
        January 1, 2008, the Company adopted SFAS No. 157, *“Fair
        Value Measurements”* (“SFAS
        157”). In February 2008, the Financial Accounting Standards Board (“FASB”)
        issued staff position (FSP) No. FAS 157-2, *“Effective
        Date of FASB Statement No. 157,”* which
        delays the effective date of SFAS 157 for one year for all non-financial
        assets
        and liabilities except those recognized or disclosed on a recurring basis.
        Therefore, the Company has adopted the provisions of SFAS 157 with respect
        to
        its financial assets and liabilities only. SFAS 157 defines fair value,
        establishes a framework for measuring fair value and expands disclosure about
        fair value measurements. Valuation techniques used to measure fair value
        under
        SFAS 157 must maximize the use of observable inputs. The standard describes
        a
        fair value hierarchy utilizing three levels of input. The first two levels
        are
        considered observable and the third, unobservable:
 
 Level
        1 –
Quoted prices in active markets for identical assets or
        liabilities.
  5
  Level
        2 –
Inputs other than Level 1 that are directly or indirectly observable, such
        as
        quoted prices for similar assets or liabilities or quoted prices in markets
        which are not active. The inputs are generally observable or can be corroborated
        in observable markets.
 Level
        3 –
Unobservable inputs where there is little or no market activity to support
        valuation.
 
 The
        adoption of SFAS 157 did not have a material impact on our consolidated
        financial statements.
 
 In
        October 2008, the FASB issued FSP 157-3, *“Determining
        the Fair Value of a Financial Asset when the Market for that Asset is not
        Active”* (“FSP
        157-3”). FSP 157-3 clarifies the application of SFAS 157 in a market that
        is not active and provides an example to illustrate key considerations in
        determining the fair value of a financial asset when the market for that
        financial asset is not active. FSP 157-3 was effective upon issuance, including
        prior periods for which financial statements have not been issued. The adoption
        of FSP 157-3 had no impact on our financial statements.
 
 In
        February 2007, the FASB issued SFAS No. 159, ** “ *The
        Fair Value Option for Financial Assets and Financial Liabilities – Including an
        Amendment of FASB Statement No. 115”* (“SFAS
        159”). Under SFAS 159, a company may elect to measure many eligible financial
        instruments and certain other items at fair value that are not currently
        required to be measured at fair value. The Company did not elect to adopt
        the
        fair value option under SFAS 159.
 
 In
        March
        2008, the FASB issued SFAS No. 161, *“Disclosures
        about Derivative Instruments and Hedging Activities – an amendment of FASB
        Statement No. 133”* (“SFAS
        161”). SFAS 161 expands quarterly disclosure requirements in SFAS No. 133, *“Accounting
        for Derivative Instruments and Hedging Activities,”* about an
        entity’s derivative instruments and hedging activities. SFAS 161 is effective
        for fiscal years beginning after November 15, 2008. The implementation of
        this
        standard will not have a material impact on our consolidated financial position
        and results of operations.
 
 In
        April
        2008, the FASB issued FSP 142-3, *“Determination
        of the Useful Life of Intangible Assets”* (“FSP
        142-3”). FSP 142-3 amends the factors that should be considered in developing
        renewal or extension assumptions used to determine the useful life of a
        recognized intangible asset under SFAS No. 142, *“Goodwill
        and Other Intangible Assets,”* and
        replaces it with a requirement that an entity consider its own historical
        experience in renewing similar arrangements, or a consideration of market
        participant assumptions in the absence of historical experience. FSP 142-3
        also
        requires entities to disclose information that enables users of financial
        statements to assess the extent to which the expected future cash flows
        associated with the asset are affected by the entity’s intent and/or ability to
        renew or extend the arrangement. We are required to adopt FSP 142-3 effective
        January 1, 2009 on a prospective basis. FSP 142-3 is effective for fiscal
        years
        beginning after December 15, 2008. The Company is currently assessing the
        impact
        of FSP 142-3 on its consolidated financial position and results of
        operations.
 
 In
        December 2007, the FASB issued SFAS No. 141(R), *“Business
        Combinations (Revised)”* (“SFAS
        141(R)”), to replace SFAS No. 141, *“Business
        Combinations.”* SFAS
        141(R) requires the use of the acquisition method of accounting, defined
        the
        acquirer, established the acquisition date and broadens the scope to all
        transactions and other events in which one entity obtains control over one
        or
        more other businesses. SFAS 141(R) is effective for business combinations
        or
        transactions entered into for fiscal years beginning on or after December
        15,
        2008. The impact of the adoption of SFAS 141(R) will depend on the nature
        and
        significance of business combinations the Company enters into subsequent
        to
        adoption.
 
 In
        May
        2008, the FASB issued SFAS No. 162, *“The
        Hierarchy of Generally Accepted Accounting Principles”* (“SFAS
        162”). SFAS 162 identifies the sources of accounting principles and the
        framework for selecting the principles used in the preparation of financial
        statements. SFAS 162 is effective 60 days following the Securities and Exchange
        Commission’s approval of the Public Company Accounting Oversight Board
        amendments to AU Section 411, *“The
        Meaning of Present Fairly in Conformity with Generally Accepted Accounting
        Principles.”* The
        implementation of this standard will not have a material impact on our
        consolidated financial position and results of operations.
  6
  In
        June
        2008, the FASB ratified EITF Issue No. 07-5, *“Determining
        Whether an Instrument (or an Embedded Feature) Is Indexed to an Entity’s Own
        Stock”* (“EITF
        07-5”). EITF 07-5 provides that an entity should use a two step approach to
        evaluate whether an equity-linked financial instrument (or embedded feature)
        is
        indexed to its own stock, including evaluating the instrument’s contingent
        exercise and settlement provisions. It also clarifies on the impact of foreign
        currency denominated strike prices and market-based employee stock option
        valuation instruments on the evaluation. EITF 07-5 is effective for fiscal
        years
        beginning after December 15, 2008. The Company is currently assessing the
        impact
        of EITF 07-5 on its consolidated financial position and results of
        operations.
  In
        June
        2008, the FASB ratified EITF Issue No. 08-3, *“Accounting
        for Lessees for Maintenance Deposits Under Lease Arrangements”* (“EITF
        08-3”). EITF 08-3 provides guidance for accounting for nonrefundable maintenance
        deposits. It also provides revenue recognition accounting guidance for the
        lessor. EITF 08-3 is effective for fiscal years beginning after December
        15,
        2008. The Company is currently assessing the impact of EITF 08-3 on its
        consolidated financial position and results of operations.
 
 **2.** **Commitment
          and Contingencies**
 From
        time
        to time, we may be involved in various claims, legal actions and regulatory
        proceedings incidental to and in the ordinary course of business, including
        administrative hearings of the Alabama, Maine and Missouri Public Service
        Commissions related primarily to rate making. Currently, none of the legal
        proceedings are expected to have a material adverse effect on our
        business.




**3.** **Derivative
            and Hedge Activities**
 An
        interest rate cap was purchased on December 21, 2004, coincident with the
        closing of our initial public offering and the recapitalization of our senior
        notes payable. The interest rate cap was purchased to mitigate the risk of
        rising interest rates to limit or cap the rate at 3% plus the applicable
        margin
        on $80 million in senior debt for five years. On July 5, 2007, the Company
        repaid $55,353,032 in debt, reducing its senior debt below the level of the
        rate
        cap. The cap is considered an effective hedge for the remaining senior debt
        as
        all critical terms of the interest rate cap are identical to the underlying
        debt
        it hedges. The balance of the cap is no longer considered an effective hedge
        but
        is considered an investment.
 
 Changes
        in the fair value of the effective portion of the interest rate cap are not
        included in earnings but are reported as a component of accumulated other
        comprehensive income (loss). For the three months ended September 30, 2007
        and
        2008, the change in the fair value of the effective portion of the interest
        rate
        cap was $(1,197,248) and $(135,463), respectively. For the nine months ended
        September 30, 2007 and 2008, the change in the fair value of the effective
        portion of the interest rate cap was $(965,842) and $111,165, respectively.
 
 The
        cost
        of the effective portion of the interest rate cap is expensed as interest
        over
        the effective life of the hedge in accordance with the quarterly value of
        the
        caplets as determined at the date of inception. The expense related to the
        ineffective portion of the interest rate cap is reflected in the change in
        fair
        value of derivative. For the three months ended September 30, 2007 and 2008,
        the
        cost of the effective portion of the interest rate cap was $254,494 and
        $252,507, respectively. For the nine months ended September 30, 2007 and
        2008,
        the cost of the effective portion of the interest rate cap was $722,288 and
        $722,529, respectively.
 
 **4.** **Income
            (Loss) per Common Share and Potential Common Share**
 Basic
        income (loss) per common share is computed by dividing net income (loss)
        by the
        weighted-average number of shares outstanding for the period. Diluted income
        (loss) per common share reflects the potential dilution that could occur
        if the
        Class B common stock were exercised into Income Deposit Securities (“IDS”)
        units. Class B common stock is convertible on a one-for-one basis into IDS
        units, each of which includes a Class A common share.
  7
  A
        reconciliation of the common shares and net income (loss) for the Company’s
        basic and diluted income (loss) per common share calculation is as
        follows:


Three months ended
                September 30,
              
              Nine months ended
                September 30,2007
              
              2008
              
              2007
              
              2008Weighted
                  average common shares-basic
              
              
              12,546,298
              
              
              12,676,733
              
              
              10,643,766
              
              
              12,676,733Effect
                  of dilutive securities
              
              
              544,671
              
              
              544,671
              
              
              544,671
              
              
              544,671Weighted-average
                  common shares and potential common shares-diluted
              
              
              13,090,969
              
              
              13,221,404
              
              
              11,188,437
              
              
              13,221,404Net
                  income (loss) available to common stockholders
              
              $
              (667,711
              )
              $
              789,243
              
              $
              (890,498
              )
              $
              1,603,419Net
                  income (loss) per basic share
              
              $
              (0.05
              )
              $
              0.06
              
              $
              (0.08
              )
              $
              0.13Net
                  income (loss) available to common stockholders
              
              $
              (667,711
              )
              $
              789,243
              
              $
              (890,498
              )
              $
              1,603,419Less:
                  Change in fair value of B share derivative
              
              
              (186,055
              )
              
              (201,655
              )
              
              (654,472
              )
              
              (297,893
              )Net
                  income (loss) available for diluted shares
              
              $
              (853,766
              )
              $
              587,588
              
              $
              (1,544,970
              )
              $
              1,305,526Net
                  income (loss) per diluted share
              
              $
              (0.07
              )
              $
              0.04
              
              $
              (0.14
              )
              $
              0.10




**5.**  **Fair
      Value Measurements**




Financial
      assets and liabilities are classified in their entirety based on the lowest
      level of input that is significant to the fair value measurements. Our
      assessment of the significance of a particular input to the fair value
      measurements requires judgment, and may affect the valuation of the assets
      and
      liabilities being measured and their placement within the fair value hierarchy.





In
      accordance with SFAS 157, the following table represents the Company’s fair
      value hierarchy for its financial assets and liabilities as of September 30,
      2008:




**September
                30, 2008****Fair
                Value**
            
            **Level
                1(1)**
            
            **Level
                2(2)**
            
            **Level
                3(3)****Assets**Cash
                and cash equivalents
            
            $
            13,160,898
            
            $
            13,160,898
            
            $
            -
            
            $
            -Interest
                rate cap
            
            
            479,152
            
            
            -
            
            
            479,152
            
            
            -Co-operative
                patronage shares
            
            
            707,501
            
            
            -
            
            
            -
            
            
            707,501Total
                assets
            
            
            14,347,551
            
            
            13,160,898
            
            
            479,152
            
            
            707,501**Liabilities**Class
                B derivative liability
            
            
            516,112
            
            
            -
            
            
            -
            
            
            516,112Total
                liabilities
            
            $
            516,112
            
            $
            -
            
            $
            -
            
            $
            516,112




(1)
      Quoted prices in active markets for identical assets.


(2)
      Significant other observable inputs.


(3)
      Significant unobservable inputs.





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




8




The
      Class
      B derivative is valued at the end of each quarter utilizing current observable
      factors and a market based model developed by a company whose business includes
      the provision of valuation expertise. Annually, the Company evaluates the
      probability of its Class B shares converting to IDS units in advance of their
      unrestricted December 2009 conversion date. This estimate, as well as current
      market conditions, impacts the quarterly valuation of the B share derivative
      liability. This liability is extinguished once the Class B shares can be
      converted into IDS units. This conversion can occur without any financial tests
      after 2009.




**6.**  **Subsequent
      Events**




On
      October 31, 2008, the Company closed the acquisition of three subsidiaries
      of
      Country Road Communications LLC (“Country Road”) - Pine Tree Holdings, Inc.
      (Portland, ME), Granby Holdings, Inc. (Granby, MA) and War Holdings, Inc. (War,
      WV). The purchase price was $101.3 million, subject to adjustment as provided
      in
      the Stock Purchase Agreement, dated as of August 7, 2008, between the
      Company and Country Road. The purchase price was financed with borrowings under
      the Company’s second amended and restated credit agreement, dated as of October
      20, 2008, among the Company and the other credit parties thereto, General
      Electric Capital Corporation, as a lender and as an agent for the lenders,
      and
      the other lenders from time to time party thereto.




The
      credit facilities under the second amended and restated credit agreement are
      comprised of:




·
            term
                loans of $173,500,000, consisting of $64,646,968 that remained outstanding
                under the existing credit agreement, and an additional term loan
                of
                $108,853,032; and


·
            the
                continuation of a revolving loan commitment in an amount of up to
                $15,000,000.





The
      full
      amount of the term loan is due in a single payment on October 31, 2013. Interest
      is paid quarterly and is based on a variable margin of between 2.5% and 3.25%
      plus an index rate or between 3.5% and 4.25% plus LIBOR. At closing, the margin
      was 3% or 4%, respectively.





**7.**  **Subsidiary
      Guarantees**




The
      Company has no independent assets or operations separate from its operating
      subsidiaries. The guarantees of its senior subordinated notes by five of its
      seven operating subsidiaries are full and unconditional, joint and several.
      The
      operating subsidiaries have no independent long-term notes payable. There are
      no
      significant restrictions on the ability of the Company to obtain funds from
      its
      operating subsidiaries by dividend or loan. The condensed consolidated financial
      information is provided for the guarantor entities.




The
      following tables present condensed consolidating balance sheets as of September
      30, 2008 and December 31, 2007; condensed consolidating statements of operations
      for the three months ended September 30, 2008 and 2007; condensed consolidating
      statements of operations for the nine months ended September 30, 2008 and 2007;
      and condensed consolidating statements of cash flows for the nine months ended
      September 30, 2008 and 2007.




9




**Otelco
        Inc.**
 **Condensed
        Consolidating Balance Sheet**
 **September
        30, 2008**
 Guarantor
                
                Non-GuarantorParent
                
                Subsidiaries
                
                Subsidiaries
                
                Eliminations
                
                ConsolidatedASSETSCurrent
                    assetsCash
                    and cash equivalents
                
                $
                -
                
                $
                13,120,472
                
                $
                40,426
                
                $
                -
                
                $
                13,160,898Accounts
                    receivable, net
                
                
                2,634
                
                
                6,252,383
                
                
                1,228,632
                
                
                -
                
                
                7,483,649Materials
                    and supplies
                
                
                -
                
                
                976,307
                
                
                1,283,630
                
                
                -
                
                
                2,259,937Prepaid
                    and other current assets
                
                
                31,895
                
                
                477,508
                
                
                38,676
                
                
                -
                
                
                548,079Income
                    tax receivables
                
                
                214,440
                
                
                -
                
                
                -
                
                
                -
                
                
                214,440Deferred
                    income taxes
                
                
                1,486,439
                
                
                -
                
                
                -
                
                
                -
                
                
                1,486,439Investment
                    in subsidiaries
                
                
                99,741,050
                
                
                -
                
                
                -
                
                
                (99,741,050
                )
                
                -Intercompany
                    receivables
                
                
                52,836,939
                
                
                -
                
                
                -
                
                
                (52,836,939
                )
                
                -Total
                    current assets
                
                
                154,313,397
                
                
                20,826,670
                
                
                2,591,364
                
                
                (152,577,989
                )
                
                25,153,442Property
                    and equipment, net
                
                
                -
                
                
                39,359,517
                
                
                13,426,616
                
                
                -
                
                
                52,786,133Goodwill
                
                
                -
                
                
                136,507,075
                
                
                (1,936,640
                )
                
                -
                
                
                134,570,435Intangibles
                    assets, net
                
                
                -
                
                
                5,296,143
                
                
                3,166,647
                
                
                -
                
                
                8,462,790Investments
                
                
                1,000
                
                
                861,691
                
                
                325,360
                
                
                -
                
                
                1,188,051Other
                    long-term assets
                
                
                6,379,674
                
                
                (489,831
                )
                
                -
                
                
                -
                
                
                5,889,843Total
                    assets
                
                $
                160,694,071
                
                $
                202,361,265
                
                $
                17,573,347
                
                $
                (152,577,989
                )
                $
                228,050,694LIABILITIES
                    AND STOCKHOLDERS' EQUITYCurrent
                    liabilitiesAccounts
                    payables and accrued expenses
                
                $
                2,880,313
                
                $
                2,790,318
                
                $
                1,407,864
                
                $
                -
                
                $
                7,078,495Intercompany
                    payables
                
                
                -
                
                
                44,507,723
                
                
                8,329,216
                
                
                (52,836,939
                )
                
                -Other
                    current liabilities
                
                
                -
                
                
                2,051,859
                
                
                86,787
                
                
                -
                
                
                2,138,646Total
                    current liabilities
                
                
                2,880,313
                
                
                49,349,900
                
                
                9,823,867
                
                
                (52,836,939
                )
                
                9,217,141Deferred
                    income taxes
                
                
                5,397,329
                
                
                15,241,738
                
                
                4,584,589
                
                
                -
                
                
                25,223,656Other
                    liabilities
                
                
                -
                
                
                929,992
                
                
                -
                
                
                -
                
                
                929,992Long-term
                    notes payables
                
                
                129,702,112
                
                
                40,263,476
                
                
                -
                
                
                -
                
                
                169,965,588Derivative
                    liability
                
                
                516,112
                
                
                -
                
                
                -
                
                
                -
                
                
                516,112Class
                    B common convertible to senior subordinated notes
                
                
                4,085,033
                
                
                -
                
                
                -
                
                
                -
                
                
                4,085,033Stockholders'
                    equity
                
                
                18,113,172
                
                
                96,576,159
                
                
                3,164,891
                
                
                (99,741,050
                )
                
                18,113,172Total
                    liabilities and stockholders' equity
                
                $
                160,694,071
                
                $
                202,361,265
                
                $
                17,573,347
                
                $
                (152,577,989
                )
                $
                228,050,694


10




**Otelco
        Inc.**
 **Condensed
        Consolidating Balance Sheet**
 **December
        31, 2007**


Guarantor
              
              Non-GuarantorParent
              
              Subsidiaries
              
              Subsidiaries
              
              Eliminations
              
              ConsolidatedASSETSCurrent
                  assetsCash
                  and cash equivalents
              
              $
              -
              
              $
              12,707,674
              
              $
              102,823
              
              $
              -
              
              $
              12,810,497Accounts
                  receivable, net
              
              
              29,305
              
              
              5,976,939
              
              
              1,124,281
              
              
              -
              
              
              7,130,525Materials
                  and supplies
              
              
              -
              
              
              860,363
              
              
              1,131,361
              
              
              -
              
              
              1,991,724Prepaid
                  and other current assets
              
              
              3,192
              
              
              965,322
              
              
              180,666
              
              
              -
              
              
              1,149,180Income
                  tax receivables
              
              
              469,546
              
              
              -
              
              
              -
              
              
              -
              
              
              469,546Deferred
                  income taxes
              
              
              1,486,439
              
              
              -
              
              
              -
              
              
              -
              
              
              1,486,439Investment
                  in subsidiaries
              
              
              84,166,351
              
              
              -
              
              
              -
              
              
              (84,166,351
              )
              
              -Intercompany
                  receivables
              
              
              70,984,187
              
              
              -
              
              
              -
              
              
              (70,984,187
              )
              
              -Total
                  current assets
              
              
              157,139,020
              
              
              20,510,298
              
              
              2,539,131
              
              
              (155,150,538
              )
              
              25,037,911Property
                  and equipment, net
              
              
              -
              
              
              39,117,969
              
              
              15,492,386
              
              
              -
              
              
              54,610,355Goodwill
              
              
              -
              
              
              136,507,075
              
              
              (1,936,640
              )
              
              -
              
              
              134,570,435Intangibles
                  assets, net
              
              
              -
              
              
              6,161,852
              
              
              3,352,920
              
              
              -
              
              
              9,514,772Investments
              
              
              1,000
              
              
              880,823
              
              
              325,360
              
              
              -
              
              
              1,207,183Other
                  long-term assets
              
              
              8,052,863
              
              
              (507,396
              )
              
              -
              
              
              -
              
              
              7,545,467Total
                  assets
              
              $
              165,192,883
              
              $
              202,670,621
              
              $
              1
                  9,773,157
              
              $
              (155,150,538
              )
              $
              232,486,123LIABILITIES
                  AND STOCKHOLDERS' EQUITYCurrent
                  liabilitiesAccounts
                  payables and accrued expenses
              
              $
              1,816,546
              
              $
              2,611,265
              
              $
              1,348,058
              
              $
              -
              
              $
              5,775,869Intercompany
                  payables
              
              
              -
              
              
              58,381,147
              
              
              12,603,040
              
              
              (70,984,187
              )
              
              -Other
                  current liabilities
              
              
              -
              
              
              2,183,424
              
              
              79,436
              
              
              -
              
              
              2,262,860Total
                  current liabilities
              
              
              1,816,546
              
              
              63,175,836
              
              
              14,030,534
              
              
              (70,984,187
              )
              
              8,038,729Deferred
                  income taxes
              
              
              5,397,329
              
              
              15,241,738
              
              
              4,584,589
              
              
              -
              
              
              25,223,656Other
                  liabilities
              
              
              -
              
              
              981,254
              
              
              -
              
              
              -
              
              
              981,254Long-term
                  notes payables
              
              
              129,756,229
              
              
              40,263,476
              
              
              -
              
              
              -
              
              
              170,019,705Derivative
                  liability
              
              
              814,005
              
              
              -
              
              
              -
              
              
              -
              
              
              814,005Class
                  B common convertible to senior subordinated notes
              
              
              4,085,033
              
              
              -
              
              
              -
              
              
              -
              
              
              4,085,033Stockholders'
                  equity
              
              
              23,323,741
              
              
              83,008,317
              
              
              1,158,034
              
              
              (84,166,351
              )
              
              23,323,741Total
                  liabilities and stockholders' equity
              
              $
              165,192,883
              
              $
              202,670,621
              
              $
              1
                  9,773,157
              
              $
              (155,150,538
              )
              $
              232,486,123




11


**Otelco
        Inc.**
 **Condensed
        Consolidating**
 **Statement
        of Operations**
 **For
        the Three Months Ended**
 **September
        30, 2008**


****
              Guarantor
              
              Non-Guarantor
              ****
              ****
              ****
              ****
              ********
              ****
              Parent
              ****
              Subsidiaries
              
              Subsidiaries
              ****
              Eliminations
              
              Consolidated
              ********
              ****
              ****
              ****
              ****
              ****
              ****
              ****
              ****
              ****
              ****
              ****Revenue
              
              $
              813,891
              
              $
              16,533,991
              
              $
              3,250,425
              
              $
              (2,360,733
              )
              $
              18,237,574Operating
                  expenses
              
              
              (813,891
              )
              
              (11,711,478
              )
              
              (2,408,323
              )
              
              2,360,733
              
              
              (12,572,959
              )Income
                  from operations
              
              
              -
              
              
              4,822,513
              
              
              842,102
              
              
              -
              
              
              5,664,615Other
                  income (expense)
              
              
              (4,410,341
              )
              
              (1,253
              )
              
              (51
              )
              
              -
              
              
              (4,411,645
              )Earnings
                  from subsidiaries
              
              
              5,663,311
              
              
              -
              
              
              -
              
              
              (5,663,311
              )
              
              -Income
                  before income tax
              
              
              1,252,970
              
              
              4,821,260
              
              
              842,051
              
              
              (5,663,311
              )
              
              1,252,970Income
                  tax expense
              
              
              (463,727
              )
              
              -
              
              
              -
              
              
              -
              
              
              (463,727
              )****
              ****
              ****
              ****
              ****
              ****
              ****
              ****
              ****
              ****
              ****
              ****
              ****
              ****
              ****
              ****
              ****Net
                  income (loss) to common stockholders
              
              $
              789,243
              
              $
              4,821,260
              
              $
              842,051
              
              $
              (5,663,311
              )
              $
              789,243




**Otelco
        Inc.**
 **Condensed
        Consolidating**
 **Statement
        of Operations**
 **For
        the Three Months Ended**
 **September
        30, 2007**


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




12




**Otelco
        Inc.**
 **Condensed
        Consolidating**
 **Statement
        of Operations**
 **For
        the Nine Months Ended**
 **September
        30, 2008**


Guarantor
              
              Non-GuarantorParent
              
              Subsidiaries
              
              Subsidiaries
              
              Eliminations
              
              ConsolidatedRevenue
              
              $
              2,273,659
              
              $
              48,924,931
              
              $
              9,376,845
              
              $
              (6,809,709
              )
              $
              53,765,726Operating
                  expenses
              
              
              (2,273,659
              )
              
              (35,121,133
              )
              
              (7,370,020
              )
              
              6,809,709
              
              
              (37,955,103
              )Income
                  from operations
              
              
              -
              
              $
              3,803,798
              
              
              2,006,825
              
              
              -
              
              
              15,810,623Other
                  income (expense)
              
              
              (13,275,232
              )
              
              (235,954
              )
              
              31
              
              
              -
              
              
              (13,511,155
              )Earnings
                  from subsidiaries
              
              
              15,574,700
              
              
              -
              
              
              -
              
              
              (15,574,700
              )
              
              -Income
                  before income tax
              
              
              2,299,468
              
              
              13,567,844
              
              
              2,006,856
              
              
              (15,574,700
              )
              
              2,299,468Income
                  tax expense
              
              
              (696,049
              )
              
              -
              
              
              -
              
              
              -
              
              
              (696,049
              )Net
                  income (loss) to common stockholders
              
              $
              1,603,419
              
              $
              13,567,844
              
              $
              2,006,856
              
              $
              (15,574,700
              )
              $
              1,603,419




**Otelco
        Inc.**
 **Condensed
        Consolidating**
 **Statement
        of Operations**
 **For
        the Nine Months Ended**
 **September
        30, 2007**


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


13




**Otelco
        Inc.**
 **Condensed
        Consolidating**
 **Statement
        of Cash Flows**
 **For
        the Nine Months Ended**
 **September
        30, 2008**


Guarantor
              
              Non-GuarantorParent
              
              Subsidiaries
              
              ****Subsidiaries****
              
              Eliminations
              
              ConsolidatedCash
                  flows from operating activities:Net
                  income (loss)
              
              $
              1,603,419
              
              $
              13,567,845
              
              $
              2,006,856
              
              $
              (15,574,701
              )
              $
              1,603,419Adjustment
                  to reconcile net income (loss) to cash flows from operating
                  activities
              
              
              1,687,104
              
              
              6,984,658
              
              
              3,027,324
              
              
              -
              
              
              11,699,086Changes
                  in assets and liabilities, net of assets and liabilities
                  acquired
              
              
              19,464,090
              
              
              (13,931,795
              )
              
              (4,399,680
              )
              
              -
              
              
              1,132,615Net
                  cash provided by operating activities
              
              
              22,754,613
              
              
              6,620,708
              
              
              634,500
              
              
              (15,574,701
              )
              
              14,435,120Cash
                  flows from investing activities
              
              
              (477,090
              )
              
              (6,207,910
              )
              
              (696,897
              )
              
              -
              
              
              (7,381,897
              )Cash
                  flows from financing activities
              
              
              (22,277,523
              )
              
              -
              
              
              -
              
              
              15,574,701
              
              
              (6,702,822
              )Net
                  increase (decrease) in cash and cash equivalents
              
              
              -
              
              
              412,798
              
              
              (62,397
              )
              
              -
              
              
              350,401Cash
                  and cash equivalents, beginning of period
              
              
              -
              
              
              12,707,674
              
              
              102,823
              
              
              -
              
              
              12,810,497Cash
                  and cash equivalents, end of period
              
              $
              -
              
              $
              13,120,472
              
              $
              40,426
              
              $
              -
              
              $
              13,160,898




**Otelco
        Inc.**
 **Condensed
        Consolidating**
 **Statement
        of Cash Flow**
 **For
        the Nine Months Ended**
 **September
        30, 2007**
 Guarantor
                
                Non-GuarantorParent
                
                Subsidiaries
                
                ****Subsidiaries****
                
                Eliminations
                
                ConsolidatedCash
                    flows from operating activities:Net
                    income (loss)
                
                $
                (890,498
                )
                $
                8,685,379
                
                $
                2,016,427
                
                $
                (10,701,806
                )
                $
                (890,498
                )Adjustment
                    to reconcile net income (loss) to cash flows from operating
                    activities
                
                
                1,054,855
                
                
                8,863,229
                
                
                3,312,318
                
                
                -
                
                
                13,230,402Changes
                    in assets and liabilities, net of assets and liabilities
                    acquired
                
                
                (41,288,005
                )
                
                46,644,477
                
                
                (4,418,488
                )
                
                -
                
                
                937,984Net
                    cash provided by operating activities
                
                
                (41,123,648
                )
                
                64,193,085
                
                
                910,257
                
                
                (10,701,806
                )
                
                13,277,888Cash
                    flows from investing activities
                
                
                (121,090
                )
                
                (3,370,039
                )
                
                (889,612
                )
                
                -
                
                
                (4,380,741
                )Cash
                    flows from financing activities
                
                
                41,244,738
                
                
                (57,680,487
                )
                
                -
                
                
                10,701,806
                
                
                (5,733,943
                )Net
                    increase (decrease) in cash and cash equivalents
                
                
                -
                
                
                3,142,559
                
                
                20,645
                
                
                -
                
                
                3,163,204Cash
                    and cash equivalents, beginning of period
                
                
                -
                
                
                14,376,843
                
                
                25,006
                
                
                -
                
                
                14,401,849Cash
                    and cash equivalents, end of period
                
                $
                -
                
                $
                17,519,402
                
                $
                45,651
                
                $
                -
                
                $
                17,565,053


14




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




**Overview**




***General***




Since
      1999, we have acquired and operate six rural local exchange carriers (“RLEC”)
      providing service in eleven counties in approximately 2,390 square miles of
      north central Alabama, central Maine and central Missouri. We are the sole
      wireline telephone services provider in the rural communities we serve. We
      also
      provide competitive telecommunications services through several subsidiaries,
      including a competitive local exchange carrier (“CLEC”) in Maine. Our services
      include local and long distance telephone, network access, transport, digital
      high-speed data and dial-up Internet access, cable television and other
      telephone related services. We view, manage and evaluate the results of
      operations from the various telephony products and services as one company
      and
      therefore have one reporting segment. As of September 30, 2008, we operated
      approximately 70,088 voice and data access lines or access line
      equivalents.




Our
      core
      businesses are local and long distance telephone services and the provision
      of
      network access to other wireline and wireless carriers for calls originated
      or
      terminated on our network. Our core businesses generated approximately 73.3%
      of
      our total revenues in the third quarter of 2008. We also provide digital
      high-speed data and dial-up Internet access in all of our markets, as well
      as
      data transport and, in some markets, cable television service and satellite
      television installation.




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




***Revenue
      Sources***




We
      derive
      our revenues from five sources:




·
            *Local
                services.*We
                receive revenues from providing local exchange telephone services
                in both
                our six rural territories and on a competitive basis throughout Maine.
                These revenues include monthly subscription charges for basic service,
                calling to adjacent communities on a per minute basis, local private
                line
                services and enhanced calling features, such as voicemail, caller
                identification, call waiting and call forwarding. We receive revenues
                for
                providing long distance services to our customer. We also provide
                billing
                and collections services for other carriers under contract and receive
                revenues from directory advertising in our local communities. A growing
                portion of our subscribers take bundled service plans which contain
                multiple services, including unlimited domestic long distance calling,
                for
                a flat rate.




·
            *Network
                access services.*We
                receive revenues from charges established to compensate us for the
                origination, transport and termination of calls of long distance
                and other
                interexchange carriers. These include subscriber line charges imposed
                on
                end users and switched and special access charges paid by carriers.
                Switched access charges for long distance services within Alabama,
                Maine
                and Missouri are based on rates approved by the Alabama Public Service
                Commission (“APSC”), Maine Public Utilities Commission (“MPUC”) and
                Missouri Public Service Commission (“MPSC”), respectively. Switched and
                special access charges for interstate and international services
                are based
                on rates approved by the Federal Communications
                Commission.




·
            *Cable
                television services.*We
                offer a variety of digital cable television services to a portion
                of our
                telephone service territory in Alabama and Missouri where we are
                the
                incumbent cable provider. Our offering includes high definition,
                digital
                video recording and pay-per-view services in Alabama. We also install
                satellite television in portions of our territory and expect to expand
                our
                cable service area with the implementation of Internet Protocol Television
                services (IPTV) by the end of 2008.




15




·
            *Internet
                services.*We
                receive revenues from monthly recurring charges for digital high-speed
                Internet data access lines and their related equipment, as well as
                dial-up
                Internet services, including customers outside of our RLEC service
                territory throughout Maine and
                Missouri.




·
            *Transport
                services.*We
                receive monthly recurring revenues for the rental of fiber to transport
                data and other telecommunications services in Maine. We have increased
                the
                coverage of our fiber in Maine to cover 220
                miles.




***Voice
      and Data Access Line Trends***




The
      number of voice and data access lines served is one
      of the fundamental factors in determining revenue stability for
      telecommunications providers. Reflecting the trend in the RLEC industry, the
      number of rural voice access lines we serve has been decreasing gradually when
      normalized for territory acquisitions. This trend is expected to continue for
      the industry and our territory. Our competitive carrier voice access lines
      continue to grow as we further penetrate our chosen markets. The widespread
      adoption of unlimited calling bundles may positively impact rural customer
      churn
      over time. Our digital high-speed Internet data lines continue to grow as more
      customers utilize these services to meet both business requirements and personal
      needs. This growth will continue to reduce demand for second voice access lines
      for residential and small business customers. Our continued ability to stimulate
      data access line growth will have an important impact on our future revenues.
      Our primary strategy consists of leveraging our strong incumbent position in
      rural markets; bundling services to meet customer communications needs; and
      providing better service and support than the incumbent carrier to our
      competitive customer base.




**Year Ended December 31,**
              
              **March 31,**
              
              **June 30,**
              
              **September 30,****Key Operating Statistics**
              
              **2006**
              
              **2007**
              
              **2008**
              
              **2008**
              
              **2008**RLEC
                  access lines:Voice
                  lines
              
              
              37,736
              
              
              36,687
              
              
              36,239
              
              
              35,989
              
              
              35,600Data
                  lines
              
              
              10,016
              
              
              12,160
              
              
              12,729
              
              
              13,065
              
              
              13,395RLEC
                  access line equivalents (1)
              
              
              47,752
              
              
              48,847
              
              
              48,968
              
              
              49,054
              
              
              48,995CLEC
                  access lines:Voice
                  lines
              
              
              14,267
              
              
              16,973
              
              
              17,457
              
              
              17,740
              
              
              18,229Data
                  lines
              
              
              2,016
              
              
              2,571
              
              
              2,602
              
              
              2,735
              
              
              2,864CLEC
                  access line equivalents (1)
              
              
              16,283
              
              
              19,544
              
              
              20,059
              
              
              20,475
              
              
              21,093Otelco
                        access line equivalents(1)
              
              
              64,035
              
              
              68,391
              
              
              69,027
              
              
              69,529
              
              
              70,088Cable
                  television customers
              
              
              4,188
              
              
              4,169
              
              
              4,175
              
              
              4,109
              
              
              4,115Dial-up
                  Internet customers
              
              
              19,587
              
              
              15,249
              
              
              14,290
              
              
              13,419
              
              
              12,537


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




In
      our
      RLEC territories, access line equivalents decreased by 59 during third quarter
      2008, or 0.1%, compared to June 30, 2008. Voice access lines declined 1.1%
      while
      data access lines increased 2.5% during the period. Our rural customer base
      is
      approximately 74%, 80% and 88% residential in Alabama, Missouri, and Maine,
      respectively. We offer bundled service packages including unlimited domestic
      calling to our Alabama residential and all Missouri customers. As of September
      30, 2008, over 9,500 customers participate in one of these packages or
      approximately 41% of those eligible to participate.




In
      our
      Maine CLEC operations, access line equivalents increased by 618 during third
      quarter 2008, or 3.0%, compared to June 30, 2008. Voice access lines increased
      2.8% while data access lines increased 4.7% during the period. Virtually all
      of
      our competitive customers are businesses, with service bundles tailored to
      their
      specific business requirements.




16




Competitive
      pricing and bundling of services have led Otelco’s long distance service to be
      the choice of over 50% of the long distance customers in each rural market
      we
      serve. Over 90% of our Maine CLEC customers have selected us as their long
      distance carrier. Our cable television customers increased slightly from
      June 30, 2008 to 4,115 as of September 30, 2008. Included in this number
      are 162 customers who have upgraded to our digital high definition offer.
      Dial-up Internet customers decreased 6.6% to 12,537 on September 30, 2008 compared to June 30,
      2008. This also includes the subscribers we service outside of our telephone
      service area throughout Missouri and Maine, reflecting the shift to digital
      high-speed Internet services.




***Our
      Rate and Pricing Structure***




Our
      Alabama rural companies are regulated under the Alabama Communications Reform
      Act of 2005 (“ACRA”). Regulation under ACRA eliminates the APSC’s jurisdiction
      over retail telephone rates and service terms, with the exception of limited
      authority to enforce a statutory cap on certain non-bundled basic residential
      and business service and optional calling features. Our Missouri rural company
      operates as a traditional rate of return company. Its rates, set in 1999 by
      the
      MPSC, were reviewed in 2002 and remain in effect for local and exchange access
      services. Missouri is initiating a review of their state access charges. No
      proposal has yet been formalized. In Maine, the Company’s rural entity is
      regulated by the MPUC as a traditional rate of return company. The competitive
      entities have market pricing flexibility.




**Categories
      of Operating Expenses**




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




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




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




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




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




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




17




***Results
      of Operations***




The
      following table sets forth our results of operations as a percentage of total
      revenues for the periods indicated.




**Three Months Ended September 30,**
            
            **Nine Months Ended September 30,****2007**
            
            **2008**
            
            **2007**
            
            **2008**RevenuesLocal
                services
            
            
            36.9
            %
            
            36.7
            %
            
            37.3
            %
            
            37.4
            %Network
                access
            
            
            37.6
            
            
            36.6
            
            
            37.0
            
            
            35.8Cable
                television
            
            
            3.1
            
            
            3.3
            
            
            3.2
            
            
            3.2Internet
            
            
            16.3
            
            
            16.6
            
            
            16.5
            
            
            16.8Transport
                services
            
            
            6.1
            
            
            6.8
            
            
            6.0
            
            
            6.8Total
                revenues
            
            
            100.0
            %
            
            100.0
            %
            
            100.0
            %
            
            100.0
            %Operating
                expensesCost
                of services and products
            
            
            36.0
            %
            
            36.5
            %
            
            36.9
            
            
            37.3Selling,
                general and administrative expenses
            
            
            15.2
            
            
            15.2
            
            
            14.6
            
            
            14.9Depreciation
                and amortization
            
            
            19.7
            
            
            17.2
            
            
            21.0
            
            
            18.4Total
                operating expenses
            
            
            70.9
            
            
            68.9
            
            
            72.5
            
            
            70.6Income
                from operations
            
            
            29.1
            
            
            31.1
            
            
            27.5
            
            
            29.4Other
                income (expense)Interest
                expense
            
            
            (33.2
            )
            
            (26.2
            )
            
            (32.1
            )
            
            (26.5
            )Change
                in fair value of derivative
            
            
            1.1
            
            
            1.0
            
            
            1.3
            
            
            0.2Other
                income
            
            
            1.5
            
            
            1.0
            
            
            1.4
            
            
            1.2Total
                other expense
            
            
            (30.6
            )
            
            (24.2
            )
            
            (29.4
            )
            
            (25.1
            )Income
                before income taxes
            
            
            (1.5
            )
            
            6.9
            
            
            (1.9
            )
            
            4.3Income
                tax expense
            
            
            (2.3
            )
            
            (2.6
            )
            
            0.2
            
            
            (1.3
            )Net
                income available to common stockholders
            
            
            (3.8
            )%
            
            4.3
            %
            
            (1.7
            )%
            
            3.0
            %




***Three
      Months and Nine Months Ended September 30, 2008 Compared to Three Months and
      Nine Month Ended September 30, 2007***




*Total
      revenues.* Total
      revenues increased 3.7% in the three months ended September 30, 2008 to $18.2
      million from $17.6 million in the three months ended September 30, 2007. Total
      revenues increased 3.6% in the nine months ended September 30, 2008 to $53.8
      million from $51.9 million in the nine months ended September 30, 2007. The
      primary reason for the increase is the growth of competitive customers in Maine
      and digital Internet lines throughout the Company. The tables below provide
      the
      components of our revenues for the three months and nine months ended September
      30, 2008 compared to the same periods of 2007.




*For
      the three months ended September 30, 2007 and 2008*




**Three Months Ended**
              **September 30,**
            
            **Change****2007**
            
            **2008**
            
            **Amount**
            
            **Percent**(dollars in thousands)Local
                services
            
            $
            6,502
            
            $
            6,679
            
            $
            177
            
            
            2.7
            %Network
                access
            
            
            6,612
            
            
            6,694
            
            
            82
            
            
            1.2Cable
                television
            
            
            547
            
            
            601
            
            
            54
            
            
            9.9Internet
            
            
            2,867
            
            
            3,029
            
            
            162
            
            
            5.7Transport
                services
            
            
            1,066
            
            
            1,235
            
            
            169
            
            
            15.9Total
            
            $
            17,594
            
            $
            18,238
            
            $
            644
            
            
            3.7




18




Local
      services .
      Local
      services revenue increased 2.7% to $6.7 million in the three months ended
      September 30, 2008 from $6.5 million in the three months ended September 30,
      2007. CLEC revenue in Maine increased $0.2 million. RLEC revenue, including
      bundled services such as long distance and a modest price increase on Alabama
      basic services, offset the lost revenue from the decline in RLEC access lines.




Network
      access .
      Network
      access revenue increased 1.2% to $6.7 million in the three months ended
      September 30, 2008 from $6.6 million in the three months ended September 30,
      2007. RLEC switched access revenue increased $0.1 million.




Cable
      television .
      Cable
      television revenue increased 9.9% to $0.6 million in the three months ended
      September 30, 2008 from $0.5 million in the three months ended September 30,
      2007. Growth in high definition television fees in Alabama and satellite
      television services in Missouri accounted for the increase.




Internet .
      Internet revenue increased 5.7% to $3.0 million in the three months ended
      September 30, 2008 from $2.9 million in the three months ended September 30,
      2007. The increase reflects growth of more than $0.3 million from more than
      2,100 new digital data access lines, including related equipment rental, which
      more than offset the decline of less than $0.2 million in dial-up Internet
      customers associated with the conversion to digital data access lines, including
      those customers in Maine and Missouri that are outside of our local service
      areas.




Transport
      services .
      Transport services revenue increased 15.9% to $1.2 million in the three months
      ended September 30, 2008 from $1.1 million in the three months ended September
      30, 2007. The continued growth in Wide Area Network revenue from CLEC customers
      in Maine drove this increase.




*For
      the nine months ended September*  *30,
      2007 and 2008*




**Nine Months Ended**
              **September 30,**
            
            **Change****2007**
            
            **2008**
            
            **Amount**
            
            **Percent**(dollars in thousands)Local
                services
            
            $
            19,381
            
            $
            20,117
            
            $
            736
            
            
            3.8
            %Network
                access
            
            
            19,191
            
            
            19,237
            
            
            46
            
            
            0.2Cable
                television
            
            
            1,643
            
            
            1,714
            
            
            71
            
            
            4.3Internet
            
            
            8,547
            
            
            9,061
            
            
            514
            
            
            6.0Transport
                services
            
            
            3,123
            
            
            3,637
            
            
            514
            
            
            16.5Total
            
            $
            51,885
            
            $
            53,766
            
            $
            1,881
            
            
            3.6





Local
      services .
      Local
      services revenue in the nine months ended September 30, 2008 increased 3.8%
      to
      $20.1 million from $19.4 million in the nine months ended September 30, 2007.
      CLEC revenue in Maine increased $0.6 million. RLEC revenue, including bundled
      services such as long distance and a modest price increase on Alabama basic
      services, increased by $0.1 million more than the revenue lost from the decline
      in RLEC access lines.




Network
      access .
      Network
      access revenue remained constant at $19.2 million in the nine months ended
      September 30, 2008 and 2007. RLEC
      interstate access revenue and Universal Service Fund receipts increased $0.4
      million. This increase was offset by a decline in intrastate access of $0.3
      million and subscriber based fees of $0.1 million.




Cable
      television .
      Cable
      television revenue in the nine months ended September 30, 2008 increased 4.3%
      to
      $1.7 million from $1.6 million in the nine months ended September 30, 2007.
      Growth in high definition television fees, as well as the introduction of
      satellite television services in Missouri, accounted for the
      increase.




Internet .
      Internet revenue in the nine months ended September 30, 2008 increased 6.0%
      to
      $9.1 million from slightly more than $8.5 million in the nine months ended
      September 30, 2007. The increase reflects growth of $1.0 million from more
      than
      2,100 new digital data access lines, including related equipment rental, which
      more than offset the decline of less than $0.5 million in dial-up Internet
      customers associated with the conversion to digital data access lines, including
      those customers in Maine and Missouri that are outside of our local service
      areas.




19




Transport
      services .
      Transport services revenue increased 16.5% to $3.6 million in the nine months
      ended September 30, 2008 from $3.1 million in the nine months ended September
      30, 2007. The continued growth in Wide Area Network revenue from CLEC customers
      in Maine was responsible for this increase.




*Operating
      expenses.* Operating
      expenses in the three months ended September 30, 2008 increased 0.8% to $12.6
      million from $12.5 million in the three months ended September 30, 2007.
      Operating expenses in the nine months ended September 30, 2008 increased 0.9%
      to
      $38.0 million from $37.6 million in the nine months ended September 30,
      2007.




*For
      the three months ended September 30, 2007 and 2008*




**Three Months Ended**
              **September 30,**
            
            **Change****2007**
            
            **2008**
            
            **Amount**
            
            **Percent**(dollars in thousands)Cost
                of services and products
            
            $
            6,326
            
            $
            6,655
            
            $
            329
            
            
            5.2
            %Selling,
                general and administrative expenses
            
            
            2,676
            
            
            2,777
            
            
            101
            
            
            3.8Depreciation
                and amortization
            
            
            3,475
            
            
            3,141
            
            
            (334
            )
            
            (9.6
            )Total
            
            $
            12,477
            
            $
            12,573
            
            $
            96
            
            
            0.8





Cost
      of services and products .
      Cost of
      services and products increased 5.2% to $6.7 million in the three months ended
      September 30, 2008 from $6.4 million in the three months ended September 30,
      2007. The growth in competitive local exchange and transport services in Maine
      increased costs $0.3 million, and energy costs, higher long distance minutes
      and
      higher bandwidth required to support more long distance and digital high-speed
      Internet customers increased costs by $0.1 million, partially offset by outside
      plant operational efficiencies.




Selling,
      general and administrative expenses .
      Selling, general and administrative expenses increased 3.8% to $2.8 million
      in
      the three months ended September 30, 2008 from $2.7 million in the three months
      ended September 30, 2007. Increases in employee and external relations costs
      of
      $0.3 million were partially offset by lower operating taxes, property taxes,
      insurance costs and legal expenses of $0.2 million.




Depreciation
      and amortization .
      Depreciation and amortization decreased 9.6% to $3.1 million in the three months
      ended September 30, 2008 from $3.5 million in the three months ended September
      30, 2007. The decrease reflects lower amortization expense for an intangible
      asset of $0.2 million and lower depreciation expense in Alabama and Maine of
      $0.1 million.




*For
      the nine months ended September 30, 2007 and 2008*




**Nine Months Ended**
              **September 30,**
            
            **Change****2007**
            
            **2008**
            
            **Amount**
            
            **Percent**(dollars in thousands)Cost
                of services and products
            
            $
            19,131
            
            $
            20,052
            
            $
            921
            
            
            4.8
            %Selling,
                general and administrative expenses
            
            
            7,598
            
            
            7,999
            
            
            401
            
            
            5.3Depreciation
                and amortization
            
            
            10,880
            
            
            9,904
            
            
            (976
            )
            
            (9.0
            )Total
            
            $
            37,609
            
            $
            37,955
            
            $
            346
            
            
            0.9





Cost
      of services and products .
      Cost of
      services and products increased 4.8% to $20.0 million in the nine months ended
      September 30, 2008 from $19.1 million in the nine months ended September 30,
      2007. The growth in competitive local exchange and transport services in Maine
      increased costs $0.8 million and increased long distance minutes and higher
      bandwidth required to support more long distance and digital high-speed Internet
      customers increased costs $0.1 million.




20




Selling,
      general and administrative expenses .
      Selling, general and administrative expenses increased 5.3% to $8.0 million
      in
      the nine months ended September 30, 2008 from $7.6 million in the nine months
      ended September 30, 2007. Employee costs increased $0.3 million and costs
      associated with investigating an acquisition, Sarbanes-Oxley expenses, and
      cable
      and satellite advertising costs increased $0.3 million. These increases were
      partially offset by lower property taxes, legal and insurance costs of $0.2
      million.




Depreciation
      and amortization .
      Depreciation and amortization decreased 9.0% to $9.9 million in the nine months
      ended September 30, 2008 from $10.9 million in the nine months ended September
      30, 2007. The decrease reflects lower depreciation expense in Alabama and Maine
      of $0.7 million and lower amortization expense for an intangible asset of $0.3
      million.




*For
      the three months September 30, 2007 and 2008*




**Three Months Ended**
              **September 30,**
            
            **Change****2007**
            
            **2008**
            
            **Amount**
            
            **Percent**(dollars in thousands)Interest
                expense
            
            $
            5,845
            
            $
            4,774
            
            $
            (1,071
            )
            
            (18.3
            )%Change
                in fair value of derivative
            
            
            186
            
            
            174
            
            
            (12
            )
            
            (6.5
            )Other
                income
            
            
            268
            
            
            188
            
            
            (80
            )
            
            (29.9
            )Income
                tax expense
            
            
            (394
            )
            
            (464
            )
            
            (70
            )
            
            (17.8
            )





*Interest
      expense.* Interest
      expense decreased 18.3% to $4.8 million in the three months ended September
      30,
      2008 from $5.8 million in the three months ended September 30, 2007. Our senior
      credit facility was reduced by $55.4 million in July 2007 to $64.6 million
      using
      the proceeds of our offering of an additional 3,000,000 Income Deposit
      Securities (“IDS”) units. Associated with the reduction in senior debt, the
      remaining loan cost of $1.1 million associated with a portion of the repaid
      loan
      was expensed in third quarter 2007.




*Change
      in fair value of derivative associated with Class B common convertible to Class
      A common.* The
      derivative value associated with the conversion option for our Class B common
      stock must be fair valued each quarter until conversion occurs, not later than
      December 21, 2009. The reduction in maximum time to conversion, the change
      in
      price of IDS units and the underlying Class A common stock and the expected
      time
      for conversion impact the fair value of the derivative. The combination of
      these
      factors reduced the value of the derivative liability slightly less in the
      three
      months ended September 30, 2008 compared to the three months ended September
      30,
      2007.




The
      repayment of senior indebtedness in July 2007 reduced senior debt below the
      $80
      million level of our 3% three month LIBOR rate cap through 2009. The $15.4
      million balance of the rate cap is no longer an effective hedge to interest
      costs and is considered an investment. The change in fair value of the
      ineffective portion of the rate cap decreased by slightly more than $0.1 million
      during third quarter 2008, compared to a decrease of slightly less than $0.1
      million in the third quarter of 2007.




*Other
      income.* Other
      income decreased 29.9% to $0.2 million in the three months ended September
      30,
      2008 from $0.3 million in the three months ended September 30, 2007. The
      decrease was the result of $0.1 million in lower interest associated with short
      term investing of our cash balances and a decrease of $0.1 million associated
      with the ineffective portion of the rate cap, driven by lower interest rates.
      These impacts were partially offset by a gain of $0.1 million associated with
      a
      gain on a lease termination.




*Income
      taxes.* Provision
      for income taxes was $0.5 million in the three months ended September 30, 2008
      compared to $0.4 million in the three months ended September 30, 2007.




21




*For
      the nine months ended September 30, 2007 and 2008*




**Nine Months Ended**
              **September 30,**
            
            **Change****2007**
            
            **2008**
            
            **Amount**
            
            **Percent**(dollars in thousands)Interest
                expense
            
            $
            16,634
            
            $
            14,230
            
            $
            (2,404
            )
            
            (14.5
            )%Change
                in fair value of derivative
            
            
            655
            
            
            (100
            )
            
            (555
            )
            
            (84.7
            )Other
                income
            
            
            715
            
            
            619
            
            
            (96
            )
            
            (13.4
            )Income
                tax expense
            
            
            97
            
            
            (696
            )
            
            (793
            )
            
            (817.5
            )





*Interest
      expense.* Interest
      expense decreased 14.5% to $14.2 million in the nine months ended September
      30,
      2008 from $16.6 million in the nine months ended September 30, 2007. Our senior
      credit facility was reduced by $55.4 million in July 2007 to $64.6 million
      using
      the proceeds of our offering of an additional 3,000,000 IDS units. An amendment
      to our senior credit facility also lowered the margin from 3.25% to 2.00%.
      The
      combination of these two factors reduced interest expense by $2.8 million.
      The
      debt associated with the additional IDS units increased interest expense for
      the
      period by $1.5 million. Associated with the reduction in senior debt, the
      remaining loan cost of $1.1 million associated with a portion of the repaid
      loan
      was expensed in third quarter 2007.




*Change
      in fair value of derivative associated with Class B common convertible to Class
      A common.* The
      derivative value associated with the conversion option for our Class B common
      stock must be fair valued each quarter until conversion occurs, not later than
      December 21, 2009. The reduction in maximum time to conversion, the change
      in
      price of IDS units and the underlying Class A common stock and the expected
      time
      for conversion impact the fair value of the derivative. The combination of
      these
      factors reduced the value of the derivative $0.4 million more in the nine
      months ended September 30, 2008 than in the nine months ended September 30,
      2007.




The
      repayment of senior indebtedness in July 2007 reduced senior debt below the
      $80
      million level of our 3% three month LIBOR rate cap through 2009. The $15.4
      million balance of the rate cap is no longer an effective hedge to interest
      costs and is considered an investment. The change in fair value of the
      ineffective **]** portion
      of the rate cap decreased in value by $0.1 million more in the nine months
      ended
      September 30, 2008 than in the nine months ended September 30, 2007, reflecting
      the reduction in expected LIBOR rates and the shorter remaining life of the
      rate
      cap.




*Other
      income.* Other
      income decreased $0.1 million to $0.6 million in the nine months ended September
      30, 2008 from $0.7 million in the nine months ended September 30, 2007. The
      decrease was the result of $0.3 million in lower interest associated with
      short term investing of our cash balances and the ineffective portion of the
      rate cap, driven by lower interest rates. These impacts were partially offset
      by
      a gain of $0.2 million associated with a lease termination, higher dividends
      from CoBank, ACB and an additional distribution associated with the Rural
      Telephone Bank dissolution.




*Income
      taxes.* Provision
      for income taxes was $0.7 million in the nine months ended September 30, 2008
      compared to an income tax benefit of $0.1 million in the nine months ended
      September 30, 2007.




*Net
      income.* As
      a
      result of the foregoing, there was net income of $0.8 million and $1.6 million
      available to common stockholders in the three and nine months ended September
      30, 2008 compared to a net loss of $0.7 million and $0.9 million in the three
      and nine months ended September 30, 2007, respectively.




**Liquidity
      and Capital Resources**




Our
      liquidity needs arise primarily from: (i) interest payments related to our
      credit facility and our senior subordinated notes; (ii) capital expenditures;
      (iii) working capital requirements; (iv) dividend payments on our Class A common
      stock; and (v) potential acquisitions.




22




Historically,
      we satisfy our operating cash requirements from the cash generated by our
      business and utilize borrowings under our credit facility to facilitate
      acquisitions. For the nine months ended September 30, 2008, we generated cash
      from our business to invest in additional property and equipment, pay interest
      on our senior debt, pay interest associated with the subordinated debt inherent
      in our IDS units, and fund dividends on our Class A common stock (as declared
      by
      our board of directors) that are inherent in our IDS units. After meeting all
      of
      these needs of our business, cash grew from $12.8 million at December 31, 2007
      to $13.2 million at September 30, 2008. The Company has as its current policy
      to
      return a high percentage of its available cash to its IDS unit
      holders.




Cash
      flows from operating activities for the first nine months of 2008 amounted
      to
      $14.4 million compared to $13.3 million for the first nine months of 2007.
      The
      primary differences relate to higher net income and the collection of an income
      tax receivable in 2008.




Cash
      flows used in investing activities in the first nine months of 2008 were $7.4
      million compared to $4.4 million in the first nine months of 2007. The
      acquisition and construction of property and equipment utilized
      $2.6 million more in the first nine months of 2008 than in the same period
      of 2007, reflecting expanded investment in our business for the future,
      including initial investment in Internet Protocol Television services (IPTV)
      in
      our Alabama properties. The balance reflects deferred charges associated with
      the acquisition of Country Road Communications LLC (“Country Road”) subsidiaries
      announced on August 7, 2008 and subsequently completed on October 31,
      2008.




Cash
      flows used in financing activities for the first nine months of 2008 were $6.7
      million compared to $5.7 million for the same period of 2007, reflecting payment
      of dividends to stockholders in both periods. The dividend was $0.17625 per
      share per quarter in both periods. We have paid fifteen dividends since the
      Company went public in December 2004.




We
      do not
      invest in financial instruments as part of our business strategy. At September
      30, 2008, the Company had an $80 million interest rate cap at 3% LIBOR through
      December 2009 which was valued at market price. It also has received patronage
      shares, primarily from one of its lenders, over a period of years for which
      there is a limited market to determine value until the shares are redeemed
      by
      the issuing institution. Historically, these shares have been redeemed at a
      value similar to their issued value. Due to the uncertainty of this future
      value, these shares are carried at approximately 55% of their issued value.
      The
      Class B derivative is valued based on an expert model developed specifically
      for
      the valuation of this derivative which uses current market factors to assess
      the
      B share derivative value and the end of each quarter. This liability will be
      extinguished upon the conversion of the Class B shares into IDS units. The
      specific value of each instrument is included in the notes to the September
      30,
      2008 financial statements.




We
      anticipate that operating cash flow, together with borrowings under our credit
      facility, will be adequate to meet our currently anticipated operating and
      capital expenditure requirements for at least the next 12 months.




**Recent
      Accounting Pronouncements**




Effective
      January 1, 2008, the Company adopted SFAS No. 157, *“Fair
      Value Measurements”* (“SFAS
      157”). In February 2008, the Financial Accounting Standards Board (“FASB”)
      issued staff position (FSP) No. FAS 157-2, *“Effective
      Date of FASB Statement No. 157,”* which
      delays the effective date of SFAS 157 for one year for all non-financial assets
      and liabilities except those recognized or disclosed on a recurring basis.
      Therefore, the Company has adopted the provisions of SFAS 157 with respect
      to
      its financial assets and liabilities only. SFAS 157 defines fair value,
      establishes a framework for measuring fair value and expands disclosure about
      fair value measurements. Valuation techniques used to measure fair value under
      SFAS 157 must maximize the use of observable inputs. The standard describes
      a
      fair value hierarchy utilizing three levels of input. The first two levels
      are
      considered observable and the third, unobservable:





Level
                1 –
            Quoted
                prices in active markets for identical assets or
                liabilities.


Level
                2 –
            Inputs
                other than Level 1 that are directly or indirectly observable, such
                as
                quoted prices for similar assets or liabilities or quoted prices
                in
                markets which are not active. The inputs are generally observable
                or can
                be corroborated in observable
                markets.


Level
                3 –
            Unobservable
                inputs where there is little or no market activity to support
                valuation.




23




The
      adoption of SFAS 157 did not have a material impact on our consolidated
      financial statements.





In
      October 2008, the FASB issued FSP 157-3, *“Determining
      the Fair Value of a Financial Asset when the Market for that Asset is not
      Active”* (“FSP
      157-3”). FSP 157-3 clarifies the application of SFAS 157 in a market that
      is not active and provides an example to illustrate key considerations in
      determining the fair value of a financial asset when the market for that
      financial asset is not active. FSP 157-3 was effective upon issuance, including
      prior periods for which financial statements have not been issued. The adoption
      of FSP 157-3 had no impact on our financial statements.





In
      February 2007, the FASB issued SFAS No. 159, ** “ *The
      Fair Value Option for Financial Assets and Financial Liabilities – Including an
      Amendment of FASB Statement No. 115”* (“SFAS
      159”). Under SFAS 159, a company may elect to measure many eligible financial
      instruments and certain other items at fair value that are not currently
      required to be measured at fair value. The Company did not elect to adopt the
      fair value option under SFAS 159.





In
      March
      2008, the FASB issued SFAS No. 161, *“Disclosures
      about Derivative Instruments and Hedging Activities – an amendment of FASB
      Statement No. 133”* (“SFAS
      161”). SFAS 161 expands quarterly disclosure requirements in SFAS No. 133, *“Accounting
      for Derivative Instruments and Hedging Activities,”* about an
      entity’s derivative instruments and hedging activities. SFAS 161 is effective
      for fiscal years beginning after November 15, 2008. The implementation of this
      standard will not have a material impact on our consolidated financial position
      and results of operations.





In
      April
      2008, the FASB issued FSP 142-3, *“Determination
      of the Useful Life of Intangible Assets”* (“FSP
      142-3”). FSP 142-3 amends the factors that should be considered in developing
      renewal or extension assumptions used to determine the useful life of a
      recognized intangible asset under SFAS No. 142, *“Goodwill
      and Other Intangible Assets,”* and
      replaces it with a requirement that an entity consider its own historical
      experience in renewing similar arrangements, or a consideration of market
      participant assumptions in the absence of historical experience. FSP 142-3
      also
      requires entities to disclose information that enables users of financial
      statements to assess the extent to which the expected future cash flows
      associated with the asset are affected by the entity’s intent and/or ability to
      renew or extend the arrangement. We are required to adopt FSP 142-3 effective
      January 1, 2009 on a prospective basis. FSP 142-3 is effective for fiscal years
      beginning after December 15, 2008. The Company is currently assessing the impact
      of FSP 142-3 on its consolidated financial position and results of
      operations.





In
      December 2007, the FASB issued SFAS No. 141(R), *“Business
      Combinations (Revised)”* (“SFAS
      141(R)”), to replace SFAS No. 141, *“Business
      Combinations.”* SFAS
      141(R) requires the use of the acquisition method of accounting, defined the
      acquirer, established the acquisition date and broadens the scope to all
      transactions and other events in which one entity obtains control over one
      or
      more other businesses. SFAS 141(R) is effective for business combinations or
      transactions entered into for fiscal years beginning on or after December 15,
      2008. The impact of the adoption of SFAS 141(R) will depend on the nature and
      significance of business combinations the Company enters into subsequent to
      adoption.





In
      May
      2008, the FASB issued SFAS No. 162, *“The
      Hierarchy of Generally Accepted Accounting Principles”* (“SFAS
      162”). SFAS 162 identifies the sources of accounting principles and the
      framework for selecting the principles used in the preparation of financial
      statements. SFAS 162 is effective 60 days following the Securities and Exchange
      Commission’s approval of the Public Company Accounting Oversight Board
      amendments to AU Section 411, *“The
      Meaning of Present Fairly in Conformity with Generally Accepted Accounting
      Principles.”* The
      implementation of this standard will not have a material impact on our
      consolidated financial position and results of operations.





In
      June
      2008, the FASB ratified EITF Issue No. 07-5, *“Determining
      Whether an Instrument (or an Embedded Feature) Is Indexed to an Entity’s Own
      Stock”* (“EITF
      07-5”). EITF 07-5 provides that an entity should use a two step approach to
      evaluate whether an equity-linked financial instrument (or embedded feature)
      is
      indexed to its own stock, including evaluating the instrument’s contingent
      exercise and settlement provisions. It also clarifies on the impact of foreign
      currency denominated strike prices and market-based employee stock option
      valuation instruments on the evaluation. EITF 07-5 is effective for fiscal
      years
      beginning after December 15, 2008. The Company is currently assessing the impact
      of EITF 07-5 on its consolidated financial position and results of
      operations.




24




In
      June
      2008, the FASB ratified EITF Issue No. 08-3, *“Accounting
      for Lessees for Maintenance Deposits Under Lease Arrangements”* (“EITF
      08-3”). EITF 08-3 provides guidance for accounting for nonrefundable maintenance
      deposits. It also provides revenue recognition accounting guidance for the
      lessor. EITF 08-3 is effective for fiscal years beginning after December 15,
      2008. The Company is currently assessing the impact of EITF 08-3 on its
      consolidated financial position and results of operations.





**Subsequent
      Events**





On
      October 31, 2008, the Company closed the acquisition of three subsidiaries
      of
      Country Road - Pine Tree Holdings, Inc. (Portland, ME), Granby Holdings, Inc.
      (Granby, MA) and War Holdings, Inc. (War, WV). The purchase price was $101.3
      million, subject to adjustment as provided in the Stock Purchase Agreement,
      dated as of August 7, 2008, between the Company and Country Road. The
      purchase price was financed with borrowings under the Company’s second amended
      and restated credit agreement, dated as of October 20, 2008, among the Company
      and the other credit parties thereto, General Electric Capital Corporation,
      as a
      lender and as an agent for the lenders, and the other lenders from time to
      time
      party thereto.




The
      credit facilities under the second amended and restated credit agreement are
      comprised of:




·
            term
                loans of $173,500,000, consisting of $64,646,968 that remained outstanding
                under the existing credit agreement, and an additional term loan
                of
                $108,853,032; and


·
            the
                continuation of a revolving loan commitment in an amount of up to
                $15,000,000.





The
      full
      amount of the term loan is due in a single payment on October 31, 2013. Interest
      is paid quarterly and is based on a variable margin of between 2.5% and 3.25%
      plus an index rate or between 3.5% and 4.25% plus LIBOR. At closing, the margin
      was 3% or 4%, respectively.





**Item
      3.** **Quantitative
      and Qualitative Disclosures about Market Risk**




Our
      short-term excess cash balance is invested in short-term commercial paper.
      We do
      not invest in any speculative derivative or commodity type instruments.
      Accordingly, we are subject to minimal market risk on our
      investments.




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




**Item
      4.** **Controls
      and Procedures**




With
      the
      participation of the Chief Executive Officer and the Chief Financial Officer,
      management has evaluated the effectiveness of our disclosure controls and
      procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act
      of
      1934). Based on that evaluation, the Chief Executive Officer and the Chief
      Financial Officer concluded that our disclosure controls and procedures were
      effective as of September 30, 2008.




There
      were no changes in our internal control over financial reporting (as defined
      in
      Rule 13a-15(f) under the Securities Exchange Act of 1934) during the three
      months ended September 30, 2008 that materially affected, or are reasonably
      likely to materially affect, our internal control over financial
      reporting.




**PART
      II  OTHER INFORMATION**




**Item
      6.** **Exhibits**




Exhibits




See
      Exhibit Index.




25




**Signatures**




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


Date:
                  November 6, 2008
              **OTELCO
                  INC.**By:
              /s/
                  Curtis L. Garner, Jr.Curtis
                  L. Garner, Jr.Chief
                  Financial Officer









**EXHIBIT
      INDEX**





**Exhibit No.**
            
            **Description**31.1
            
            Certificate
                pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange
                Act of 1934 of the Chief Executive Officer31.2
            
            Certificate
                pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange
                Act of 1934 of the Chief Financial Officer32.1
            
            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
                Officer32.2
            
            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