UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549




Form
10-K


x
            ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE
      ACT OF 1934




For
the Fiscal Year Ended December 31, 2008




OR


o
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE
      ACT OF 1934




For
the Transition Period from     to




Commission
File Number: 1-32362




OTELCO
INC.


(Exact
Name of Registrant as Specified in Its Charter)


Delaware
            52-2126395(State
      or Other Jurisdiction of
              Incorporation
      or Organization)
            (I.R.S.
      Employer
              Identification
      No.)505
      Third Avenue East, Oneonta, Alabama
            35121(Address
      of Principal Executive Offices)
            (Zip
      Code)205-625-3574(Registrant’s
      Telephone Number, Including Area
Code)




Securities
registered pursuant to Section 12(b) of the Act:


Title
      of Each Class
            
            Name
      of Each Exchange on Which RegisteredIncome
      Deposit Securities, each representing shares of
              Class
      A Common Stock and Senior Subordinated
              Notes
      due 2019
            
            The
      NASDAQ Stock Market LLC




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




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


Yes o No x









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


Yes o No x




Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. Yes x No o




Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. o




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


Large
      accelerated filer o
            Accelerated
      filer x
            Non-accelerated
      filer  o
              (Do
      not check if a smaller reporting
              company)
            Smaller
      reporting
              companyo




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


Yes o No x




As
of June 30, 2008, the aggregate market value of the registrant’s Income Deposit
Securities (IDSs) held by non-affiliates of the registrant was $203.7 million
based on the closing sale price as reported on NASDAQ. Each IDS represents one
share of Class A Common stock, par value $0.01 per share, and $7.50 principal
amount of senior subordinated notes due 2019. In determining the market value of
the registrant’s IDSs held by non-affiliates, IDSs beneficially owned by
directors, officers and holders of more than 10% of the registrant’s IDSs have
been excluded. This determination of affiliate status is not necessarily a
conclusive determination for other purposes.




As
of March 10, 2009, the registrant had 12,676,733 shares of Class A Common Stock,
par value $0.01 per share, and 544,671 shares of Class B Common Stock, par value
$0.01 per share, outstanding.




DOCUMENTS
INCORPORATED BY REFERENCE




Certain
information required in Part III of this report is incorporated by reference
from the registrant’s proxy statement to be filed pursuant to Regulation 14A
with respect to the registrant’s 2009 annual meeting of
stockholders.









OTELCO
INC.




TABLE
OF CONTENTS


PagePART
    I
              
              
              
              2Item
    1.
              Business
              
              2Item
    1A.
              Risk
      Factors
              
              8Item
    1B.
              Unresolved Staff
      Comments
              
              12Item
    2.
              Properties
              
              12Item
    3.
              Legal
      Proceedings
              
              13Item
    4.
              Submission of Matters to a
      Vote of Security Holders
              
              13Item
    X.
              Executive Officers of the
      Registrant
              
              13PART
    II
              
              
              
              15Item
    5.
              Market for Registrant’s
      Common Equity, Related Stockholder Matters and Issuer Purchases of Equity
      Securities
              
              15Item
    6.
              Selected Financial
      Data
              
              18Item
    7.
              Management’s Discussion and
      Analysis of Financial Condition and Results of
      Operations
              
              19Item
    7A.
              Quantitative and
      Qualitative Disclosures about Market Risk
              
              33Item
    8.
              Financial Statements and
      Supplementary Data
              
              34Item
    9.
              Changes in and
      Disagreements with Accountants on Accounting and Financial
      Disclosure
              
              61Item
    9A.
              Controls and
      Procedures
              
              61Item
    9B.
              Other
      Information
              
              61PART
    III
              
              
              
              62Item
    10.
              Directors, Executive
      Officers and Corporate Governance
              
              62Item
    11.
              Executive
      Compensation
              
              62Item
    12.
              Security Ownership of
      Certain Beneficial Owners and Management and Related Stockholder
      Matters
              
              62Item
    13.
              Certain Relationships and
      Related Transactions, and Director Independence
              
              62Item
    14.
              Principal Accountant Fees
      and Services
              
              62PART
    IV
              
              
              
              63Item
    15.
              Exhibits and Financial
      Statement Schedules
              
              63





Unless the context otherwise
requires, the words “we”, “us”, “our”, the “Company” and “Otelco” refer to
Otelco Inc., a Delaware corporation.




FORWARD-LOOKING
STATEMENTS




The
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. These
factors include, among other things, those discussed under the caption “Risk
Factors” in Item 1A.




PART
I




Item
1. Business




History




We were
formed in Delaware in 1998 for the purpose of operating and acquiring rural
local exchange carriers, or RLECs. Since 1999, we have acquired ten RLEC
businesses, four of which serve contiguous territories in north central Alabama;
three of which serve territories adjacent to either Portland or Bangor, Maine;
one each which serve a portion of central Missouri, southern West Virginia and
western Massachusetts. We provide competitive services through several
subsidiaries in these territories. In addition, we acquired two facilities based
competitive local exchange carriers, or CLECs, which provide services through
most of the state of Maine. The Company completed an initial public offering of
income deposit securities, or IDSs, in December 2004 at which time it converted
from a Delaware limited liability company into a Delaware corporation and
changed its name to Otelco Inc. In July 2007, the Company completed an
additional offering of 3,000,000 IDS units.




The
following table shows the aggregate number of our voice and data access lines
(which together are access line equivalents) and other services we offer such as
wholesale network connections, television, and dial-up Internet customers as of
December 31, 2008:


Voice
      and data access line equivalents
                      
                      
                      100,043Wholesale
      network connections
                      
                      
                      98,187Cable
      television customers
                      
                      
                      4,082Dial-up
      Internet customers
                      
                      
                      11,864




The RLEC
companies we acquired can trace their history as local communications providers
to the introduction of telecommunications services in the areas they serve. We
are able to leverage our long-standing relationship with our local service
customers by offering them a broad suite of telecommunications and information
services, such as long distance, Internet/data access and, in some areas, cable
or satellite television, thereby increasing customer loyalty and revenue per
access line.




Our RLECs
have historically experienced relatively stable operating results and strong
cash flows and operate in supportive regulatory environments. Each RLEC
qualifies as a rural telephone company under the federal Communications Act of
1934, so we are currently exempt from certain costly interconnection
requirements imposed on incumbent or historical local telephone companies, or
incumbent local exchange carriers, by the Communications Act. While this
exemption helps us maintain our strong competitive position, we do have direct
competition in portions of our RLEC market, primarily where another cable
provider also serves the same market. The cost of operations and capital
investment requirements for new entrants is high, discouraging such
investments.




In Maine,
our facilities based CLECs serve primarily business customers throughout the
state, utilizing our 231 mile fiber backbone network. In ten years of
operations, the CLECs have grown to provide more than 29,000 voice and data
access lines.




Otelco
Telephone.  On January 5, 1999, through Otelco Telephone LLC,
or Otelco Telephone, we acquired certain telecommunications businesses from
Oneonta Telephone Company, Inc., a rural local exchange carrier that serves a
portion of Blount county in Alabama. In connection with the transaction, we
acquired 8,127 voice and data access lines.




Hopper.  On
September 30, 1999, we acquired Hopper Telecommunications Company, Inc., or
Hopper, a rural local exchange carrier that serves portions of Blount and Etowah
counties in Alabama. In connection with the transaction, we acquired 3,827 voice
and data access lines.




Brindlee
Mountain.  On July 19, 2000, we acquired Brindlee Mountain
Telephone Company, or Brindlee, a rural local exchange carrier that serves
portions of Marshall, Morgan, Blount and Cullman counties in Alabama. In
connection with the transaction, we acquired 14,013 voice and data access
lines.




Blountsville.  On
June 30, 2003, we acquired Blountsville Telephone Company, Inc., or
Blountsville, a rural local exchange carrier that serves a portion of Blount
county in Alabama. In connection with the transaction, we acquired 4,080 access
lines.




Mid-Missouri.  On
December 21, 2004, we acquired Mid-Missouri Telephone Company, or Mid-Missouri,
a rural local exchange carrier that serves portions of Cooper, Moniteau, Morgan,
Pettis and Saline counties in central Missouri. In connection with the
transaction, we acquired approximately 4,585 voice and data access lines. In
addition, we provide Internet services in areas surrounding our
territory.


2




Mid-Maine.  On July
3, 2006, we acquired Mid-Maine Communications, Inc., or Mid-Maine, a rural local
exchange carrier that serves portions of Penobscot, Somerset and Piscataquis
counties adjacent to Bangor, Maine and a competitive local exchange carrier,
serving customers adjacent to its fiber network along the I-95 corridor in
Maine. In connection with the transaction, we acquired approximately 22,413
voice and data access lines. In addition, we provide dial-up Internet services
throughout Maine.




Country Road.  On
October 31, 2008, we acquired Pine Tree Holdings, Inc., Granby Holdings, Inc.
and War Holdings, Inc., which we collectively refer to as the CR Companies, from
Country Road Communications LLC. The three holding companies have four RLEC
operating subsidiaries: War Acquisition Corp., or War, serves areas in and
around War, West Virginia; The Granby Telephone and Telegraph Co. of Mass., or
Granby, serves areas in and around Granby, Massachusetts; and Saco River
Telegraph and Telephone Company, or Saco River, and The Pine Tree Telephone and
Telegraph Company, or Pine Tree, which collectively serve areas in and around
Buxton, Hollis, Waterboro, Gray and New Gloucester, Maine (adjacent to
Portland). There are also two CLEC subsidiaries providing services primarily to
business customers in Maine – CRC Communications of Maine, Inc. and
Communications Design Acquisition Corporation, which we collectively refer to as
Pine Tree Networks. In connection with the transaction, we acquired
approximately 29,112 voice and data access lines and 93,994 wholesale network
connections.




The
following table reflects the percentage of total revenues derived from each of
our service offerings for the year ended December 31, 2008:




Revenue Mix




Source
      of RevenueLocal
      services
                                      
                                      
                                      38.9
                                      %Network
      access
                                      
                                      
                                      35.4Cable
      television
                                      
                                      
                                      3.1Internet
                                      
                                      
                                      16.1Transport
      services
                                      
                                      
                                      6.5Total
                                      
                                      
                                      100.0
                                      %




Local
Services




We are
the sole provider of wireline telephone services in eight of the ten RLEC
territories we serve. In the remaining two territories, the incumbent cable
provider also offers local services. Local services enable customers to
originate and receive telephone calls. The amount that we can charge a customer
for certain basic services in Alabama, Massachusetts, Maine, Missouri and West
Virginia is regulated by the Alabama Public Service Commission, or APSC; the
Maine Public Utilities Commission, or MPUC; the Massachusetts Department of
Telecommunications and Cable, or MDTC; the Missouri Public Service Commission,
or MPSC; and the West Virginia Public Service Commission, or WVPSC. We also have
authority to provide service in New Hampshire from the New Hampshire Public
Utilities Commission or NHPUC. The regulatory involvement in pricing varies by
state and by type of service. Increasingly, bundled services involve less
regulation.




Revenue
derived from local services includes monthly recurring charges for voice access
lines providing local dial tone and calling features, including caller
identification, call waiting, call forwarding and voicemail. We also receive
revenue for providing long distance services to our customers, billing and
collection services for other carriers under contract, and directory
advertising. We provide local services on a retail basis to residential and
business customers. With the high level of acceptance of local service bundles,
a growing percentage of our customers receive a broad range of services,
including long distance, for a single, fixed monthly price.




We also
offer long distance telephone services to our local telephone customers who do
not purchase a local service bundle. We resell long distance services purchased
from various long distance providers. At December 31, 2008, approximately 60% of
our regulated access lines subscribed to our long distance services. We intend
to continue to expand our long distance business within our rural local exchange
carrier territories, principally through bundling services for our local
telephone customers.


3




Our CLECs
provide communications services tailored to business customers, including
specialized data and voice network configurations, to support their unique
business requirements. Our fiber network in Maine allows us to offer our
customers affordable and reliable voice and data solutions to support their
unique business requirements and applications, which is a significant
differentiator for our Company in the competitive local exchange carrier
environment in Maine. The acquisition of the CR Companies increased the market
presence and service footprint of the Company in Maine and created an
opportunity to expand into New Hampshire.




We derive
revenue from other telephone related services, including leasing, selling,
installing, and maintaining customer premise telecommunications equipment and
the publication of local telephone directories in certain of our rural local
exchange carrier territories. We also provide billing and collection services
for interexchange carriers through negotiated billing and collection agreements
for certain types of toll calls placed by our local customers.




Network
Access




Network
access revenue relates primarily to services provided by us to other long
distance carriers (also referred to as interexchange carriers) in connection
with their use of our facilities to originate and terminate interstate and
intrastate long distance, or toll, telephone calls. As toll calls are generally
billed to the customer originating the call, network access charges are applied
in order to compensate each telecommunications company providing services
relating to the call. Network access charges apply to both interstate and
intrastate calls. Our network access revenues also include revenues we receive
from wireless carriers for terminating their calls on our networks pursuant to
our interconnection agreements with those wireless carriers. Blountsville,
Granby, Hopper, Mid-Maine and Mid-Missouri also receive Universal Service Fund
High Cost Loop, or USF HCL, revenue which is included in our reported network
access revenue.




Intrastate Access Charges.  We
generate intrastate access revenue when a long distance call involving one of
our RLECs and a long distance carrier is originated and terminated within the
same state. The interexchange carrier pays us an intrastate access payment for
either terminating or originating the call. We record the details of the call
through our carrier access billing system. Our access charges for our intrastate
access services are set by the APSC, the MPUC, the MDTC, the MPSC, the NHPUC,
and the WVPSC, respectively for Alabama, Maine, Massachusetts, Missouri, New
Hampshire and West Virginia.




Interstate Access Charges.  We
generate interstate access revenue when a long distance call originates from an
area served by one of our rural local exchange carriers and terminates outside
of that state, or vice versa. We bill interstate access charges in a manner
similar to intrastate access charges. Our RLEC interstate access charges are
regulated by the Federal Communications Commission, or FCC, through our
participation in tariffs filed by the National Exchange Carriers Association, or
NECA. The FCC regulates the prices local exchange carriers charge for access
services in two ways: price caps and rate-of-return. All of our rural local
exchange carriers are rate-of-return carriers for purposes of interstate network
access regulation. Interstate access revenue for rate-of-return carriers is
based on an FCC regulated rate-of-return currently authorized up to 11.25% on
investment and recovery of operating expenses and taxes, in each case solely to
the extent related to interstate access.




Federal Universal Service Fund High Cost Loop
Revenue.  Blountsville, Hopper, Mid-Maine and Mid-Missouri
recover a portion of their costs through the USF HCL, which is regulated by the
FCC and administered by the Universal Service Administrative Company, or USAC, a
non-profit organization. Based on historic and other information, a nationwide
average cost per loop is determined by USAC. Any incumbent local exchange
carrier whose individual cost per loop exceeds the nationwide average by more
than 15% qualifies for USF HCL support. Although all of our rural local exchange
carriers have been designated as eligible telecommunications carriers or ETCs,
Otelco Telephone, Brindlee, War, Granby, Saco River and Pine Tree do not receive
USF HCL support because their cost per loop does not exceed the national average
by more than fifteen percent. The USF HCL, which is funded by assessments on all
United States telecommunications carriers as a percentage of their revenue from
end-users of interstate and international service, distributes funds to our
participating RLECs based upon their respective costs for providing local
services. USF HCL payments are received monthly.




Transition Service Fund
Revenue.  Otelco Telephone, Hopper, Brindlee, and Blountsville
recover a portion of their costs through the Transition Service Fund, or TSF,
which is administered by the APSC. All interexchange carriers originating or
completing calls in Alabama contribute to the TSF on a monthly basis, with the
amount of each carrier’s contribution calculated based upon its relative
originating and terminating minutes of use compared to the aggregate originating
and terminating minutes of use for all telecommunications carriers participating
in the TSF. The TSF reduces the vulnerability of our Alabama rural local
exchange carriers to a loss of access and interconnection revenue. TSF payments
are received monthly.


4




Cable
Television Services




We
provide cable television services over networks with 750 MHz of transmission
capacity in the towns of Bunceton and Pilot Grove in Missouri, and in portions
of Blount and Etowah counties in Alabama. Our cable television packages offer
from 17 to 191 channels, depending upon the location in which the services are
offered. In December 2007, we upgraded our Alabama system to provide high
definition and digital video recording capability to our subscribers. In
December 2008, we completed the first phase of an Internet Protocol TV (IPTV)
expansion of our service in Alabama, offering a full set of programs to a
portion of the Blountsville service area. Over the next year, we expect to add
other communities within our Alabama service area. We are a licensed installer
of satellite television and have services deployed to customers in our Missouri
territory.




Internet
Services




We
provide three forms of Internet access lines to our customers: bulk broadband
data access to support large corporate users; digital high-speed data lines in
varying capacity speeds for business and residential use; and residential
dial-up connectivity. Digital high-speed Internet access is provided via DSL,
cable modems or wireless broadband, depending upon the location in which the
service is offered and via dedicated fiber connectivity to larger business
customers. We charge our Internet customers a flat rate for unlimited Internet
usage and a premium for higher speed Internet services. We are able to provide
digital high-speed Internet access to over 90% of our RLEC access lines and all
of our CLEC lines. We intend to expand the availability of our high-speed
Internet services as warranted by customer demand by installing additional DSL
equipment at certain switching locations. In Maine and Missouri, we offer
dial-up Internet services throughout the state.




Transport
Services




Our CLECs
receive monthly recurring revenues for the rental of fiber to transport data and
other telecommunications services in Maine from businesses and
telecommunications carriers along their fiber route. In 2008, we expanded this
network to over 231 miles.




Network
Assets




Our
telephone networks include carrier grade advanced switching capabilities
provided by traditional digital as well as software based switches; fiber rings
and routes; and network software supporting specialized business applications,
all of which meet industry standards for service integrity, redundancy,
reliability and flexibility. Our networks enable us to provide switched wireline
telephone services and other calling features; long distance services; digital
Internet access services through DSL and cable modems and dedicated circuits;
and specialized customer specific applications.




Our cable
television networks in Alabama and Missouri have been upgraded to a transmission
capacity of 750 MHz. Our cable television system in Alabama was upgraded in 2007
to deliver digital signals, high-definition program content and digital video
recording capability, with IPTV capability added in 2008.




Sales,
Marketing & Customer Service




In Maine,
our CLEC subsidiaries compete with the incumbent carriers throughout the state,
utilizing both an employee and agent sales force. Service configurations are
tailored to meet specific customer requirements, utilizing customer designed
voice and data telecommunications configurations. Increased service monitoring
for business customers is provided through a state of the art network operations
center and serves as a differentiator for our offers. Currently, we have
retained the Mid-Maine and Pine Tree brand names as they are well known in the
markets served. The Company plans to introduce the Otelco brand name as a
replacement for both names over a transition period designed to retain the
existing brand recognition and loyalty.




Our RLEC
marketing approach emphasizes locally managed, customer-oriented sales,
marketing and service. We are able to differentiate ourselves from any
competition by providing a superior level of service in our territories. Each of
our RLECs has a long history in the communities it serves, which has helped to
enhance our reputation among local residents by fostering familiarity with our
products and level of service. To demonstrate our commitment to the markets we
serve, we maintain local offices in most of the population centers within our
service territories. While customers have the option of paying their bills by
mail, credit card or automatic withdrawal from their bank account, many elect to
pay their monthly bill in person at the local office. This provides us with an
opportunity to directly market our services to our existing customers. These
offices typically are staffed by local residents and provide sales and customer
support services in the community. Local offices facilitate a direct connection
to the community, which we believe improves customer satisfaction and enhances
our reputation with local residents. We also build upon our strong reputation by
participating in local activities, such as local fund raising and charitable
events for schools and community organizations and by airing local interest
programs on our local access community cable channels.


5




In order
to capitalize on the strong branding of each of our rural local exchange
carriers, while simultaneously establishing and reinforcing the “Otelco” brand
name across our service territories, we identify both the historical name of the
RLEC and Otelco on our marketing materials and other customer communications.
Part of our strategy is to increase customer loyalty and strengthen our brand
name by deploying new technologies and by offering comprehensive bundling of
services, including digital high-speed Internet access, cable and satellite
television, long distance and a full array of calling features. In addition, our
ability to provide our customers with a single, unified bill for all of our
services is a major competitive advantage and helps to enhance customer
loyalty.




Competition




Local
Services




We
believe that many of the competitive threats now confronting larger telephone
companies are not as significant in our RLEC service areas. The demographic
characteristics of rural telecommunications markets generally require
significant capital investment to offer competitive wireline telephone services
with low potential revenues. For instance, the per minute cost of operating both
telephone switches and interoffice facilities is higher in rural areas than in
urban areas, because rural local exchange carriers typically have fewer, more
geographically dispersed customers and lower calling volumes. Furthermore, the
distance from the telephone switch to the customer is typically longer in rural
areas, which results in increased distribution facilities costs that tend to
discourage wireline telephone competitors from entering territories serviced by
rural local exchange carriers. As a result, rural local exchange carriers
generally do not face the threat of significant wireline telephone competition
except in markets where a cable company provides existing services. We face
current or future direct competition from cable providers in portions of four of
our ten RLEC territories. New market entrants, such as providers of satellite
broadband or voice over electric lines and indirect competition such as voice
over Internet protocol, or VoIP, may gain traction in the future.




We
currently qualify for the rural exemption from certain interconnection
obligations which support industry competition, including obligations to provide
services for resale at discounted wholesale prices and to offer unbundled
network elements. If the APSC, MPUC, MDTC, NHPUC, MPSC or WVPSC terminates this
exemption for our rural local exchange carriers, we may face competition from
resellers and other wireline carriers.  A CLEC in Alabama has filed a
petition with the APSC seeking termination of the rural exemption and
arbitration of an interconnection for the four Alabama RLECs.  The
APSC has not yet set a hearing date for the petition.




In our
markets, we face competition from wireless carriers. We have experienced a
limited decrease in access lines as a result of customers switching their
residential wireline telephone service to a wireless service. We have also
experienced an increase in network access revenue associated with terminating
wireless calls on our telephone network. The introduction of residential bundled
offerings including unlimited calling appears to have shifted additional minutes
back from wireless. A portion of the wireless technology threat to our business
is reduced due in part to the topography of our telephone territories and the
current inconsistent wireless coverage. However, as wireless carriers continue
to employ new technologies, we may experience increased competition from these
carriers.




The long
distance market remains competitive in all of our rural local exchange carrier
territories. We compete with major national and regional interexchange carriers,
including AT&T and Verizon (formerly MCI, Inc.), as well as wireless
carriers, and other service providers. However, we believe that our position as
the rural local exchange carrier in our territories, our long-standing local
presence in our territories and our ability to provide a single, unified bill
for all of our services, are major competitive advantages. At December 31, 2008,
more than half of our regulated access lines subscribed to our long distance
services. The majority of our CLEC customers have also selected us for their
long distance services as part of their overall package of
services.




In
addition, under the Communications Act, a competitor can obtain USF HCL support
if a state public service commission (or the FCC in certain instances)
determines that it would be in the public interest and designates such
competitor as an ETC. While access to USF HCL support by our competitors
currently would not reduce our current USF HCL revenue, such economic support
could facilitate competition in our RLEC territories, particularly from wireless
carriers. The FCC is currently considering ways to reform USF HCL which could
impact amounts paid to and received from, as well as eligibility for payments
from, USF HCL.




In Maine,
we operate as a facilities based competitive local exchange carrier in a number
of the larger metropolitan areas primarily currently served by FairPoint
Communications as the incumbent local exchange carrier. There are other
competitors who serve these markets today as both facilities based and resale
carriers. Our focus has been on the small to medium business customer with
multiple locations and enterprise telecommunications requirements, where we
offer a combination of knowledge, experience and competitive pricing to meet
their specialized needs.


6




Cable
Television Services




We offer
cable television services in select areas of our territories and are a licensed
agent for a satellite provider. In 2008, we installed IPTV capability in the
Alabama territory not currently served by our cable operations. No provider has
overbuilt cable facilities in the areas we currently serve. In our Alabama
territory, Charter Communications, Inc. provides cable service, passing about
30% of our subscribers. In Maine, Time Warner Cable provides cable service,
passing approximately 60% of our RLEC subscribers. In addition, in all of our
cable television territories, we compete against digital broadcast satellite
providers including Dish Network and DirecTV.




Internet
Services




Competition
in the provision of RLEC data lines and Internet services currently comes from
alternative digital high-speed Internet service providers. Individual
competitors vary on a market-to-market basis and include Charter Communications,
Inc., Time Warner Cable, and a number of small, local competitors. At December
31, 2008, we provided data access lines to approximately 36% of our rural access
lines. In Maine and Missouri, we also provide dial-up and digital high-speed
Internet services to approximately 10,600 subscribers outside of our rural
telephone services territory. Our CLEC customers are provided a variety of data
access alternatives.




Transport
Services




Other
local telephone companies, long distance carriers, cable providers, utilities,
governments, and industry associations deploy and sell fiber capacity to users.
Existing and newly deployed capacity could be made available, impacting market
pricing. Multi-year contracts generally protect existing relationships and
provide revenue stability. The cost of and time required for deploying new fiber
can be a deterrent to adding capacity. We have expanded our fiber network in
Maine to reach additional locations and serve incremental
customers.




Information
Technology and Support Systems




We have
integrated software systems that function as an operational support and customer
care/billing system. One system serves our Alabama and Missouri local exchange
subscribers, one serves our additional Internet subscribers, and two serve our
Maine, Massachusetts and West Virginia subscribers. The systems include
automated provisioning and service activation, mechanized line records and
trouble reporting. These services are provided through the use of licensed
third-party software. By utilizing integrated software systems, we are able to
reduce individual company costs and standardize functions resulting in greater
efficiencies and profitability.




Each
system allows us to provide a single, unified bill for all our services which we
believe is a significant competitive advantage. Additionally, the systems
provide us an extensive database that enables us to gather detailed marketing
information in our service territory. This capability allows us to market new
services as they become available to particular customers. The Company has
implemented all currently established safeguards to Customer Proprietary Network
Information (CPNI) as established by the FCC for telecommunications providers
and is compliant with the “red flag” provisions of the Fair and Accurate
Transaction Act.




Environment




We are
subject to various federal, state and local laws relating to the protection of
the environment. We believe that we are in compliance in all material respects
with all such laws. The environmental compliance costs incurred by us to date
have not been material, and we currently have no reason to believe that such
costs will become material in the foreseeable future.




Employees




As of
December 31, 2008, we employed approximately 320 full-time and 7 part-time
employees. None of our employees are members of, or are represented by, any
labor union or other collective bargaining unit. We consider our relations with
our employees to be good.




Available
Information




Under the
Securities Exchange Act of 1934, we are required to file with or furnish to the
Securities and Exchange Commission, or SEC, annual, quarterly and current
reports, proxy and information statements and other information. You may read
and copy any document we file with or furnish to the SEC at the SEC’s Public
Reference Room at 100 F Street, N.E., Washington, D.C. 20549. Please call the
SEC at 1-800-SEC-0330 for further information about the Public Reference Room.
The SEC maintains a web site at http://www.sec.gov
that contains reports, proxy and information statements, and other information
regarding issuers that file electronically with the SEC. We file electronically
with the SEC.


7




We make
available, free of charge, through the investor relations section of our web
site, our reports on Forms 10-K, 10-Q and 8-K, and amendments to those reports,
as soon as reasonably practicable after they are filed with the SEC. The address
for our web site ishttp://www.OtelcoInc.com.




Our Code
of Ethics applies to all of our employees, officers and directors, including our
chief executive officer and our chief financial officer and principal accounting
officer. The full text of the Code of Ethics is available at the investor
relations section of our web site,http://www.OtelcoInc.com. We
intend to disclose any amendment to, or waiver from, a provision of the Code of
Ethics that applies to our chief executive officer or chief financial officer
and principal accounting officer in the investor relations section of our web
site.




The
information contained on our web site is not part of, and is not incorporated
in, this or any other report we file with or furnish to the SEC.




Item
1A.  Risk Factors




In
evaluating our business, every investor should carefully consider the following
risks. Our business, financial condition or results of operation could be
materially adversely affected by any of the following risks.




Our
Business is Geographically Concentrated and Dependent on Regional Economic
Conditions.




Our
business is conducted primarily in north central Alabama, Maine, western
Massachusetts, central Missouri and southern West Virginia and, accordingly, our
business is dependent upon the general economic conditions of these regions.
There can be no assurance that future economic conditions in these regions,
including the current global economic crisis, will not impact demand for our
services or cause residents to relocate to other regions, which may adversely
impact our business, revenue and cash flow.




The
Telecommunications Industry has Experienced Increased Competition.




Although
we have historically experienced limited wireline telephone competition in our
RLEC territories, the market for telecommunications services is highly
competitive. Certain competitors benefit from brand recognition and financial,
personnel, marketing and other resources that are significantly greater than
ours. We cannot predict the number of competitors that will emerge, especially
as a result of existing or new federal and state regulatory or legislative
actions. Increased competition from existing and new entities could have an
adverse effect on our business, revenue and cash flow.




In our
markets, we face competition from wireless carriers. Our unlimited calling
bundles provide our customers with an alternative to using cell phones. As
wireless carriers continue to build-out their networks and add products and
services aimed at the fixed wireless market, we may experience increased
competition, which could have an adverse effect on our business, revenue and
cash flow.




The
current and potential competitors in our RLEC territories include cable
television companies, competitive local exchange carriers and other providers of
telecommunications and data services, including Internet and VoIP service
providers, wireless carriers, satellite television companies, alternate access
providers, neighboring incumbent local exchange carriers, long distance
companies and electric utilities that may provide services competitive with
those products and services that we provide or intend to provide.




In Maine,
our competitive local exchange carrier operations may encounter a change in the
competitive landscape that would impact its continued ability to grow and/or
retain customers, sustain current pricing plans, and control the cost of access
to incumbent carrier customers.




Although
our long distance operations have historically been modest in relation to our
competitors, we have expanded our long distance business within our territories,
primarily through bundling long distance with other local services and providing
a single bill for these services. Our existing long distance competitors could
respond to such initiatives, including those with significantly greater
resources than us. New competitors may enter the market with attractive
offerings. There can be no assurance that our local services revenue, including
long distance services, will not decrease in the future as competition and/or
the cost of providing services increase.


8




The FCC
has adopted regulations requiring wireline telephone carriers to provide
portability of telephone numbers to wireless carriers when a customer
substitutes wireless service for wireline service. Wireline to wireless
portability enhances the competitive position of wireless carriers, although we
have experienced limited portability requests from wireless
carriers.




We
May Not be Able to Integrate New Technologies and Provide New Services in a
Cost-Efficient Manner.




The
telecommunications industry is subject to rapid and significant changes in
technology, frequent new service introductions and evolving industry standards.
We cannot predict the effect of these changes on our competitive position, our
capital expenditure requirements, our profitability or the industry generally.
Technological developments may reduce the competitiveness of our networks and
require additional capital expenditures or the procurement of additional
products that could be expensive and time consuming. In addition, new products
and services arising out of technological developments may reduce the
attractiveness of our services. If we fail to adapt successfully to
technological advances or fail to obtain access to new technologies, we could
lose customers and be limited in our ability to attract new customers and/or
sell new services to our existing customers. In addition, delivery of new
services in a cost-efficient manner depends upon many factors, and we may not
generate anticipated revenue from such services.




Disruptions
in Our Networks and Infrastructure May Cause Us to Lose Customers and Incur
Additional Expenses.




To be
successful, we will need to continue to provide our customers with reliable and
timely service over our networks. We face the following risks to our networks
and infrastructure:


●
                our
      territory can have significant weather events which physically damage
      access lines;●
                our
      rural geography creates the risk of security breaches, break-ins and
      sabotage;●
                power
      surges and outages, computer viruses or hacking, and software or hardware
      defects which are beyond our control; and●
                unusual
      spikes in demand or capacity limitations in our or our suppliers’
      networks.




Disruptions
may cause interruptions in service or reduced capacity for customers, either of
which could cause us to lose customers and/or incur expenses, and thereby
adversely affect our business, revenue and cash flow. In addition, the APSC,
MPUC, MDTC, MPSC, NHPUC and/or WVPSC could require us to issue credits on
customer bills for such service interruptions, further impacting revenue and
cash. Wholesale network contracts could impose service level penalties for
service disruptions.




Our
Success Depends on a Small Number of Key Personnel.




Our
success depends on the personal efforts of a small group of skilled employees
and senior management. The rural nature of our service area provides for a
smaller pool of skilled telephone employees and increases the challenge of
hiring employees. The loss of key personnel could have a material adverse effect
on our financial performance.




We
Provide Services to Our Customers Over Access Lines, and if We Lose Access
Lines, Our Business and Results of Operations May Be Adversely
Affected.




Our
business generates revenue by delivering voice and data services over access
lines. We have experienced net voice access line loss in our RLEC territories
due to challenging economic conditions, wireless substitution, loss of second
lines when we sell data access lines for Internet and increased competition. Our
RLEC voice access line count increased 40.5% through the acquisition of the CR
Companies. Excluding the acquisition, RLEC voice access lines declined by
approximately 4.1% during 2008. We expect to continue to experience net voice
access line loss in our rural markets, which will be wholly or partially offset
by increases in data access lines. If voice access line losses are not
substantially offset by data access line gains, it could adversely affect our
business and results of operations.




Our
Performance Is Subject to a Number of Other Economic and Non-Economic Factors,
Which We May Not Be Able to Predict Accurately.




There are
factors that may be beyond our control that could affect our operations and
business. Such factors include adverse changes in the conditions in the specific
markets for our products and services, the conditions in the broader market for
telecommunications services and the conditions in the domestic and global
economies, generally.


9




Although
our performance is affected by the general condition of the economy, not all of
our services are affected equally. Voice access revenue is generally linked to
relatively consistent variables such as population changes, housing starts and
general economic activity levels in the areas served. Data access and cable
television revenue is generally related to more variable factors such as
changing levels of discretionary spending on entertainment, the adoption of
e-commerce and other on-line activities by our current or prospective customers.
It is not possible for management to accurately predict all of these factors and
the impact of such factors on our performance.




Changes
in the regulatory, competitive and technological environments may also impact
our ability to increase revenue and/or earnings from the provision of local
wireline services. We may therefore have to place increased emphasis on
developing and realizing revenue through the provision of new and enhanced
services with higher growth potential. In such a case, there is a risk that
these revenue sources as well as our cost savings efforts through further
efficiency gains will not grow or develop at a fast enough pace to offset
slowing growth in local services. It is also possible that as we invest in new
technologies and services, demand for those new services may not develop. There
can be no assurance that we will be able to successfully expand our service
offerings through the development of new services, and our efforts to do so may
have a material adverse effect on our financial performance.




Changes
in the Regulation of the Telecommunications Industry Could Adversely Affect Our
Business, Revenue or Cash Flow.




We
operate in a regulated industry. The majority of our revenue has historically
been supported by and subject to regulation at the federal, state and local
level. Certain federal and state regulations and local franchise requirements
have been, are currently, and may in the future be, the subject of judicial
proceedings, legislative hearings and administrative proposals. Such proceedings
may relate to, among other things, the rates we may charge for our local,
network access and other services, the manner in which we offer and bundle our
services, the terms and conditions of interconnection, federal and state
universal service funds (including USF HCL), unbundled network elements and
resale rates, and could change the manner in which telecommunications companies
operate. We cannot predict the outcome of these proceedings or the impact they
will have on our business, revenue and cash flow.




Governmental
Authorities Could Decrease Network Access Charges or Rates for Local Services,
Which Would Adversely Affect Our Revenue.




Approximately
13.7% of our revenue for the year ended December 31, 2008 was derived from
interstate network access charges paid by long distance carriers for use of our
facilities to originate and terminate interstate and intrastate telephone calls.
The interstate network access rates that we can charge are regulated by the FCC,
and the intrastate network access rates that we can charge are regulated by the
regulatory commissions in each state in which we operate. Those rates may change
from time to time. The FCC has reformed and continues to reform the federal
network access charge system. It is unknown at this time what additional
changes, if any, the FCC or state regulatory commissions may adopt. Such
regulatory developments could adversely affect our business, revenue and cash
flow.




The local
services rates and intrastate access charges charged by our rural local exchange
carriers are regulated by state regulatory commissions which have the power to
grant and revoke authorization to companies to provide telecommunications
services and to impose other conditions and penalties. If we fail to comply with
regulations set forth by the state regulatory commissions, we may face
revocation of our authorizations in a state or other conditions and penalties.
It is possible that new plans would require us to reduce our rates, forego
future rate increases, provide greater features as part of our basic service
plan or limit our rates for certain offerings. We cannot predict the ultimate
impact, if any, of such changes on our business, revenue and cash
flow.




Our RLECs
operating in Maine, Missouri and West Virginia charge rates for local services
and intrastate access service based in part upon a rate-of-return authorized by
the state regulatory commissions. These authorized rates are subject to audit at
any time and may be reduced if the regulatory commission finds them excessive.
If any company is ordered to reduce its rates or if its applications to increase
rates are denied or delayed, our business, revenue and cash flow may be
negatively impacted.




NECA may
file revisions to its average schedule formula each year which are subject to
FCC approval. Five of our companies participate in average schedule rates. The
level of funding and future changes in the average schedule settlement rates are
not currently known with certainty and could be higher or lower.




A
Reduction in Universal Service Fund High Cost Loop Support Would Adversely
Affect Our Business, Revenue and Cash Flow.




Five of
our RLECs receive federal USF HCL revenue to support their high cost of
operations. Such support payments represented approximately 7.4% of our revenue
for the year ended December 31, 2008, and were based upon each participating
rural local exchange carrier’s average cost per loop as compared to the national
average cost per loop. These support payments fluctuate based upon the
historical costs of our participating rural local exchange carriers as compared
to the national average cost per loop. If our participating rural local exchange
carriers are unable to receive support from the USF HCL, or if such support is
reduced, our business, revenue and cash flow would be negatively
affected.


10




In the
last several years, the FCC made certain modifications to the USF HCL support
system that changed the sources of support and the method for determining the
level of support. In addition, a number of issues regarding source and amount of
contributions to, and eligibility for, payments from USF HCL are currently being
reviewed by the FCC. There is a cap on the total USF HCL payments made to
Incumbent Local Exchange Carriers (ILECs) nationwide. It is unclear whether the
changes in methodology will continue to accurately reflect the costs incurred by
our participating rural local exchange carriers, and whether they will provide
for the same amount of USF HCL support that we have received in the past. On
February 25, 2005, the FCC adopted several Federal-State Joint Board
recommendations to augment the requirements for telecommunications carriers
seeking designation as ETCs and urged states exercising ETC designation
authority to take the same steps. Applicants for ETC designation by the FCC will
now be required to provide a five-year plan for utilization of the high-cost
universal service support to be received, demonstrate an ability to remain
functional during emergency situations, demonstrate an ability to satisfy
consumer protection and service quality standards, offer local service plans
comparable to that provided by the incumbent local exchange carrier, and
acknowledge the possibility of being required to provide equal access to long
distance service providers if only one ETC remains designated within the service
area. Those carriers already designated as ETCs by the FCC were required to
demonstrate compliance with these standards by October 1, 2006. Additional
annual certification and reporting requirements were also adopted. These changes
have not had a material impact on the Company.




Similarly,
the FCC in September 2004 asked the Federal-State Joint Board on Universal
Service to review the federal rules relating to universal service support
mechanisms for rural carriers, including addressing the relevant costs and the
definition of rural telephone company for the purpose of determining the
appropriate universal service support. On May 16, 2006, the FCC released an
order extending the current high-cost universal support rules until the FCC
adopts changes, if any, to these rules. The Federal-State Joint Board issued its
long-term USF reform recommendations on November 20, 2007 which, if approved,
could affect USF support. The outcome of these proceedings and other regulatory
or legislative changes could affect the amount of USF HCL support that we
receive, and could have an adverse effect on our business, revenue and cash
flow. If a wireless or other telecommunications carrier receives ETC status in
our service areas or even outside of our service areas, the amount of support we
receive from the USF HCL could decline under current rules, and under some
proposed USF HCL rule changes, could be significantly reduced. In the past, some
disbursements to another class of universal service fund recipients, schools and
libraries, were suspended to comply with the Anti-Deficiency Act (31 U.S.C. §
1341) (2000). Legislation was passed that exempts USF funds from the
Anti-Deficiency Act temporarily, with permanent legislation pending. We cannot
predict the outcome of these actions.




USAC
serves as the administrative agent to collect data and distribute funds for USF.
In 2006, it began conducting High Cost Beneficiary audits, designed to ensure
compliance with FCC rules and program requirements and to assist in program
compliance. Carriers are chosen from a random sample of each type of ETC,
including average schedule and cost companies, incumbents and competitors, rural
and non-rural, from various states. Audits are designed to ensure proper
designation of a carrier as ETC, accuracy of data submissions, documentation of
accounting procedures, physical inventory of assets, true-up of projected data,
and samples of detailed documentation (e.g., invoices, continuing property
records). We were notified by USAC in December 2006 that two of our companies,
Blountsville and Hopper, were selected for audit. In January 2008, we were
notified that two more of our companies, Otelco Telephone and Brindlee Mountain
Telephone, were selected for audit. These audits have been completed and no
action is pending. Granby was selected for audit in January 2008. The audit firm
subsequently withdrew from the audit and USAC has not replaced the auditor.
These audits are being conducted widely across our industry as directed by the
FCC and are anticipated to continue, although there is no guidance on the
process currently available.




If
We Were to Lose Our Protected Status Under Interconnection Rules, We Would Incur
Additional Administrative and Regulatory Expenses and Face More
Competition.




As a
“rural telephone company” under the Communications Act, each of our RLECs is
exempt from the obligation to lease its unbundled facilities to competitive
local exchange carriers, to offer retail services at wholesale prices for
resale, to permit competitive collocation at its facilities and to comply with
certain other requirements applicable to larger incumbent local exchange
carriers. However, we eventually may be required to comply with these
requirements in some or all of our service areas if: (i) we receive a bona fide
request from a telecommunications carrier; and (ii) the state regulatory
commissions, as applicable, determine that it is in the public interest to
impose such requirements. In addition, we may be required to comply with some or
all of these requirements in order to achieve greater pricing flexibility from
state regulators. If we are required to comply with these requirements, we could
incur additional administrative and regulatory expenses and face more
competition which could adversely affect our business, revenue and cash
flow.


11


Our
Current Dividend Policy May Negatively Impact Our Ability to Maintain or Expand
Our Network Infrastructure and Finance Capital Expenditures or
Operations.




Our board
of directors has adopted a dividend policy pursuant to which substantially all
of the cash generated by our business in excess of operating needs, interest and
principal payments on indebtedness, and capital expenditures sufficient to
maintain our network infrastructure, would in general be distributed as regular
quarterly cash dividends to the holders of our Class A common stock and not
retained by us. Our Class B common stock is expected to convert to income
deposit securities after the end of 2009, increasing the number of Class A
shares with a resultant increase in dividend cost within the current policy. As
a result, we may not have a sufficient amount of cash to fund our operations in
the event of a significant business downturn, finance growth of our network or
unanticipated capital expenditure needs. We may have to forego growth
opportunities or capital expenditures that would otherwise be necessary or
desirable if we do not find alternative sources of financing or if we do not
modify our dividend policy. If we do not have sufficient cash for these
purposes, our financial condition and our business will suffer or our board of
directors may change our dividend policy.




We
Are Subject to Restrictive Debt Covenants That Limit Our Business Flexibility By
Imposing Operating and Financial Restrictions on Our Operations.




The
agreements governing our indebtedness impose significant operating and financial
restrictions on us. These restrictions prohibit or limit, among other
things:


●
                the
      incurrence of additional indebtedness and the issuance of preferred stock
      and certain redeemable capital stock;●
                the
      making of certain types of restricted payments, including investments and
      acquisitions;●
                specified
      sales of assets;●
                specified
      transactions with affiliates;●
                the
      creation of a number of liens;●
                consolidations,
      mergers and transfers of all or substantially all of our assets;
      and●
                our
      ability to change the nature of our
business.




Item
1B. Unresolved Staff Comments




None.




Item
2. Properties




Our
property consists primarily of land and buildings; central office, Internet and
cable equipment; computer software; telephone lines; and related equipment. Our
telephone lines include aerial and underground cable, conduit, poles and wires.
Our central office equipment includes digital and software defined switches,
Internet and other servers and related peripheral equipment. We own
substantially all our real property in Alabama and Missouri, including our
corporate office. We primarily lease property in Maine, Massachusetts and West
Virginia, including our primary office locations in Bangor, New Gloucester and
Portland, Maine; Granby, Massachusetts; and War, West Virginia. We also lease
certain other real property, including land in Oneonta, Alabama, pursuant to a
long-term, renewable lease. A significant portion of our Alabama cable
television service equipment is located on this leased property. As of December
31, 2008, our property and equipment consisted of the
following:


12





(In
      Thousands)Land
                          
                          $
                          1,181Buildings
      and improvements
                          
                          
                          11,244Telephone
      equipment
                          
                          
                          201,218Cable
      television equipment
                          
                          
                          8,964Furniture
      and equipment
                          
                          
                          2,828Vehicles
                          
                          
                          5,414Computer
      hardware and software
                          
                          
                          12,851Internet
      equipment
                          
                          3,061Total
      property and equipment
                          
                          
                          246,761Accumulated
      depreciation
                          
                          (171,354
                          )Net
      property and equipment
                          
                          $
                          75,407




Our
senior credit facility is secured by substantially all of the assets of our
subsidiaries that are guarantors of the senior credit facility. As of December
31, 2008, the subsidiary guarantors represent $62.5 million of the $75.4 million
in net property and equipment.




Item
3. Legal Proceedings




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 APSC, MPUC, MDTC, MPSC, NHPUC, and WVPSC relating
primarily to rate making and customer service requirements. Currently, none of
the legal proceedings are expected to have a material adverse effect on our
business.




Item
4. Submission of Matters to a Vote of Security Holders




During
the fourth quarter of fiscal 2008, no matter was submitted to a vote of our
security holders.




Item
X. Executive Officers of the Registrant




The
following table sets forth the names and positions of our executive officers and
certain other officers, and their ages as of December 31, 2008.


Name
                                                
                                                
                                                
                                                Age
                                                
                                                
                                                PositionMichael
      D. Weaver
                                                
                                                56
                                                
                                                President,
      Chief Executive Officer and DirectorCurtis
      L. Garner, Jr.
                                                
                                                61
                                                
                                                Chief
      Financial OfficerDennis
      Andrews
                                                
                                                52
                                                
                                                Senior
      Vice President and General Manager, AlabamaJerry
      C. Boles
                                                
                                                56
                                                
                                                Vice
      President and ControllerGary
      B. Romig
                                                
                                                58
                                                
                                                Vice
      President and General Manager, MissouriNicholas
      A. Winchester
                                                
                                                39
                                                
                                                Senior
      Vice President and General Manager, New EnglandRobert
      J. Souza
                                                
                                                55
                                                
                                                Vice
      President of Operations, New
England




Michael D. Weaver has served
as our President, Chief Executive Officer and a Director since January 1999.
Prior to this time, he spent 10 years with Oneonta Telephone Co., Inc., the
predecessor to Otelco Telephone, serving as Chief Financial Officer from 1990 to
1998 and General Manager from January 1998 to January 1999.


13




Curtis L. Garner, Jr. has
served as our Chief Financial Officer since February 2004. Prior to this
position, he provided consulting services to a number of businesses and
not-for-profit organizations from October 2002. He served PTEK Holdings, Inc.
from November 1997 through September 2002 (including one year as a consultant),
first as President of one of its divisions, and later as Chief Administrative
Officer for another division. Prior thereto, he spent 26 years at AT&T
Corp., retiring in 1997 as the Chief Financial Officer of the Southern and
Southwestern Regions of AT&T Corp.’s consumer long distance
business.




Dennis Andrews was appointed
Senior Vice President and General Manager of our Alabama division in August
2006. He served as our Vice President and General Manager, Brindlee and
Blountsville since November 2005 and Vice President — Regulatory
Affairs since July 2000. Prior to this position, he spent 21 years at Brindlee
where he held several positions, including Vice President — Finance,
General Manager, Operations Manager and Accounting Department
Manager.




Jerry C. Boles has served as
our Vice President and Controller since he joined the Company in January 1999.
Prior to joining Otelco, he was controller for McPherson Oil Company for 14
years. He also worked in public accounting for 10 years, is licensed as a CPA by
the state of Alabama, and is a member in good standing of the American Institute
of Certified Public Accountants.




Gary B. Romig has served as
our Vice President and General Manager of our Missouri division since its
acquisition in December 2004. He served as Co-President of Mid-Missouri for five
years prior to the acquisition by Otelco. He joined Mid-Missouri in May 1973 and
has been involved in all aspects of the outside plant operation.




Nicholas A. Winchester joined
Otelco in July 2006 as the Senior Vice President and General Manager of our New
England division (previously known as our Maine division). He served as the
President of Mid-Maine when it was acquired by Otelco. From 1998 through 2005,
he served in various leadership positions in the sales organization, building
the successful competitive sales team for Mid-Maine.




Robert J. Souza joined Otelco
in October 2008 as the Vice President of Operations for New England. He served
as President for the CR Companies from 2001 until they were acquired by Otelco
in October 2008. Prior to that role, he served as Operations Manager for Saco
River, having joined that company in 1983. His 33 years experience in the
industry includes three years with Ooltewah-Collegedale Telephone Company in
Tennessee and five years with New England Telephone in Maine.





Officers
are not elected for a fixed term of office but hold their position until a
successor is named.


14




PART
II
  Item
5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer
Purchases of Equity Securities
  Market
Information
  We have
outstanding two separate classes of common stock, our Class A common stock, par
value $0.01 per share, and our Class B common stock, par value $0.01 per
share.
  Our IDSs,
each representing one share of Class A common stock and $7.50 principal amount
of senior subordinated notes due 2019, began trading on the American Stock
Exchange, or AMEX, under the symbol “OTT” and on the Toronto Stock Exchange, or
TSX, under the symbol “OTT.un” on December 16, 2004. On June 30, 2008, the
Company voluntarily withdrew its listing on the AMEX and began trading on the
NASDAQ Global Market, or NASDAQ, continuing to use the symbol “OTT”. During this
period, our IDSs continued to trade on the TSX. The high and low for the IDSs on
the AMEX and NASDAQ, as applicable, during the quarters indicated are as
follows:
 High
      ($US)
                              
                              
                              Low
      ($US)2008Fourth
      Quarter
                              
                              $
                              14.27
                              
                              
                              $
                              6.79Third
      Quarter
                              
                              $
                              16.50
                              
                              
                              $
                              12.50Second
      Quarter
                              
                              $
                              17.23
                              
                              
                              $
                              13.61First
      Quarter
                              
                              $
                              18.20
                              
                              
                              $
                              14.002007Fourth
      Quarter
                              
                              $
                              19.69
                              
                              
                              $
                              13.72Third
      Quarter
                              
                              $
                              19.75
                              
                              
                              $
                              14.01Second
      Quarter
                              
                              $
                              22.94
                              
                              
                              $
                              19.25First
      Quarter
                              
                              $
                              24.47
                              
                              
                              $
                              18.05
  There is
no established trading market for our Class B common stock. The Class B common
stock is convertible into IDS units on a one-for-one basis without a financial
test after December 21, 2009.
  Holders
  As of
March 10, 2009, there were approximately 14,700 record holders of our IDSs.
Holders of our IDSs have the right to separate the IDSs into the shares of Class
A common stock and senior subordinated notes represented thereby. As of the date
of this report, no holder has elected to separate the IDSs.
  As of
March 10, 2009, there were approximately 10 record holders of our Class B common
stock.
  Dividends
  The board
of directors declared and the Company paid dividends of $0.17625 per Class A
common share each quarter in 2006, 2007 and 2008 for a total of $0.705 per share
for each year. The dividend in the fourth quarter of 2006 was paid on January 2,
2007. For 2007, $0.02 of the dividend is considered qualified for holder tax
purposes and the balance is considered a non-taxable return of capital. For
2008, all of the dividends are considered a non-taxable return of
capital.
  The
payment of dividends on our Class B common stock is prohibited by our
certificate of incorporation. As such, we have never declared or paid cash
dividends on our Class B common stock, nor do we intend to declare or pay cash
dividends on our Class B common stock in the foreseeable
future.
  15
  Our board
of directors has adopted a dividend policy for our Class A common stock pursuant
to which, in the event and to the extent we have any available cash for
distribution to the holders of shares of our Class A common stock and subject to
applicable law and the terms of our credit facility, the indenture governing our
senior subordinated notes and any other then outstanding indebtedness of ours,
our board of directors will declare cash dividends on our Class A common stock.
Our dividend policy reflects a basic judgment
that our stockholders would be better served by distributing available cash in
the form of dividends rather than retaining it. Under this dividend policy, cash
generated by our business in excess of operating needs, interest and principal
payments on indebtedness, capital expenditures and income taxes, if any, would
in general be distributed as regular quarterly dividends to the holders of our
Class A common stock rather than retained by us as cash on our consolidated
balance sheet. In determining our expected dividend levels, we review and
analyze, among other things, our operating and financial performance; the
anticipated cash requirements associated with our capital structure; our
anticipated capital expenditure requirements; our expected other cash needs; the
terms of our debt instruments, including our credit facility; other potential
sources of liquidity; and various other aspects of our business. If these
factors change, the board would need to reassess our dividend
policy.
  As
described more fully below, holders of our Class A common stock may not receive
any dividends as a result of the following factors:
 ●
                nothing
      requires us to pay dividends;●
                while
      our current dividend policy contemplates the distribution of our available
      cash, this policy could be modified or revoked at any
  time;●
                even
      if our dividend policy were not modified or revoked, the actual amount of
      dividends distributed under the policy and the decision to make any
      distribution is entirely at the discretion of our board of
      directors;●
                the
      amount of dividends distributed is subject to covenant restrictions in our
      indenture and our credit facility;●
                the
      amount of dividends distributed is subject to state law
      restrictions;●
                our
      stockholders have no contractual or other legal right to dividends;
      and●
                we
      may not have enough cash to pay dividends due to changes to our operating
      earnings, working capital requirements and anticipated cash
      needs.
  Dividends
on our Class A common stock will not be cumulative. Consequently, if dividends
on our Class A common stock are not declared and/or paid at the targeted levels,
our stockholders will not be entitled to receive such payments in the
future.
  If we
have any remaining cash after the payment of dividends as contemplated above,
our board of directors will, in its sole discretion, decide to use that cash to
fund capital expenditures or acquisitions, repay indebtedness, pay additional
dividends or for general corporate purposes.
  Restrictions
on Payment of Dividends
  The
indenture governing our senior subordinated notes restricts our ability to
declare and pay dividends on our common stock as follows:
 ●
                we
      may only pay dividends in any given fiscal quarter equal to 100% of our
      excess cash for the period from and including the first fiscal quarter
      beginning after the date of the indenture to the end of our most recently
      ended fiscal quarter for which internal financial statements are available
      at the time of such payment. “Excess Cash” means with respect to any
      period, Adjusted EBITDA, as defined in the indenture, minus the sum of (i)
      cash interest expense, (ii) capital expenditures and (iii) cash income tax
      expense, in each case, for such period;●
                we
      may not pay dividends if our interest coverage ratio, which is defined as
      Adjusted EBITDA divided by consolidated interest expense, is below 1.4
      times;●
                we
      may not pay any dividends if not permitted under any of our senior
      indebtedness;●
                we
      may not pay any dividends while interest on the senior subordinated notes
      is being deferred or, after the end of any interest deferral, so long as
      any deferred interest has not been paid in full; and●
                we
      may not pay any dividends if a default or event of default under the
      indenture governing the senior subordinated notes has occurred and is
      continuing.
  Our
credit facility does not allow us to pay dividends on our common stock unless we
maintain:
  16
  ●
                  a
      “fixed charge coverage ratio” (defined as our Consolidated EBITDA, as
      defined in the credit facility, for any period of four consecutive fiscal
      quarters divided by the sum of certain capital expenditures, cash income
      taxes, the aggregate amount of cash interest expense and scheduled
      principal payments for such period) of not less than 1.14 times;
      and●
                  a
      “senior leverage ratio” (defined as senior secured debt as of the last day
      of any period divided by our Consolidated EBITDA, as defined in the credit
      facility, for any period of four consecutive fiscal quarters) of not more
      than 3.85 times.
  In
addition, our credit facility does not allow us to pay dividends on our common
stock if and for as long as (a) interest payments on our senior subordinated
notes are required to be deferred pursuant to the terms of the credit facility,
(b) any default or event of default exists under the credit facility, (c)
deferred interest or interest on deferred interest is outstanding under our
senior subordinated notes, (d) a compliance certificate for the prior fiscal
quarter has not been timely delivered or (e) there is insufficient excess cash,
as defined in the credit facility.
  Securities
Authorized for Issuance under Equity Compensation Plans
  No
securities have been issued under any equity compensation plan and no such plan
is currently in place.
  Recent
Sales of Unregistered Securities
  During
the fiscal year ended December 31, 2008, we did not issue any unregistered
securities.
  Beginning
on December 21, 2006, and subject to a financial test relating to our Adjusted
EBITDA (as such term is defined in the indenture governing our senior
subordinated notes) that will no longer apply following December 21, 2009, and
certain other conditions, at the option of the holders of our Class B common
stock, such holders may exchange one share of Class B common stock for one IDS,
subject to compliance with law and applicable agreements. The Adjusted EBITDA
financial test at December 31, 2008 did not allow for an early exchange of our
Class B common stock for IDS units.
  Performance
Graph
  The
following graph compares the cumulative total stockholder return (stock price
appreciation plus reinvested dividends) for our Class A shares (represented by
IDSs) with the cumulative total return (including reinvested dividends) of the
Russell 2000 Index (“R2000”) and the Standard & Poor’s — Telecommunications
Services Index (“S&P-TS”), assuming a $100 investment on December 16, 2004
(the date our IDSs began trading on the American Stock Exchange) through
December 31, 2008:
  COMPARISON
OF 4 YEAR CUMULATIVE TOTAL RETURN*
 Among
Otelco Inc., The Russell 2000 Index
 And The
S&P Telecommunication Services Index
  
  *$100
invested on 12/16/04 in stock or 11/30/04 in index-including reinvestment of
dividends.
 Fiscal
year ending December 31.
  Copyright©
2009 S&P, a division of The McGraw-Hill Companies Inc. All rights
reserved.
  17


Cumulative
      Stockholder Returns on $100 Invested:12/16/04
                                                      
                                                      
                                                      12/04
                                                      
                                                      
                                                      12/05
                                                      
                                                      
                                                      12/06
                                                      
                                                      
                                                      12/07
                                                      
                                                      
                                                      12/08Otelco
      Inc.
                                                      
                                                      
                                                      100.00
                                                      
                                                      
                                                      
                                                      104.20
                                                      
                                                      
                                                      
                                                      115.23
                                                      
                                                      
                                                      
                                                      170.00
                                                      
                                                      
                                                      
                                                      121.46
                                                      
                                                      
                                                      
                                                      75.33Russell
      2000
                                                      
                                                      
                                                      100.00
                                                      
                                                      
                                                      
                                                      102.96
                                                      
                                                      
                                                      
                                                      107.65
                                                      
                                                      
                                                      
                                                      127.42
                                                      
                                                      
                                                      
                                                      125.43
                                                      
                                                      
                                                      
                                                      83.05S&P
      Telecommunication Services
                                                      
                                                      
                                                      100.00
                                                      
                                                      
                                                      
                                                      102.57
                                                      
                                                      
                                                      
                                                      96.79
                                                      
                                                      
                                                      
                                                      132.42
                                                      
                                                      
                                                      
                                                      148.23
                                                      
                                                      
                                                      
                                                      103.04
  Item
6. Selected Financial Data
  The
following table sets forth our selected consolidated financial and other
information. The consolidated financial information as of December 31, 2006,
2007, and 2008 and for each of the three years in the period ended December 31,
2008 has been derived from, and should be read together with, our audited
consolidated financial statements and the accompanying notes included in Item 8
of this report. The consolidated financial information as of December 31, 2004
and 2005 and for each of the two years in the period ended December 31, 2005 has
been derived from our audited consolidated financial statements not included in
this report. The consolidated financial information set forth should be read in
conjunction with, and is qualified in its entirety by reference to,
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations” in Item 7 and our audited consolidated financial statements and
related notes in Item 8 of this report.
 At
      and For The Year Ended December 31,2004(1)
                                                                            
                                                                            
                                                                            2005
                                                                            
                                                                            
                                                                            2006(1)
                                                                            
                                                                            
                                                                            2007
                                                                            
                                                                            
                                                                            2008(1)(In
      Thousands Except Per Share Amounts)Income
      Statement DataRevenues:Local
      services
                                                                            
                                                                            $
                                                                            16,657
                                                                            
                                                                            
                                                                            $
                                                                            17,376
                                                                            
                                                                            
                                                                            $
                                                                            21,371
                                                                            
                                                                            
                                                                            $
                                                                            26,102
                                                                            
                                                                            
                                                                            $
                                                                            30,014Network
      access
                                                                            
                                                                            
                                                                            16,602
                                                                            
                                                                            
                                                                            
                                                                            21,873
                                                                            
                                                                            
                                                                            
                                                                            23,481
                                                                            
                                                                            
                                                                            
                                                                            25,671
                                                                            
                                                                            
                                                                            
                                                                            27,281Cable
      television
                                                                            
                                                                            
                                                                            1,818
                                                                            
                                                                            
                                                                            
                                                                            2,087
                                                                            
                                                                            
                                                                            
                                                                            2,191
                                                                            
                                                                            
                                                                            
                                                                            2,184
                                                                            
                                                                            
                                                                            
                                                                            2,389Internet
                                                                            
                                                                            
                                                                            2,189
                                                                            
                                                                            
                                                                            
                                                                            5,636
                                                                            
                                                                            
                                                                            
                                                                            8,669
                                                                            
                                                                            
                                                                            
                                                                            11,517
                                                                            
                                                                            
                                                                            
                                                                            12,449Transport
      Services
                                                                            
                                                                            
                                                                            —
                                                                            
                                                                            
                                                                            
                                                                            —
                                                                            
                                                                            
                                                                            
                                                                            1,877
                                                                            
                                                                            
                                                                            
                                                                            4,275
                                                                            
                                                                            
                                                                            
                                                                            4,982Total
                                                                            
                                                                            $
                                                                            37,266
                                                                            
                                                                            
                                                                            $
                                                                            46,972
                                                                            
                                                                            
                                                                            $
                                                                            57,589
                                                                            
                                                                            
                                                                            $
                                                                            69,749
                                                                            
                                                                            
                                                                            $
                                                                            77,115Income
      from operations
                                                                            
                                                                            $
                                                                            14,658
                                                                            
                                                                            
                                                                            $
                                                                            19,439
                                                                            
                                                                            
                                                                            $
                                                                            19,803
                                                                            
                                                                            
                                                                            $
                                                                            19,265
                                                                            
                                                                            
                                                                            $
                                                                            21,087Income
      (loss) before income tax and accretion expense
                                                                            
                                                                            $
                                                                            10,074
                                                                            
                                                                            
                                                                            $
                                                                            3,246
                                                                            
                                                                            
                                                                            $
                                                                            2,802
                                                                            
                                                                            
                                                                            $
                                                                            (195
                                                                            )
                                                                            
                                                                            $
                                                                            243Net
      income available to common stockholders
                                                                            
                                                                            $
                                                                            6,114
                                                                            
                                                                            
                                                                            $
                                                                            1,792
                                                                            
                                                                            
                                                                            $
                                                                            1,161
                                                                            
                                                                            
                                                                            $
                                                                            179
                                                                            
                                                                            
                                                                            $
                                                                            214Net
      income (loss) per share(2)Basic
                                                                            
                                                                            $
                                                                            0.75
                                                                            
                                                                            
                                                                            $
                                                                            0.19
                                                                            
                                                                            
                                                                            $
                                                                            0.12
                                                                            
                                                                            
                                                                            $
                                                                            0.02
                                                                            
                                                                            
                                                                            $
                                                                            0.02Diluted
                                                                            
                                                                            $
                                                                            0.71
                                                                            
                                                                            
                                                                            $
                                                                            0.12
                                                                            
                                                                            
                                                                            $
                                                                            0.12
                                                                            
                                                                            
                                                                            $
                                                                            (0.10
                                                                            )
                                                                            
                                                                            $
                                                                            (0.03
                                                                            )Dividends
      declared per share
                                                                            
                                                                            $
                                                                            —
                                                                            
                                                                            
                                                                            $
                                                                            0.71
                                                                            
                                                                            
                                                                            $
                                                                            0.71
                                                                            
                                                                            
                                                                            $
                                                                            0.71
                                                                            
                                                                            
                                                                            $
                                                                            0.71Balance
      Sheet DataCash
      and cash equivalents
                                                                            
                                                                            $
                                                                            5,407
                                                                            
                                                                            
                                                                            $
                                                                            5,569
                                                                            
                                                                            
                                                                            $
                                                                            14,402
                                                                            
                                                                            
                                                                            $
                                                                            12,810
                                                                            
                                                                            
                                                                            $
                                                                            13,542Property
      and equipment, net
                                                                            
                                                                            
                                                                            48,196
                                                                            
                                                                            
                                                                            
                                                                            44,556
                                                                            
                                                                            
                                                                            
                                                                            60,494
                                                                            
                                                                            
                                                                            
                                                                            54,610
                                                                            
                                                                            
                                                                            
                                                                            75,407Total
      assets
                                                                            
                                                                            
                                                                            196,227
                                                                            
                                                                            
                                                                            
                                                                            192,126
                                                                            
                                                                            
                                                                            
                                                                            243,852
                                                                            
                                                                            
                                                                            
                                                                            232,486
                                                                            
                                                                            
                                                                            
                                                                            355,541Long-term
      notes payable (including current portion)
                                                                            
                                                                            
                                                                            161,075
                                                                            
                                                                            
                                                                            
                                                                            161,075
                                                                            
                                                                            
                                                                            
                                                                            201,075
                                                                            
                                                                            
                                                                            
                                                                            170,020
                                                                            
                                                                            
                                                                            
                                                                            278,800
  18
 
 (1)
                During
      fiscal 2004, 2006 and 2008, we acquired Mid-Missouri, Mid-Maine and the CR
      Companies respectively, each containing one or more RLECs, with Mid-Maine
      and the CR Companies also having a competitive local exchange company.
      More information about each acquisition can be found in Item 1 of this
      report.(2)
                On
      December 21, 2004, the Company completed its initial public offering of
      IDSs. Net income (loss) per share is restated to reflect the relevant
      shares that would have been outstanding in
2004.
  Item
7. Management’s Discussion and Analysis of Financial Condition and Results of
Operations
  Overview
  General
  Since
1999, we have acquired and operate ten rural local exchange carriers serving
subscribers in north central Alabama, central Maine, western Massachusetts,
central Missouri and southern West Virginia. We are the sole wireline telephone
services provider for many of the rural communities we serve. We also acquired
and operate competitive local exchange carriers serving subscribers throughout
the state of Maine. Our services include local and long distance telephone
services, network access, other telephone related services, cable television (in
some markets) and Internet access. We view, manage and evaluate the results of
operations from the various telecommunications products and services as one
company and therefore have identified one reporting segment as it relates to
providing segment information. As of December 31, 2008, we operated
approximately 100,043 access line equivalents and supply an additional 98,187
wholesale network connections.
  Our core
businesses are local and long distance telecommunications services, wholesale
access to the local and long distance network, and the provision of network
access to other wireline, long distance and wireless carriers for calls
originated or terminated on our network. Our core businesses generated
approximately 74.3% of our total revenues in 2008. We also provide cable
television service in some markets and digital high-speed and dial-up Internet
access in all of our markets.
  The
following discussion and analysis should be read in conjunction with our
financial statements and the related notes and other financial information
appearing elsewhere in this report, including in Item 8. The following
discussion and analysis relates to our financial condition and results of
operations on a consolidated basis, including the acquisition of Mid-Maine as of
July 3, 2006 and the CR Companies as of October 31, 2008.
  Impact
of Indebtedness Levels on our Results of Operations and Liquidity
  As a
result of the significant amount of debt we have outstanding through our senior
credit facility, the senior subordinated note portion of the outstanding IDSs,
and the senior subordinated notes sold separately (not in the form of IDSs), our
interest expense remains at a significantly high level. We have an interest rate
cap that expires in December 2009. In February 2009, we entered into interest
rate swap agreements to cover the majority of borrowings under the senior credit
facility to protect against interest rate swings. See “—Subsequent Events.” Our
current credit facility matures on October 31, 2013, when it must be
refinanced.
  Our board
of directors has adopted a dividend policy for our Class A common stock pursuant
to which, in the event and to the extent we have any available cash for
distribution to the holders of shares of our Class A common stock and subject to
applicable law and terms of our then existing indebtedness, our board of
directors will declare cash dividends on our Class A common stock. The cash
requirements of this dividend policy are in addition to our high levels of
indebtedness and related debt service requirements discussed above. We expect
the cash requirements to be funded through cash flow generated from the
operations of our business. We also have access to a $15.0 million revolving
credit facility to supplement our liquidity position as needed.
  There can
be no assurance that we will have sufficient cash in the future to pay dividends
on our Class A common stock at the historical rate or at all. If we do not
generate sufficient cash from our operating activities in the future to pay
dividends, we may have to reduce or eliminate dividends or rely on cash provided
by financing activities in order to fund dividend payments, if such financing is
available. However, if we use working capital or borrowings under our credit
facility to fund dividends, we would have less cash available for future
dividends and we may not have sufficient cash to pursue growth opportunities
such as the introduction of new services and the acquisition of other telephone
companies, or to respond to unanticipated events such as the failure of a
portion of our switching or network facilities. If we do not have sufficient
cash to finance growth opportunities or capital expenditures that would
otherwise be necessary or desirable, and cannot find alternative sources of
financing, our financial condition and our business will
suffer.
  19
  Our
current dividend policy, our high indebtedness levels and related debt service
requirements and our capital expenditure requirements will significantly limit
any cash available from operations for other uses for the foreseeable
future.
  Revenue
Sources
  We derive
our revenues from five sources:
 ●
                Local services. We
      receive revenues from providing local exchange telecommunications services
      in our ten rural territories, from the wholesale network services in New
      England, and on a competitive basis throughout Maine. These revenues
      include monthly subscription charges for basic service, calling beyond the
      local territory on a fixed price and on a per minute basis, local private
      line services and enhanced calling features, such as voicemail, caller
      identification, call waiting and call forwarding. We also provide billing
      and collections services for other carriers under contract and receive
      revenues from directory advertising. A growing portion of our rural
      subscribers take bundled service plans which include multiple services,
      including unlimited domestic calling, for a flat monthly
    fee.●
                Network access
      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, Massachusetts, Maine, Missouri and West Virginia are based
      on rates approved by the APSC, MDTC, MPUC, MPSC and WVPSC respectively,
      where appropriate. Switched and special access charges for interstate and
      international services are based on rates approved by the
    FCC.●
                Cable television
      services. We offer basic, digital, high-definition, digital video
      recording and pay per view cable television services to a portion of our
      telephone service territory in both Alabama and Missouri, including
      Internet Protocol television in Alabama.●
                Internet services. We
      receive revenues from monthly recurring charges for dial-up and digital
      high-speed Internet access.●
                Transport Services. We
      receive monthly recurring revenues for the rental of fiber to transport
      data and other telecommunications services in
  Maine.
  Access
Line and Customer Trends
  The
number of access lines served is a fundamental factor in determining revenue
stability for a telecommunications provider. Reflecting a general trend in the
rural local exchange carrier industry, the number of rural voice access lines we
serve has been decreasing gradually when normalized for territory acquisitions.
We expect that this trend will continue, and may be potentially impacted by the
effect of the economy on our customers. These trends will be offset by the
growth of data access lines, also called digital high-speed Internet access
service. Our competitive carrier voice and data access lines have grown as we
continue to further penetrate our chosen markets. Our ability to continue this
growth and our response to the rural trends will have an important impact on our
future revenues. Our primary strategy consists of leveraging our strong
incumbent market position, selling additional services to our rural customer
base and providing better service and support levels than the incumbent carrier
to our competitive customer base.
  20
  Year
      Ended December 31,2006
                                    
                                    
                                    2007
                                    
                                    
                                    2008Key
      Operating StatisticsRLEC
      access lines:Voice
      lines
                                    
                                    
                                    37,736
                                    
                                    
                                    
                                    36,687
                                    
                                    
                                    
                                    51,530Data
      lines
                                    
                                    
                                    10,016
                                    
                                    
                                    
                                    12,160
                                    
                                    
                                    
                                    18,709RLEC
      access line equivalents (1)
                                    
                                    
                                    47,752
                                    
                                    
                                    
                                    48,847
                                    
                                    
                                    
                                    70,239CLEC
      access lines:Voice
      lines
                                    
                                    
                                    14,267
                                    
                                    
                                    
                                    16,973
                                    
                                    
                                    
                                    26,558Data
      lines
                                    
                                    
                                    2,016
                                    
                                    
                                    
                                    2,571
                                    
                                    
                                    
                                    3,246CLEC
      access line equivalents (1)
                                    
                                    
                                    16,283
                                    
                                    
                                    
                                    19,544
                                    
                                    
                                    
                                    29,804Otelco
      access line equivalents (1)
                                    
                                    
                                    64,035
                                    
                                    
                                    
                                    68,391
                                    
                                    
                                    
                                    100,043Wholesale
      network connections
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    98,187Cable
      television customers
                                    
                                    
                                    4,188
                                    
                                    
                                    
                                    4,169
                                    
                                    
                                    
                                    4,082Dial-up
      internet customers
                                    
                                    
                                    19,587
                                    
                                    
                                    
                                    15,249
                                    
                                    
                                    
                                    11,650
  (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).
  The
primary reasons for the increase in access line equivalents in 2008 are the
acquisition of the CR Companies on October 31, 2008 and the continuing growth in
our CLEC customers in Maine. Without the acquisition, RLEC voice and data access
lines declined 0.3% and CLEC voice and data access lines increased 11.1% for the
year ended December 31, 2008. The CR Companies provide wholesale network
connections to other providers of telecommunications services, including a large
multi-service provider in New England. We are the primary long distance provider
for our customers, serving over half of our customer base. While cable customers
declined slightly in 2008, we completed the installation of the IPTV system to
expand our coverage area in Alabama.
  We will
continue our strategy of growing our penetration of the competitive market in
Maine while increasing revenues by cross-selling to our existing RLEC customer
base, using bundled service packages including unlimited long distance and
adding new services as they become available. Our growth in data access lines to
provide digital high-speed Internet access will continue as customers increase
the use of available content and new services. We include wholesale DSL
customers in one of our RLEC territories in the data access lines
above.
  We
provide dial-up Internet on a statewide basis in Maine and Missouri. Our dial-up
Internet customers will continue to migrate to data access lines as growth in
broadband services continues. In Missouri, we have introduced data access lines
for digital high-speed Internet in selected areas outside of our telephone
service territory. These customers are not reflected in the data access lines
above.
  The
following is a discussion of the major factors affecting our access line
count:
  Cyclical Economic and Industry
Factors.  We believe that changes in global economic conditions
have and will continue to have an impact on voice access line count. This impact
has accelerated in late 2008 with the increase in unemployment. The rural nature
of much of the territory may lessen the impact below the national
average.
  Competition.  There
are currently no wireline telephone competitors operating within the majority of
our RLEC territories. Where wireline competition exists, it comes from the
incumbent cable company and has had a negative impact on voice access lines. We
have experienced access line losses to wireless carrier substitution, however
the impact is reduced due in part to the topography of our telephone territories
and current inconsistent wireless coverage. We have responded to competition by
offering bundled service packages which include unlimited domestic calling,
features like voice mail, data access lines, and where possible television
services. These service bundles are designed to meet the broader communications
needs of our customers at industry competitive prices. There are a number of
established competitive providers in our Maine CLEC market. The effectiveness of
our sales force is critical to the continued growth in this market. The
acquisition of the CR Companies will enhance our service area, market coverage,
and network capacity to meet business customer requirements.
  21
  Acquisitions.  In
December 2004, we purchased Mid-Missouri, an RLEC in central Missouri. In July
2006, we purchased Mid-Maine, an RLEC in central Maine and a CLEC carrier
serving urban markets from Portland to Bangor. In 2008, we purchased the CR
Companies, consisting of RLEC companies in Maine, Massachusetts and West
Virginia and a CLEC in Maine.
  Our
Rate and Pricing Structure
  Our CLEC
pricing is based on market requirements. We combine varying services to meet
individual customer requirements, including technical support and provide
multi-year contracts which are both market sensitive for the customer and
profitable for us.  The MPUC and NHPUC impose certain requirements on
all CLECs operating in their markets for reporting and for interactions with the
various incumbent local exchange and interexchange carriers. These requirements
provide a wide latitude in pricing services.
  Our RLECs
operate in five states and are regulated in varying degrees by the respective
state regulatory authorities. The impact on pricing flexibility varies by state.
In Maine, our Saco River and Pine Tree subsidiaries have obtained authority to
implement pricing flexibility while remaining under rate-of-return regulation.
Our rates for other services we provide, including cable, long-distance, and
dial-up and high-speed Internet access, are not price regulated. The market for
competitive services, such as wireless, also impacts the ability to adjust
prices. With the increase of bundled services offerings, including unlimited
long distance, pricing for individual services takes on reduced importance to
revenue stability. We expect this trend to continue into the immediate future.
Currently, multi-service packages represent over 25% of our RLEC customer base
as of December 31, 2008.
  Alabama
and Maine have state service funds which were implemented over the last 15 years
as part of balancing local service pricing and long distance access rates. These
funds were intended to neutralize the revenue impact on state RLECs from pricing
shifts implemented to reduce access rates over time. The Alabama Transition
Service Fund and the Maine Universal Service Fund provided total compensation of
$3.1 million, representing 4.3% of our total revenue for the year ended December
31, 2008. We do not expect material changes in the amount of revenue we receive
from these funds.
  Categories
of Operating Expenses
  Our
operating expenses are categorized as cost of services; selling, general and
administrative expenses; and depreciation and amortization.
  Cost of
services.  This includes expenses for salaries, wages and
benefits relating to plant operation, maintenance, sales and customer service;
other plant operations, maintenance and administrative costs; network access
costs; and costs of services for long distance, cable television, Internet and
directory services.
  Selling, general and administrative
expenses.  This includes expenses for salaries, wages and
benefits and contract service payments (e.g., legal fees) relating to
engineering, financial, human resources and corporate operations; information
management expenses, including billing; allowance for 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. Certain of these amortization expenses continue to be
deductible for tax purposes.
  Our
Ability to Control Operating Expenses
  We strive
to control expenses in order to maintain our strong operating margins. As our
revenue shifts to non-regulated services and CLEC customers, operating margins
decrease reflecting the lower margins associated with these services. We expect
to control expenses while we continue to grow our business.
  Results
of Operations
  The
following table sets forth our results of operations as a percentage of total
revenues for the periods indicated. The CR Companies results are
reflected from the date acquired, October 31, 2008.
  22
 
 Year
      Ended December 31,2006
                                  
                                  
                                  2007
                                  
                                  
                                  2008RevenuesLocal
      services
                                  
                                  
                                  37.1
                                  %
                                  
                                  
                                  37.4
                                  %
                                  
                                  
                                  38.9
                                  %Network
      access
                                  
                                  
                                  40.8
                                  
                                  
                                  
                                  36.8
                                  
                                  
                                  
                                  35.4Cable
      television
                                  
                                  
                                  3.8
                                  
                                  
                                  
                                  3.1
                                  
                                  
                                  
                                  3.1Internet
                                  
                                  
                                  15.0
                                  
                                  
                                  
                                  16.5
                                  
                                  
                                  
                                  16.1Transport
      services
                                  
                                  
                                  3.3
                                  
                                  
                                  
                                  6.2
                                  
                                  
                                  
                                  6.5Total
      revenues
                                  
                                  
                                  100.0
                                  %
                                  
                                  
                                  100.0
                                  %
                                  
                                  
                                  100.0
                                  %Operating
      expensesCost
      of services and products
                                  
                                  
                                  32.5
                                  %
                                  
                                  
                                  36.9
                                  %
                                  
                                  
                                  37.9
                                  %Selling,
      general and administrative expenses
                                  
                                  
                                  14.4
                                  
                                  
                                  
                                  14.9
                                  
                                  
                                  
                                  14.6Depreciation
      and amortization
                                  
                                  
                                  18.7
                                  
                                  
                                  
                                  20.6
                                  
                                  
                                  
                                  20.2Total
      operating expenses
                                  
                                  
                                  65.6
                                  
                                  
                                  
                                  72.4
                                  
                                  
                                  
                                  72.7Income
      from operations
                                  
                                  
                                  34.4
                                  
                                  
                                  
                                  27.6
                                  
                                  
                                  
                                  27.3Other
      income (expense)Interest
      expense
                                  
                                  
                                  (34.8
                                  )
                                  
                                  
                                  (30.7
                                  )
                                  
                                  
                                  (28.3
                                  )Change
      in fair value of derivative
                                  
                                  
                                  (0.5
                                  )
                                  
                                  
                                  1.4
                                  
                                  
                                  
                                  0.4Other
      income
                                  
                                  
                                  5.8
                                  
                                  
                                  
                                  1.4
                                  
                                  
                                  
                                  0.9Total
      other expense
                                  
                                  
                                  (29.5
                                  )
                                  
                                  
                                  (27.9
                                  )
                                  
                                  
                                  (27.0
                                  )Income
      before income tax and accretion expense
                                  
                                  
                                  4.9
                                  
                                  
                                  
                                  (0.3
                                  )
                                  
                                  
                                  0.3Income
      tax expense
                                  
                                  
                                  (2.1
                                  )
                                  
                                  
                                  0.6
                                  
                                  
                                  
                                  0.0Income
      before accretion expense
                                  
                                  
                                  2.8
                                  
                                  
                                  
                                  0.3
                                  
                                  
                                  
                                  0.3Accretion
      of Class B common convertible to senior subordinated notes
                                  
                                  
                                  (0.8
                                  )
                                  
                                  
                                  —
                                  
                                  
                                  
                                  —Net
      income available to common stockholders
                                  
                                  
                                  2.0
                                  %
                                  
                                  
                                  0.3
                                  %
                                  
                                  
                                  0.3
                                  %
  Year
ended December 31, 2008 compared to year ended December 31, 2007
  Total Revenues. Total
revenues grew 10.6% in 2008 to $77.1 million from $69.7 million in 2007. The
table below provides the components of our revenues for 2008 compared to 2007.
The increase is primarily related to the acquisition of the CR
Companies.
 Year
      Ended December 31,
                                                                                            
                                                                                            
                                                                                            Change2007
                                                                                            
                                                                                            
                                                                                            2008
                                                                                            
                                                                                            
                                                                                            Amount
                                                                                            
                                                                                            
                                                                                            Percent(Dollars
      in Thousands)Local
      services
                                                                                            
                                                                                            $
                                                                                            26,102
                                                                                            
                                                                                            
                                                                                            $
                                                                                            30,014
                                                                                            
                                                                                            
                                                                                            $
                                                                                            3,912
                                                                                            
                                                                                            
                                                                                            
                                                                                            15.0
                                                                                            %Network
      access
                                                                                            
                                                                                            
                                                                                            25,671
                                                                                            
                                                                                            
                                                                                            
                                                                                            27,281
                                                                                            
                                                                                            
                                                                                            
                                                                                            1,610
                                                                                            
                                                                                            
                                                                                            
                                                                                            6.3Cable
      television
                                                                                            
                                                                                            
                                                                                            2,184
                                                                                            
                                                                                            
                                                                                            
                                                                                            2,389
                                                                                            
                                                                                            
                                                                                            
                                                                                            205
                                                                                            
                                                                                            
                                                                                            
                                                                                            9.4Internet
                                                                                            
                                                                                            
                                                                                            11,517
                                                                                            
                                                                                            
                                                                                            
                                                                                            12,449
                                                                                            
                                                                                            
                                                                                            
                                                                                            932
                                                                                            
                                                                                            
                                                                                            
                                                                                            8.1Transport
      services
                                                                                            
                                                                                            
                                                                                            4,275
                                                                                            
                                                                                            
                                                                                            
                                                                                            4,982
                                                                                            
                                                                                            
                                                                                            
                                                                                            707
                                                                                            
                                                                                            
                                                                                            
                                                                                            16.5Total
                                                                                            
                                                                                            $
                                                                                            69,749
                                                                                            
                                                                                            
                                                                                            $
                                                                                            77,115
                                                                                            
                                                                                            
                                                                                            $
                                                                                            7,366
                                                                                            
                                                                                            
                                                                                            
                                                                                            10.6
  23
  Local services. Local service
revenue in 2008 grew 15.0% to $30.0 million from $26.1 million in 2007. This
increase was attributable to an increase of $3.5 million from the acquisition of
the CR Companies and an increase of $0.7 million in Maine CLEC revenue,
partially offset by a reduction of $0.3 million from access line loss by our
other rural local exchange carriers. The acceptance of bundled services,
including unlimited calling plans, continues to grow as a percentage of our
customer base.
  Network access. Network
access revenue in 2008 grew 6.3% to $27.3 million from $25.7 million in 2007.
This increase was attributable to an increase of $1.6 million from the
acquisition of the CR Companies and an increase of $0.3 million in switched
access, partially offset by a decrease of $0.2 million from end user associated
fees and $0.1 million associated with special access, interexchange carrier
traffic, and USF HCL reimbursement.
  Cable television. Cable
television revenue in 2008 increased 9.4% to $2.4 million from $2.2 million in
2007. The increase was primarily due to the introduction of high definition and
digital video recording services, an increase in pay per view services and
satellite television commissions.
  Internet. Internet revenue in
2008 increased 8.1% to $12.4 million from $11.5 million in 2007. This increase
was attributable to an increase of $0.4 million from the acquisition of the CR
Companies and $1.2 million from the addition of new data lines for digital
high-speed Internet customers, increased customer bandwidth and new related
services, partially offset by a decrease of $0.7 million associated with the
loss of dial-up Internet customers to data lines, including those we serve
outside of our territory in Missouri.
  Transport services. Transport
services revenue in 2008 increased 16.5% to $5.0 million from $4.3 million in
2007. The increase reflects the expansion of our fiber network in Maine to 231
miles and continued growth in services provided over that network.
  Operating expenses. Operating
expenses in 2008 increased 11.0% to $56.0 million from $50.5 million in 2007.
The increase is primarily related to the acquisition of the CR Companies and
increased CLEC customers in Maine.
 Year
      Ended December 31,
                                                                                            
                                                                                            
                                                                                            Change2007
                                                                                            
                                                                                            
                                                                                            2008
                                                                                            
                                                                                            
                                                                                            Amount
                                                                                            
                                                                                            
                                                                                            Percent(Dollars
      in Thousands)Cost
      of services
                                                                                            
                                                                                            $
                                                                                            25,719
                                                                                            
                                                                                            
                                                                                            $
                                                                                            29,192
                                                                                            
                                                                                            
                                                                                            $
                                                                                            3,473
                                                                                            
                                                                                            
                                                                                            
                                                                                            13.5
                                                                                            %Selling,
      general and administrative expenses
                                                                                            
                                                                                            
                                                                                            10,419
                                                                                            
                                                                                            
                                                                                            
                                                                                            11,228
                                                                                            
                                                                                            
                                                                                            
                                                                                            809
                                                                                            
                                                                                            
                                                                                            
                                                                                            7.8Depreciation
      and amortization
                                                                                            
                                                                                            
                                                                                            14,346
                                                                                            
                                                                                            
                                                                                            
                                                                                            15,608
                                                                                            
                                                                                            
                                                                                            
                                                                                            1,262
                                                                                            
                                                                                            
                                                                                            
                                                                                            8.8Total
                                                                                            
                                                                                            $
                                                                                            50,484
                                                                                            
                                                                                            
                                                                                            $
                                                                                            56,028
                                                                                            
                                                                                            
                                                                                            $
                                                                                            5,544
                                                                                            
                                                                                            
                                                                                            
                                                                                            11.0
  Cost of services. The cost of
services increased 13.5% to $29.2 million in 2008 from $25.7 million in 2007.
The acquisition of the CR Companies accounted for an increase of $2.7 million.
Growth in the Maine CLEC revenue increased cost $0.3 million; digital cable and
satellite costs increased $0.2 million; Internet costs increased $0.2 million;
and long distance resale costs increased $0.2 million, partially offset by other
network savings of $0.1 million.
  Selling, general and administrative
expenses. Selling, general and administrative expenses increased 7.8% to
$11.2 million in 2008 from $10.4 million in 2007. The acquisition of the CR
Companies accounted for an increase of $0.6 million. The balance of the increase
reflects higher employee wages, human resources and cable engineering costs and
bad debt, partially offset by lower insurance and operating and property taxes
in the remainder of the Company.
  Depreciation and
amortization. Depreciation and amortization increased 8.8% to $15.6
million in 2008 from $14.3 million in 2007. The acquisition of the CR Companies
accounted for an increase of $2.5 million, including amortization of
non-compete, plant acquisition, and other intangibles, partially offset by a
decrease of $1.2 million in the remainder of the Company, including a decrease
of $0.5 million in amortization of intangible assets.
  24
  Year
      Ended December 31,
                                              
                                              
                                              Change2007
                                              
                                              
                                              2008
                                              
                                              
                                              Amount
                                              
                                              
                                              Percent(Dollars
      in Thousands)Interest
      expense
                                              
                                              $
                                              (21,378
                                              )
                                              
                                              $
                                              (21,808
                                              )
                                              
                                              $
                                              430
                                              
                                              
                                              
                                              2.0
                                              %Change
      in fair value of derivative
                                              
                                              
                                              970
                                              
                                              
                                              
                                              324
                                              
                                              
                                              
                                              (646
                                              )
                                              
                                              
                                              (66.6
                                              )Other
      income
                                              
                                              
                                              948
                                              
                                              
                                              
                                              640
                                              
                                              
                                              
                                              (308
                                              )
                                              
                                              
                                              (32.5
                                              )Income
      tax (expense) benefit
                                              
                                              
                                              374
                                              
                                              
                                              
                                              (29
                                              )
                                              
                                              
                                              (403
                                              )
                                              
                                              NM
  Interest expense. Interest
expense increased 2.0% to $21.8 million in 2008 from $21.4 million in 2007.
Interest on senior debt declined $1.4 million on lower interest rates, lower
average margins for the year and lower average outstanding balance for the year
when compared to 2007. The interest on the senior subordinated debt increased
$1.5 million associated with the full year effect of the additional July 2007
IDS offering. Non-cash interest caplet expense associated with the recognition
of the cost of the five year interest rate cap purchased at the time of the
initial public offering increased approximately $0.1 million. The write-off of
$1.2 million in loan costs associated with the amendment of the senior debt
facility related to the acquisition of the CR Companies was offset by a
reduction of $1.2 million in lower loan cost amortization. An additional $0.2
million in loan cost amortization was associated with the amended senior debt
facility.
  Change in fair value of
derivative. 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 the IDSs and the underlying Class A common
stock, changes in the interest rates in the market and the expected time for
conversion all impact the fair value of the derivative. The combination of these
factors decreased the value of the derivative by $0.7 million when compared with
the end of 2007. The balance of the change reflected the change in value of the
$80 million 3% LIBOR rate cap which is effective through December
2009.
  Other income. Other income
decreased 32.5% to $0.6 million in 2008 from $0.9 million in 2007. There was a
one time gain of $0.2 million on a fiber lease termination and an additional
Rural Telephone Bank stock redemption. Interest income decreased $0.4 million as
interest rates associated with invested cash declined in the market. The
ineffective portion of our interest rate cap produced $0.1 million less in 2008
than in 2007.
  Income taxes. Income tax
expense in 2008 was less than $0.1 million compared to an income tax benefit of
$0.4 million in 2007. Our 2008 effective income tax rate reflects the impact of
acquiring the CR Companies and their impact on state and federal income taxes.
In calculating the effective tax rate, the change in fair value of the
derivative associated with the Class B common stock convertible into Class A
common stock is excluded as a permanent difference. This can cause the effective
rate to vary based on the level of income before taxes and generate swings in
the effective tax rate. Additional detail on income taxes may be found in note
10 to the consolidated financial statements found in Item 8 of this report on
Form 10-K.
  Net income. As a result of
the foregoing, net income in 2008 was $0.2 million, unchanged from
2007.
  Year
ended December 31, 2007 compared to year ended December 31, 2006
  Total Revenues. Total
revenues grew 21.1% in 2007 to $69.7 million from $57.6 million in 2006. The
table below provides the components of our revenues for 2007 compared to
2006.
 Year
      Ended December 31,
                                                                                          
                                                                                          
                                                                                          Change2006
                                                                                          
                                                                                          
                                                                                          2007
                                                                                          
                                                                                          
                                                                                          Amount
                                                                                          
                                                                                          
                                                                                          Percent(Dollars
      in Thousands)Local
      services
                                                                                          
                                                                                          $
                                                                                          21,371
                                                                                          
                                                                                          
                                                                                          $
                                                                                          26,102
                                                                                          
                                                                                          
                                                                                          $
                                                                                          4,731
                                                                                          
                                                                                          
                                                                                          
                                                                                          22.1
                                                                                          %Network
      access
                                                                                          
                                                                                          
                                                                                          23,481
                                                                                          
                                                                                          
                                                                                          
                                                                                          25,671
                                                                                          
                                                                                          
                                                                                          
                                                                                          2,190
                                                                                          
                                                                                          
                                                                                          
                                                                                          9.3Cable
      television
                                                                                          
                                                                                          
                                                                                          2,191
                                                                                          
                                                                                          
                                                                                          
                                                                                          2,184
                                                                                          
                                                                                          
                                                                                          
                                                                                          (7
                                                                                          )
                                                                                          
                                                                                          
                                                                                          (0.3
                                                                                          )Internet
                                                                                          
                                                                                          
                                                                                          8,669
                                                                                          
                                                                                          
                                                                                          
                                                                                          11,517
                                                                                          
                                                                                          
                                                                                          
                                                                                          2,848
                                                                                          
                                                                                          
                                                                                          
                                                                                          32.9Transport
      services
                                                                                          
                                                                                          
                                                                                          1,877
                                                                                          
                                                                                          
                                                                                          
                                                                                          4,275
                                                                                          
                                                                                          
                                                                                          
                                                                                          2,398
                                                                                          
                                                                                          
                                                                                          
                                                                                          127.8Total
                                                                                          
                                                                                          $
                                                                                          57,589
                                                                                          
                                                                                          
                                                                                          $
                                                                                          69,749
                                                                                          
                                                                                          
                                                                                          $
                                                                                          12,160
                                                                                          
                                                                                          
                                                                                          
                                                                                          21.1
  25
   Local service. Local service
revenue in 2007 grew 22.1% to $26.1 million from $21.4 million in 2006. This
increase was attributable to an increase of $5.1 million from the acquisition of
Mid-Maine on July 3, 2006, including the growth in CLEC customer revenue. This
increase was partially offset by a reduction in Alabama and Missouri of $0.2
million from access line loss by our other rural local exchange carriers and
lower billing and collection fees from long distance carriers, $0.1 million in
one time directory advertising revenue, and $0.1 million in building rental
income. Loss of 2.6% of our Alabama and Missouri access lines was partially
caused by increased penetration of our digital high-speed Internet service which
resulted in the loss of some second access lines used by customers for dial-up
Internet access. The acceptance of unlimited calling plans continues to grow the
percentage of our customers with service bundles in those states.
  Network access. Network
access revenue in 2007 increased 9.3% to $25.7 million from $23.5 million in
2006. This increase was attributable to an increase of $2.4 million from the
acquisition of Mid-Maine and $0.3 million in Missouri access fees, offset by a
decrease of $0.2 million from USF HCL reimbursement and $0.3 million associated
with access trunks, interexchange carrier traffic, and end user associated
fees.
  Cable television. Cable
television revenue in 2007 and 2006 was flat at $2.2 million, as were cable
subscribers. In December 2007, we introduced digital signal delivery, high
definition channels and digital video recording services for our Alabama
customer base.
  Internet. Internet revenue in
2007 increased 32.9% to $11.5 million from $8.7 million in 2006. This increase
was attributable to an increase of $2.2 million from the acquisition of
Mid-Maine and $1.2 million from the addition of over 1,700 new high-speed
Internet customers in Alabama and Missouri, partially offset by a decrease of
$0.6 million associated with the loss of approximately 1,900 dial-up Internet
customers in Alabama and Missouri, including those we serve outside of our
territory in Missouri.
  Transport services. Transport
services revenue in 2007 increased to $4.3 million from $1.9 million in 2006.
The addition of $2.4 million in transport services revenue is attributable to
the acquisition of Mid-Maine on July 3, 2006 and represents continued growth in
services provided over its then 200 mile fiber network.
  Operating expenses. Operating
expenses for 2007 increased 33.6% to $50.5 million from $37.8 million in 2006.
This increase was primarily attributable to the acquisition of Mid-Maine
including the cost of increased CLEC revenues and increased costs associated
with higher Internet revenues and long distance subscribers.
 Year Ended December
      31,
                                                                                          
                                                                                          
                                                                                          Change2006
                                                                                          
                                                                                          
                                                                                          2007
                                                                                          
                                                                                          
                                                                                          Amount
                                                                                          
                                                                                          
                                                                                          Percent(Dollars in Thousands)Cost
      of services
                                                                                          
                                                                                          $
                                                                                          18,728
                                                                                          
                                                                                          
                                                                                          $
                                                                                          25,719
                                                                                          
                                                                                          
                                                                                          $
                                                                                          6,991
                                                                                          
                                                                                          
                                                                                          
                                                                                          37.3
                                                                                          %Selling,
      general and administrative expenses
                                                                                          
                                                                                          
                                                                                          8,278
                                                                                          
                                                                                          
                                                                                          
                                                                                          10,419
                                                                                          
                                                                                          
                                                                                          
                                                                                          2,141
                                                                                          
                                                                                          
                                                                                          
                                                                                          25.9Depreciation
      and amortization
                                                                                          
                                                                                          
                                                                                          10,781
                                                                                          
                                                                                          
                                                                                          
                                                                                          14,346
                                                                                          
                                                                                          
                                                                                          
                                                                                          3,565
                                                                                          
                                                                                          
                                                                                          
                                                                                          33.1Total
                                                                                          
                                                                                          $
                                                                                          37,787
                                                                                          
                                                                                          
                                                                                          $
                                                                                          50,484
                                                                                          
                                                                                          
                                                                                          $
                                                                                          12,697
                                                                                          
                                                                                          
                                                                                          
                                                                                          33.6
  Cost of services. The cost of
services increased 37.3% to $25.7 million in 2007 from $18.7 million in 2006.
The acquisition of Mid-Maine, including the costs associated with its growing
CLEC revenue, accounted for an increase of $6.4 million. The balance of the
increase was attributable to $0.5 million increase in long distance costs in
Missouri; $0.1 increase in higher cable programming costs and one-time pole
rental expense; and $0.1 million in increased digital high-speed Internet
bandwidth costs, partially offset by providing our own Internet help desk
functionality, decreased telephone directory costs and other operational
efficiencies.
  Selling, general and administrative
expenses. Selling, general and administrative expenses increased 25.9% to
$10.4 million in 2007 from $8.3 million in 2006. The acquisition of Mid-Maine
increased these expenses by $1.6 million as CLEC revenue grows as a percentage
of total revenue. Sarbanes-Oxley, board of directors and annual meeting costs
increased $0.2 million; acquisition investigation and other legal costs
increased $0.2 million; and operational taxes and human resources costs
increased $0.1 million for the balance of the increase.
  26
  Depreciation and
amortization. Depreciation and amortization increased 33.1% to $14.3
million in 2007 from $10.8 million in 2006. The acquisition of Mid-Maine
accounted for almost $3.5 million of the increase. The balance consisted of
increased depreciation associated with the investment in our Alabama
companies.
 Year
      Ended December 31,
                                                
                                                
                                                Change2006
                                                
                                                
                                                2007
                                                
                                                
                                                Amount
                                                
                                                
                                                Percent(Dollars in Thousands)Interest
      expense
                                                
                                                $
                                                (20,082
                                                )
                                                
                                                $
                                                (21,378
                                                )
                                                
                                                $
                                                1,296
                                                
                                                
                                                
                                                6.5
                                                %Change
      in fair value of derivative
                                                
                                                
                                                (278
                                                )
                                                
                                                
                                                970
                                                
                                                
                                                
                                                1,248
                                                
                                                
                                                NMOther
      income
                                                
                                                
                                                3,359
                                                
                                                
                                                
                                                948
                                                
                                                
                                                
                                                2,411
                                                
                                                
                                                
                                                (71.8
                                                )Income
      tax (expense) benefit
                                                
                                                
                                                (1,211
                                                )
                                                
                                                
                                                374
                                                
                                                
                                                
                                                1,585
                                                
                                                
                                                NM
  Interest expense. Interest
expense in 2007 increased 6.5% to $21.4 million from $20.1 million in 2006.
Interest on senior debt declined $1.2 million on lower outstanding balances from
using the proceeds of the July 2007 IDS offering to reduce debt $55.4 million
and through lower senior debt margins. The interest on the senior subordinated
debt increased $1.4 million associated with the additional July 2007 IDS
offering. Non-cash interest caplet expense associated with the recognition of
the cost of the five year interest rate cap purchased at the time of the initial
public offering increased approximately $0.1 million and an additional $1.0
million in loan cost amortization was associated with the senior debt
repayment.
  Change in fair value of
derivative. 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 the IDSs and the underlying Class A common
stock, and the expected time for conversion all impact the fair value of the
derivative. The change in value of the B share derivative increased by $1.6
million in 2007 over 2006. In addition, $14.4 million of our $80 million 3%
LIBOR rate cap was considered ineffective in hedging our senior debt and
therefore an investment. This occurred when we repaid $55.4 million of senior
debt on July 5, 2007 from the proceeds of the offering of 3,000,000 IDS units.
The change in the fair value of this instrument for 2007 over 2006 was a
reduction of $0.3 million.
  Other income. Other income in
2007 decreased 71.8% to $0.9 million from $3.4 million in 2006. This decrease
was primarily attributable to the $2.7 million one-time gain in 2006 related to
the redemption of Rural Telephone Bank stock associated with its dissolution.
Interest income on our invested cash and the value of the investment portion of
the 3% LIBOR rate cap hedge provided a $0.3 million increase over
2006.
  Income taxes. Provision for
income taxes in 2007 was a benefit of $0.4 million compared to an expense of
$1.2 million for 2006. In calculating the effective tax rate, the change in fair
value of the derivative associated with the Class B common stock convertible
into Class A common stock is excluded as a permanent difference. This can cause
the effective rate to vary between periods. Excluding the effect of the change
in fair value of the derivative, the effective income tax rate would have been
39.7% and 38.9% for 2006 and 2007 respectively. Taxes associated with the
acquisition of Mid-Maine increased $0.1 million.
  Accretion of Class B common
convertible to senior subordinated notes. Our Class B common stock was
issued to our former equity holders coincident with our initial public offering
on December 21, 2004. The payment of dividends on the Class B common stock is
prohibited by our certificate of incorporation. Shares of Class B common stock
will be exchanged for IDSs no later than December 21, 2009. The discount was
accreted over two years which is the length of time up to the earliest date the
Class B common stock could be exchanged for IDSs. This non-cash expense was $0.4
million in 2006 with no expense in 2007.
  Net income. As a result of
the foregoing, net income in 2007 decreased to $0.2 million from $1.2 million in
2006.
  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; and (iv) dividend payments on our Class A
common stock.
  Cash
flows from operating activities for 2008 amounted to $18.7 million compared to
$14.8 million for 2007. The change is related to several factors, including the
payment of December 2006 dividends of $1.7 million in January 2007; the increase
in amortization of intangibles, including the acquisition of the CR Companies,
of $1.2 million; the increase in the change in the fair value of the derivatives
of $0.6 million; an income tax refund of $0.3 million and prepaid insurance of
$0.4 million, partially offset by an increase in accounts receivable, including
the acquisition of the CR Companies.
  27
  Cash used
in investing activities for 2008 amounted to $117.9 million compared to $6.7
million for 2007. In 2008, the acquisition of the CR Companies used $108.7
million. The acquisition and construction of property and equipment, including
the Alabama IPTV system implementation and the CR Companies from date of
acquisition, reflected cash used in investing activities of $9.2 million in 2008
when compared to $6.6 million in 2007.
  Cash
provided from financing activities for 2008 generated $99.9 million compared to
cash used for financing activities for 2007 of $9.7 million. In 2008, the
Company borrowed $108.9 million in long-term notes payable as part of the
transaction to purchase the CR Companies. In 2008, the Company declared and paid
dividends amounting to $8.9 million to the holders of its Class A common stock,
compared to $9.6 million in 2007, which included the final dividend declared in
2006 paid on January 2, 2007. On July 5, 2007, the Company completed its
offering of 3,000,000 IDS units in an underwritten public offering at $19.80 per
IDS unit, using the net proceeds to reduce long-term senior debt by $55.4
million. The net impact on cash was a use of $0.1 million from this
transaction.
  Total
capital expenditures in 2008 were $9.2 million, up $2.6 million from $6.6
million in 2007, reflecting the acquisition of the CR Companies, additions to
the Maine fiber network and the installation of an IPTV system in Alabama.
Excluding the impact of the additional IPTV investment, our business continues
to invest approximately 10% of revenue each year in business
infrastructure.
  We
currently have outstanding $173.5 million under the term loan portion of our
second amended and restated credit facility that matures in October 2013. The
facility was increased by $108.9 million in October 2008 to finance the
acquisition of the CR Companies. Borrowings under the term loan bear interest at
three-month LIBOR plus a margin that can range from 3.5% to 4.25% (6.22%
including 4.0% margin as of December 31, 2008). On December 21, 2004 the Company
purchased a five year rate cap on $80 million as an effective hedge against any
increase in interest rates on that portion of our term loan, capping the three
month LIBOR rate at 3.00% per year for the five years. From July 2007 through
October 2008, the difference between the interest rate cap amount and the term
loan amount (or $15.4 million) was considered an investment as it was no longer
an effective hedge against debt. The second amended and restated credit facility
requires us to have interest rate protection equal to at least half of our
senior debt outstanding through October 31, 2010. In February 2009, we entered
into interest rate swap agreements to cover the majority of borrowings under the
credit facility to protect against interest rate swings. See “—Subsequent
Events.”
  We also
have outstanding an aggregate of $105.4 million senior subordinated notes due
2019 which bear interest at a rate of 13%, payable quarterly. This amount
increased $24.3 million associated with the issuance of 3,000,000 IDS units in
July 2007, including the impact of these notes being sold at a premium. The
premium will be amortized over the life of the debt. Our Class B common stock is
expected to be exchanged for IDSs after the financial testing requirements
expire in December 2009. At the time of exchange, the IDSs will represent an
additional $4.1 million in aggregate principal amount of senior subordinated
notes due in 2019. In addition, we currently have a $15.0 million revolving
credit facility, which bears interest at a variable rate. No borrowings were
outstanding under this facility at December 31, 2008 or at any time since its
inception. We are charged a 0.5% fee on the unused balance.
  Our
credit facility has material covenants based upon Consolidated EBITDA, as
defined in the credit facility, and our senior subordinated notes have material
covenants based upon Adjusted EBITDA, as defined in the indenture. In our credit
facility, covenants relating to our senior leverage and fixed charge ratios are
calculated based upon Consolidated EBITDA. In the indenture for the senior
subordinated notes, our ability to pay dividends on our common stock is
dependent in large part on our Adjusted EBITDA. In addition, our ability to
incur debt under the indenture for the senior subordinated notes and the credit
facility is based on our ability to meet a specified leverage ratio. If we are
unable to meet the leverage ratio, our liquidity would be adversely affected to
the extent that we intend to rely on additional debt to enhance our
liquidity.
  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. However, our
current dividend policy, our indebtedness levels and related debt service
requirements and our capital expenditure requirements will significantly limit
any cash available from operations for other uses for the foreseeable future. We
may not retain a sufficient amount of cash to finance growth opportunities or
unanticipated capital expenditure needs or to fund our operations in the event
of a significant business downturn. We may have to forego growth opportunities
or capital expenditures that would otherwise be necessary or desirable if we do
not find alternative sources of financing. If we do not have sufficient cash for
these purposes, our financial condition and our business will
suffer.
  28
  Obligations
and Commitments
  The
following table discloses aggregate information about our contractual
obligations as of December 31, 2008, including scheduled interest and principal
for the periods in which payments are due (in millions):
  Total
                                    
                                    
                                    Less
      Than
                                      1
      year
                                    
                                    
                                    1 – 3
      years
                                    
                                    
                                    3 – 5
      Years
                                    
                                    
                                    More
      Than
                                      5
      yearsAmended
      and restated credit facilityTerm
                                    
                                    $
                                    173.5
                                    
                                    
                                    $
                                    —
                                    
                                    
                                    $
                                    —
                                    
                                    
                                    $
                                    173.5
                                    
                                    
                                    $
                                    —Revolver(1)
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —Senior
      subordinated notes(2)
                                    
                                    
                                    107.7
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    107.7Expected
      interest expense(3)
                                    
                                    
                                    205.8
                                    
                                    
                                    
                                    23.1
                                    
                                    
                                    
                                    49.1
                                    
                                    
                                    
                                    49.6
                                    
                                    
                                    
                                    84.0Total
      contractual cash obligations
                                    
                                    $
                                    487.0
                                    
                                    
                                    $
                                    23.1
                                    
                                    
                                    $
                                    49.1
                                    
                                    
                                    $
                                    223.1
                                    
                                    
                                    $
                                    191.6
 
 (1)
                  We
      have a $15.0 million revolving credit facility with an October 2013
      maturity available. No amounts were drawn on this facility on December 31,
      2008 or during 2008. The Company pays a commitment fee of 0.50% per annum,
      payable quarterly in arrears, on the unused portion of the revolver
      loan.(2)
                  Includes
      $4.1 million liquidation value of Class B common stock convertible into
      senior subordinated notes and interest on those notes beginning December
      21, 2009, the date the Class B common stock can be exchanged by holders
      for IDSs on a one-for-one basis without passing a financial test. If Class
      B common were to convert prior to this date, the annual interest on the
      senior subordinated debt would be $0.5 million.(3)
                  Expected
      interest payments to be made in future periods reflect anticipated
      interest payments related to our $173.5 million senior credit facility and
      our $107.7 million senior subordinated notes at 13.0%, including those
      associated with our IDSs and those sold separately, and, beginning
      December 31, 2009, those associated with the Class B common stock
      conversion. Interest on the senior credit facility reflects a LIBOR three
      month rate of from 1.5% to 2.7% plus a margin of 4.0%, reflecting the
      impacts of interest rate hedging. We have assumed in the presentation
      above that we will hold the senior credit facility until maturity in 2013
      and the senior subordinated notes until maturity in 2019. No interest
      payment is included for the revolving credit facility because of the
      variability and timing of advances and repayments
    thereunder.
  Off-Balance
Sheet Arrangements
  The
Company has no off-balance sheet arrangements.
  Critical
Accounting Policies and Accounting Estimates
  The
process of preparing financial statements requires the use of estimates on the
part of management. These estimates are based on our historical experience
combined with management’s understanding of current facts and circumstances.
Certain of our accounting policies are considered critical as they are both
important to the portrayal of our financial statements and require significant
or complex judgment on the part of management. The following is a summary of
certain policies considered critical by management.
  Regulatory Accounting. We
follow the accounting for regulated enterprises prescribed by Statement of
Financial Accounting Standards (“SFAS”) No. 71,Accounting for the Effects of
Certain Types of Regulations, or SFAS 71, for our rural local exchange
carriers. This accounting practice recognizes the economic effects of rate
regulation by recording costs and a return on investment as such amounts are
recovered through rates authorized by regulatory authorities. Accordingly, SFAS
71 requires us to depreciate telecommunications property and equipment over the
useful lives approved by regulators, which could be different than the useful
lives that would otherwise be determined by management. SFAS 71 also requires
deferral of certain costs and obligations based upon approvals received from
regulators to permit recovery of such amounts in future years. Criteria that
would give rise to the discontinuance of accounting in accordance with SFAS 71
include (i) increasing competition restricting our ability to establish prices
that allow us to recover specific costs and (ii) significant changes in the
manner in which rates are set by regulators from cost-based regulation to
another form of regulation. We periodically review these criteria to determine
whether the continuing application of SFAS 71 is appropriate for our rural local
exchange carriers.
  29


We are
subject to reviews and audits by regulatory agencies. The effect of these
reviews and audits, if any, will be recorded in the period in which they become
known and determinable.




Intangible Assets and Goodwill.Intangible assets consist primarily of the value of customer related
intangibles, non-compete agreements and long-term customer contracts. Goodwill
represents the excess of total acquisition cost over the assigned value of net
identifiable tangible and intangible assets acquired through various business
combinations. Due to the regulatory accounting required by SFAS 71, we did not
record acquired regulated telecommunications property and equipment at fair
value as required by SFAS No. 141,Business Combinations, or
SFAS 141, through 2004. In accordance with 47 CFR 32.2000, the federal
regulation governing acquired telecommunications property and equipment, such
property and equipment is accounted for at original cost and depreciation and
amortization of property and equipment acquired is credited to accumulated
depreciation. For the acquisition of Mid-Maine and the CR Companies, property
has been recorded at fair value in accordance with SFAS 141, resulting in a
plant acquisition adjustment in Mid-Maine in 2006 and various of the
subsidiaries of the CR Companies in 2008. We have acquired identifiable
intangible assets associated with the territories we serve through our
acquisitions of various companies, including non-compete agreements with the
former CEOs of two acquired businesses. Any excess of the total purchase price
over the amounts assigned to net tangible and definable assets is recorded as
goodwill.




Revenue Recognition. Revenue
for monthly recurring local services is billed in advance to a portion of our
customers and in arrears to the balance of our customers. We record our revenue
for charges that have not yet been invoiced to our customers as unbilled revenue
when services are rendered. We record revenue billed in advance as advance
billings and defer recognition until such revenue is earned. Long distance
service is billed to customers in arrears based on actual usage or at a bundled
rate as part of a bundled offer. We record unbilled long distance revenue as
unbilled revenue when services are rendered. In bundles, unlimited usage is
billed in arrears at a flat rate.




Network
access revenue is derived from several sources. Revenue for interstate access
services is received through tariffed access charges filed by the NECA with the
FCC on behalf of the NECA member companies for our regulated subsidiaries. These
access charges are billed by the Company to interstate interexchange carriers
and pooled with like-revenues from all NECA member companies. A portion of the
pooled access charge revenue received by the Company is based upon its actual
cost of providing interstate access service, plus a return on the investment
dedicated to providing that service. The balance of the pooled access charge
revenue received by the Company is based upon the nationwide average schedule
costs of providing interstate access services. Rates for our competitive
subsidiaries are set by FCC rule to be no more than the interconnecting
interstate rate of the predominant local carrier. Revenue for intrastate access
service is received through tariffed access charges billed by the Company to the
originating intrastate carrier using access rates filed with the appropriate
state regulatory commissions and are retained by the Company. Revenue for the
intrastate/interLATA access service is received through tariffed access charges
as filed with the APSC, MDTC, MPSC, MPUC, NHPUC and WVPSC. These access charges
are billed to the intrastate carriers and are retained by the Company. Revenue
for terminating and originating long distance service is received through
charges for providing usage of the local exchange network. Toll revenues are
recognized when services are rendered.




Cable
television, Internet and transport service revenues are recognized when services
are rendered. Operating revenues from the lease of dark fiber covered by
indefeasible rights-of-use (IRU) agreements are recorded as earned. In some
cases, the entire lease payment is received at inception of the lease and
recognized ratably over the lease term after recognition of expenses associated
with lease inception. The Company has deferred revenue in the consolidated
balance sheet as of December 31, 2007 and 2008 of $797,498 and $739,736,
respectively.




Long-Lived Assets. We review
our long-lived assets for impairment at each balance sheet date and whenever
events or changes in circumstances indicate that the carrying amount of an asset
should be assessed. To determine if an impairment exists, we estimate the future
undiscounted cash flows expected to result from the use of the asset being
reviewed for impairment. If the sum of these expected future cash flows is less
than the carrying amount of the asset, we recognize an impairment loss in
accordance with SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets. The
amount of the impairment recognized is determined by estimating the fair value
of the assets and recording a loss for the excess of the carrying value over the
fair value.




Accounting Treatment for Class B
Common Stock. In connection with our initial public offering, we issued
shares of Class B common stock. In general, subject to a financial test which,
as of December 31, 2008, had not been met, and other conditions, our Class B
common stock is exchangeable at the holder’s option for IDSs registered under
the Securities Act of 1933. Each share of Class B common stock will be
exchangeable for one IDS, subject to certain adjustments. All Class B common
stock will be able to be exchanged for IDSs not later than December 21,
2009.




30




We
recorded the Class B common stock allocable to the potential debt issuance upon
exchange outside stockholders’ equity in the “mezzanine” section of our
consolidated balance sheet. This obligation is labeled “Class B common
convertible to senior subordinated notes.”
During 2005 and 2006, the Class B common convertible to senior subordinated
notes was accreted up to the par amount of the senior subordinated notes which
could be issued on or after December 21, 2006. This equals our maximum potential
cash obligation at the maturity of the senior subordinated notes assuming the
senior subordinated notes are originally issued in an aggregate principal amount
of $7.50, with a charge for the accretion recorded as a reduction to income
available to shareholders.




We are
also accounting separately for the embedded exchange feature of the Class B
common stock as a derivative liability. We have recorded the fair market value
of the embedded derivative liability with an immediate charge to retained
earnings, resulting in a reduction to permanent equity. The derivative liability
for the exchange feature of the Class B common stock will be marked to current
estimated fair value at each subsequent balance sheet date, with such
adjustments recorded as other non-operating income or expense. Upon any actual
exchange of Class B common stock for IDSs, the pro rata portion of the Class B
common convertible to senior subordinated notes of such exchange and the fair
value of the derivative liability associated with the exchange will be reduced
and the newly issued senior subordinated notes will be recorded at fair value.
Any difference in these amounts would either reduce or increase additional
paid-in capital. If the then fair value (i.e., market price) of the senior
subordinated notes is above or below the par value of the senior subordinated
notes, we will amortize any premium or accrete any discount on a non-cash basis
on our consolidated statements of income from the date that the exchange is made
and record it as a permanent debt obligation of our Company through the maturity
date of the senior subordinated notes whereby the carrying value of the senior
subordinated notes at maturity would equal the par value of the senior
subordinated notes. Following any exchange of a share of Class B common stock
for IDSs, the portion of such exchange (the permanent equity portion of the
Class B common stock) representing the exchange into shares of Class A common
stock would be reallocated as par and additional paid-in capital to the Class A
common stock issued upon the exchange.




To the
extent that holders exercise their exchange rights, the portion of the Class B
common stock included in temporary equity will be reclassified to debt and the
associated interest payments will be included in interest expense. Diluted
earnings per share of Class A common stock assumes all shares of Class B common
stock are converted into the equivalent number of IDSs. Accretion of the
discount on the Class B common convertible to senior subordinated notes reduces
the income available to Class A common stockholders for purposes of computing
earnings per share in 2006.




Income Taxes. The Company
accounts for income taxes using the asset and liability approach in accordance
with SFAS No. 109,Accounting
for Income Taxes. The asset and liability approach requires the
recognition of deferred tax liabilities and assets for the expected future tax
consequences of temporary differences between the carrying amounts and the tax
basis of assets and liabilities. A valuation allowance is provided when it is
more likely than not that some portion or all of the deferred tax assets will
not be realized.




The
provision for income taxes consists of an amount for the taxes currently payable
and a provision for the tax consequences deferred to future
periods.




Accounting for Interest Rate
Cap. Our primary objective for holding derivative financial instruments
is to manage future interest rate risk. Our derivative instruments are recorded
at fair value and are reported as other assets.




We use
derivative financial instruments to reduce our exposure to interest rate
volatility. Coincident with our initial public offering, we entered into a 3%,
three month LIBOR, five year interest rate cap agreement on $80 million in
connection with the floating rate term loan under our credit facility. The
interest rate cap agreement will effectively limit the interest expense under
the term loan, which floats based on LIBOR, to not more than 3.0% per annum plus
the relevant margin for the first five years of our credit facility. The
relevant margin has varied from 4.0% to 1.75% and currently is at 4.0%, based on
amendments to the agreement. This hedge is considered to be effective as all the
critical terms noted in the interest rate cap are essentially identical to the
terms of our credit facility and thus qualify for hedge accounting and are
accounted for at fair value under SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities,as amended, or SFAS 133. When our
senior debt was reduced to $64.6 million from July 2007 through October 2008,
the portion of the rate cap above the term loan amount became an investment. It
was marked to fair value each quarter and any change in the value was reflected
in the income statement.




We
reflect a charge to interest expense for the portion of the interest rate cap
hedge that has expired in each period. Changes in the fair value of the term
loan rate cap derivative asset will be reflected in other comprehensive income
in each respective period.




New
Accounting Standards




In
December 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No.
141R,Business
Combinations, or SFAS 141R. SFAS 141R replaces SFAS 141 and establishes
principles and requirements for how the acquirer of a business recognizes and
measures in its financial statements the identifiable assets acquired, the
liabilities assumed, and any non-controlling interest in the acquiree. The
statement also provides guidance for recognizing and measuring the goodwill
acquired in the business combination and determines what information to disclose
to enable users of the financial statements to evaluate the nature and financial
effects of the business combination. SFAS 141R is effective for financial
statements issued for fiscal years beginning after December 15, 2008.
Accordingly, any business combinations the Company engages in will be recorded
and disclosed following existing generally accepted accounting principles until
December 31, 2008. The Company expects SFAS 141R will have an impact on its
consolidated financial statements when effective, but the nature and magnitude
of the specific effects will depend upon the nature, terms and size of
acquisitions it consummates after the effective date.




31




Effective
January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements, orSFAS 157. In February 2008, the FASB issued a staff position (FSP 157-2)
that delays the effective date of SFAS 157 for all non-financial assets and
liabilities except those recognized or disclosed at least annually. 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.




The
adoption of SFAS 157 did not have a material impact on our consolidated
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,
or 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,orSFAS 161. SFAS 161
expands quarterly disclosure requirements in SFAS 133 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,or 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. 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 May
2008, the FASB issued SFAS No. 162, The Hierarchy of Generally
Accepted Accounting
Principles,or 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 SEC’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
October 2008, the FASB issued FSP 157-3, Determining the Fair Value of a
Financial Asset when the Market of that Asset is not Active, or 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. 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, or 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 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 implementation of this standard will not have a
material impact on our consolidated financial position and results of
operations.


32




In June
2008, the FASB ratified EITF Issue No. 08-3, Accounting for Lessees for
Maintenance Deposits Under
Lease Arrangements, or 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 implementation of this
standard will not have a material impact on our consolidated financial position
and results of operations.




In
September 2008, the FASB staff issued FSP FAS 133-1 and FIN 45-4, Disclosures about Credit Derivatives
and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB
Interpretation No. 45; and Clarification of the Effective Date of FASB Statement
No. 161. The FSP applies to credit derivatives within the scope of SFAS
133 and hybrid instruments that have embedded credit derivatives. It deals with
disclosures related to these derivatives and is effective for reporting periods
ending after November 15, 2008. It also clarifies the effective date of SFAS 161
as any reporting period 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.




Subsequent
Events




The
Company executed two interest rate swap agreements as the fixed rate
counterparty to hedge its exposure to changes in interest rate costs associated
with its senior credit facility. Both swap agreements hedge the 3 month LIBOR
rate. The first agreement is effective February 9, 2009 for three years with a
notional amount of $90 million and a fixed interest rate of 1.85%. The second
agreement is effective February 9, 2010 for two years with a notional amount of
$60 million and a fixed interest rate of 2.0475%. Both swaps are expected to be
effective interest rate hedges for accounting purposes.




Item 7A. Quantitative and Qualitative
Disclosures about Market Risk




Our
short-term excess cash balance is invested in short-term commercial paper. We do
not invest in any derivative or commodity type instruments, although when a
portion of our interest rate cap was ineffective, it was considered an
investment. Since October 31, 2008, there has not been an ineffective portion of
our interest rate cap. 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 are exposed to interest rate
risk, primarily from a change in LIBOR or a base rate. Currently, we have no
loans drawn under this facility.


33




Item
8. Financial Statements and Supplementary Data
  OTELCO
INC.
  CONSOLIDATED
FINANCIAL STATEMENTS
 PageReports of Independent
      Registered Public Accounting Firm
              35Consolidated Balance
      Sheets
              37Consolidated Statements of
      Income
              38Consolidated Statements of
      Changes in Stockholders’ Equity
              39Consolidated Statements of
      Cash Flows
              40Notes to Consolidated
      Financial Statements
              41
  34
  REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
  To the
Board of Directors and Stockholders
 of Otelco
Inc.
 Oneonta,
 Alabama
  We have
audited the accompanying consolidated balance sheets of Otelco Inc. as of
December 31, 2008 and 2007 and the related consolidated statements of income,
stockholders’ equity, and cash flows for each of the three years in the period
ended December 31, 2008. These financial statements are the responsibility of
the Company’s management. Our responsibility is to express an opinion on these
financial statements based on our audits.
  We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
  In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Otelco Inc. at December 31,
2008 and 2007, and the results of its operations and its cash flows for each of
the three years in the period ended December 31, 2008, in conformity with
accounting principles generally accepted in the United States of
America.
  We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), Otelco Inc.’s internal control over financial
reporting as of December 31, 2008, based on criteria established in Internal Control – Integrated
Frameworkissued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO) and our report dated March 11, 2009 expressed an
unqualified opinion thereon.
 /s/
      BDO Seidman, LLPAtlanta,
      GeorgiaMarch
      11, 2009
  35
  REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
  To the
Board of Directors and Stockholders
 of Otelco
Inc.
 Oneonta,
Alabama
  We have
audited Otelco Inc.’s internal control over financial reporting as of December
31, 2008, based on criteria established in Internal Control – Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (the COSO criteria). Otelco Inc.’s management is responsible
for maintaining effective internal control over financial reporting and for its
assessment of the effectiveness of internal control over financial reporting,
included in the accompanying “Item 9A. Controls and Procedures—Management’s
Annual Report on Internal Control over Financial Reporting”. Our responsibility
is to express an opinion on the Company’s internal control over financial
reporting based on our audit.
  We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, assessing the risk that a material weakness exists, and
testing and evaluating the design and operating effectiveness of internal
control based on the assessed risk. Our audit also included performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.
  A
company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company’s internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company’s
assets that could have a material effect on the financial
statements.
  Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate. As indicated in the accompanying “Item
9A.Controls and
Procedures—Management’sAnnual Report on Internal
Control over Financial
Reporting”, management’s assessment of and conclusion on the effectiveness of
internal control over financial reporting did not include the internal controls
of the Country Road entities, which were acquired on October 31, 2008, and whichareincluded in the consolidated balance
sheet of Otelco Inc. as of December 31, 2008, and the related consolidated
statements of income, stockholders’ equity, and cash flows for the year then
ended. The Country Road entities constituted5.0% and4.5% of total assets and net assets,
respectively, as of December 31, 2008, and7.4% of revenues for the year then ended.
Management did not assess the effectiveness of internal control over financial
reporting of the Country Road entities because of the timing of the acquisition
which was completed on October 31, 2008. Our audit of internal control over
financial reporting of Otelco Inc. also did not include an evaluation of the
internal control over financial reporting of the Country Road
entities.
 In our
opinion, Otelco Inc. maintained, in all material respects, effective internal
control over financial reporting as of December 31, 2008, based on the COSO
criteria.
  We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheets of Otelco Inc.
as of December 31, 2008 and 2007, and the related consolidated statements of
income, stockholders’ equity, and cash flows for each of the three years in the
period ended December 31, 2008 and our report dated March 11, 2009 expressed an
unqualified opinion thereon.
 /s/
      BDO Seidman, LLPAtlanta,
      GeorgiaMarch
      11, 2009
  36
  OTELCO
INC.
  CONSOLIDATED
BALANCE SHEETS
 December
      31,2007
                    
                    
                    2008AssetsCurrent
      assetsCash
      and cash equivalents
                    
                    $
                    12,810,497
                    
                    
                    $
                    13,542,255Accounts
      receivable:Due
      from subscribers, net of allowance for doubtful accounts of $257,862 and
      $318,446, respectively
                    
                    
                    2,753,451
                    
                    
                    
                    5,207,731Unbilled
      receivables
                    
                    
                    2,616,867
                    
                    
                    
                    2,567,730Other
                    
                    
                    1,760,207
                    
                    
                    
                    4,348,044Materials
      and supplies
                    
                    
                    1,991,724
                    
                    
                    
                    2,305,755Prepaid
      expenses
                    
                    
                    1,149,180
                    
                    
                    
                    1,141,908Income
      tax receivable
                    
                    
                    469,546
                    
                    
                    
                    181,644Deferred
      income taxes
                    
                    
                    435,852
                    
                    
                    
                    827,686Total
      current assets
                    
                    
                    23,987,324
                    
                    
                    
                    30,122,753Property
      and equipment, net
                    
                    
                    54,610,355
                    
                    
                    
                    75,407,062Goodwill
                    
                    
                    134,570,435
                    
                    
                    
                    189,334,837Intangible
      assets, net
                    
                    
                    9,514,772
                    
                    
                    
                    44,390,644Investments
                    
                    
                    1,207,183
                    
                    
                    
                    2,015,583Deferred
      financing costs
                    
                    
                    5,878,943
                    
                    
                    
                    8,315,921Deferred
      income taxes
                    
                    
                    1,050,587
                    
                    
                    
                    5,897,382Interest
      rate cap
                    
                    
                    1,510,951
                    
                    
                    
                    7,765Deferred
      charges
                    
                    
                    155,573
                    
                    
                    
                    49,540Total
      assets
                    
                    $
                    232,486,123
                    
                    
                    $
                    355,541,487Liabilities
      and Stockholders’ EquityCurrent
      liabilitiesAccounts
      payable
                    
                    $
                    2,058,989
                    
                    
                    $
                    2,312,920Accrued
      expenses
                    
                    
                    3,716,880
                    
                    
                    
                    6,632,287Advance
      billings and payments
                    
                    
                    2,077,713
                    
                    
                    
                    2,024,123Customer
      deposits
                    
                    
                    185,147
                    
                    
                    
                    180,582Total
      current liabilities
                    
                    
                    8,038,729
                    
                    
                    
                    11,149,912Deferred
      income taxes
                    
                    
                    25,223,656
                    
                    
                    
                    45,962,402Advance
      billings and payments
                    
                    
                    797,498
                    
                    
                    
                    739,736Other
      liabilities
                    
                    
                    183,756
                    
                    
                    
                    188,346Long-term
      notes payable
                    
                    
                    170,019,705
                    
                    
                    
                    278,799,513Total
      liabilities
                    
                    
                    204,263,344
                    
                    
                    
                    336,839,909Derivative
      liability
                    
                    
                    814,005
                    
                    
                    
                    238,054Class
      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 at December 31, 2007 and 2008,
      respectively
                    
                    
                    126,767
                    
                    
                    
                    126,767Class
      B Common Stock, $.01 par value-authorized 800,000 shares; issued and
      outstanding 544,671 shares at December 31, 2007 and
      2008,respectively
                    
                    
                    5,447
                    
                    
                    
                    5,447Additional
      paid in capital
                    
                    
                    28,215,056
                    
                    
                    
                    19,277,959Retained
      deficit
                    
                    
                    (4,084,797
                    )
                    
                    
                    (3,870,923
                    )Accumulated
      other comprehensive loss
                    
                    
                    (938,732
                    )
                    
                    
                    (1,160,759
                    )Total
      stockholders’ equity
                    
                    
                    23,323,741
                    
                    
                    
                    14,378,491Total
      liabilities and stockholders’ equity
                    
                    $
                    232,486,123
                    
                    
                    $
                    355,541,487
  The accompanying notes are an
integral part of these consolidated financial
statements.
  37
  OTELCO
INC.
  CONSOLIDATED
STATEMENTS OF INCOME
 Years
      Ended December 31,2006
                  
                  
                  2007
                  
                  
                  2008RevenuesLocal
      services
                  
                  $
                  21,370,537
                  
                  
                  $
                  26,101,800
                  
                  
                  $
                  30,013,901Network
      access
                  
                  
                  23,481,490
                  
                  
                  
                  25,670,619
                  
                  
                  
                  27,281,727Cable
      television
                  
                  
                  2,191,210
                  
                  
                  
                  2,184,072
                  
                  
                  
                  2,388,885Internet
                  
                  
                  8,668,768
                  
                  
                  
                  11,517,514
                  
                  
                  
                  12,448,776Transport
      services
                  
                  
                  1,877,387
                  
                  
                  
                  4,275,429
                  
                  
                  
                  4,981,651Total
      revenues
                  
                  
                  57,589,392
                  
                  
                  
                  69,749,434
                  
                  
                  
                  77,114,940Operating
      expensesCost
      of services and products
                  
                  
                  18,727,806
                  
                  
                  
                  25,718,634
                  
                  
                  
                  29,191,987Selling,
      general and administrative expenses
                  
                  
                  8,277,449
                  
                  
                  
                  10,418,760
                  
                  
                  
                  11,228,585Depreciation
      and amortization
                  
                  
                  10,781,333
                  
                  
                  
                  14,346,620
                  
                  
                  
                  15,607,726Total
      operating expenses
                  
                  
                  37,786,588
                  
                  
                  
                  50,484,014
                  
                  
                  
                  56,028,298Income
      from operations
                  
                  
                  19,802,804
                  
                  
                  
                  19,265,420
                  
                  
                  
                  21,086,642Other
      income (expense)Interest
      expense
                  
                  
                  (20,082,037
                  )
                  
                  
                  (21,378,434
                  )
                  
                  
                  (21,807,800
                  )Change
      in fair value of derivative
                  
                  
                  (277,782
                  )
                  
                  
                  970,281
                  
                  
                  
                  324,058Other
      income
                  
                  
                  3,358,860
                  
                  
                  
                  947,737
                  
                  
                  
                  639,784Total
      other expense
                  
                  
                  (17,000,959
                  )
                  
                  
                  (19,460,416
                  )
                  
                  
                  (20,843,958
                  )Income
      (loss) before income tax and accretion expense
                  
                  
                  2,801,845
                  
                  
                  
                  (194,996
                  )
                  
                  
                  242,684Income
      tax (expense) benefit
                  
                  
                  (1,211,269
                  )
                  
                  
                  374,375
                  
                  
                  
                  (28,810
                  )Income
      before accretion expense
                  
                  
                  1,590,576
                  
                  
                  
                  179,379
                  
                  
                  
                  213,874Accretion
      of Class B common convertible to senior
                  
                  
                  (429,579
                  )
                  
                  
                  —
                  
                  
                  
                  —Net
      income available to common stockholders
                  
                  $
                  1,160,997
                  
                  
                  $
                  179,379
                  
                  
                  $
                  213,874Weighted
      average shares outstanding:Basic
                  
                  
                  9,676,733
                  
                  
                  
                  11,156,185
                  
                  
                  
                  12,676,733Diluted
                  
                  
                  9,676,733
                  
                  
                  
                  11,700,856
                  
                  
                  
                  13,221,404Basic
      net income per share
                  
                  $
                  0.12
                  
                  
                  $
                  0.02
                  
                  
                  $
                  0.02Diluted
      net income (loss) per share
                  
                  $
                  0.12
                  
                  
                  $
                  (0.10
                  )
                  
                  $
                  (0.03
                  )Dividends
      declared per share
                  
                  $
                  0.71
                  
                  
                  $
                  0.71
                  
                  
                  $
                  0.71
  The
accompanying notes are an integral part of these consolidated financial
statements.
  38
  OTELCO
INC.
  CONSOLIDATED
STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
 
 AccumulatedClass
      A
                        
                        
                        Class
      B
                        
                        
                        Additional
                        
                        
                        Retained
                        
                        
                        Other
                        
                        
                        TotalCommon
      Stock
                        
                        
                        Common
      Stock
                        
                        
                        Paid-In
                        
                        
                        Earnings
                        
                        
                        Comprehensive
                        
                        
                        Stockholders’Shares
                        
                        
                        Amount
                        
                        
                        Shares
                        
                        
                        Amount
                        
                        
                        Capital
                        
                        
                        (Deficit)
                        
                        
                        Income
      (Loss)
                        
                        
                        EquityBalance,
      December 31, 2005
                        
                        
                        9,676,733
                        
                        
                        $
                        96,767
                        
                        
                        
                        544,671
                        
                        
                        $
                        5,447
                        
                        
                        $
                        5,613,703
                        
                        
                        $
                        (805,731
                        )
                        
                        $
                        899,019
                        
                        
                        $
                        5,809,205Comprehensive
      IncomeNet
      income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        1,160,997
                        
                        
                        
                        
                        
                        
                        
                        1,160,997Change
      in value of interest rate cap
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (20,974
                        )
                        
                        
                        (20,974
                        )Total
      comprehensive income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        1,140,023Dividends
      declared
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (5,329,662
                        )
                        
                        
                        (1,492,432
                        )
                        
                        
                        
                        
                        
                        
                        (6,822,094
                        )Balance,
      December 31, 2006
                        
                        
                        9,676,733
                        
                        
                        $
                        96,767
                        
                        
                        
                        544,671
                        
                        
                        $
                        5,447
                        
                        
                        $
                        284,041
                        
                        
                        $
                        (1,137,166
                        )
                        
                        $
                        878,045
                        
                        
                        $
                        127,134Comprehensive
      IncomeNet
      income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        179,379
                        
                        
                        
                        
                        
                        
                        
                        179,379Change
      in value of interest rate cap
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (1,816,777
                        )
                        
                        
                        (1,816,777
                        )Total
      comprehensive income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (1,637,398
                        )Dividends
      declared
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (4,752,589
                        )
                        
                        
                        (3,127,010
                        )
                        
                        
                        
                        
                        
                        
                        (7,879,599
                        )Subsequent
      Public OfferingIssuance
      of IDSs
                        
                        
                        3,000,000
                        
                        
                        
                        30,000
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        34,998,584
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        35,028,584Capitalized
      transactions costs offset against proceeds of offering
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (2,314,980
                        )
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (2,314,980
                        )Balance,
      December 31, 2007
                        
                        
                        12,676,733
                        
                        
                        $
                        126,767
                        
                        
                        
                        544,671
                        
                        
                        $
                        5,447
                        
                        
                        $
                        28,215,056
                        
                        
                        $
                        (4,084,797
                        )
                        
                        $
                        (938,732
                        )
                        
                        $
                        23,323,741Comprehensive
      IncomeNet
      income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        213,874
                        
                        
                        
                        
                        
                        
                        
                        213,874Change
      in value of interest rate cap
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (222,027
                        )
                        
                        
                        (222,027
                        )Total
      comprehensive income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (8,153
                        )Dividends
      declared
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (8,937,097
                        )
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (8,937,097
                        )Balance,
      December 31, 2008
                        
                        
                        12,676,733
                        
                        
                        $
                        126,767
                        
                        
                        
                        544,671
                        
                        
                        $
                        5,447
                        
                        
                        $
                        19,277,959
                        
                        
                        $
                        (3,870,923
                        )
                        
                        $
                        (1,160,759
                        )
                        
                        $
                        14,378,491
  The
accompanying notes are an integral part of these consolidated financial
statements.
  39




OTELCO
INC.
  CONSOLIDATED
STATEMENTS OF CASH FLOWS
 2006
                  
                  
                  2007
                  
                  
                  2008Cash
      flows from operating activities:Net
      income
                  
                  $
                  1,160,997
                  
                  
                  $
                  179,379
                  
                  
                  $
                  213,874Adjustments
      to reconcile net income to cash flows from operating
      activities:Depreciation
                  
                  
                  9,527,319
                  
                  
                  
                  11,751,673
                  
                  
                  
                  11,772,191Amortization
                  
                  
                  1,254,014
                  
                  
                  
                  2,594,943
                  
                  
                  
                  3,835,535Interest
      rate caplet
                  
                  
                  755,594
                  
                  
                  
                  890,840
                  
                  
                  
                  1,029,264Amortization
      of debt premium
                  
                  
                  —
                  
                  
                  
                  (33,552
                  )
                  
                  
                  (73,224
                  )Amortization
      of loan costs
                  
                  
                  1,627,960
                  
                  
                  
                  2,606,422
                  
                  
                  
                  2,874,164Accretion
      expense
                  
                  
                  429,579
                  
                  
                  
                  —
                  
                  
                  
                  —Change
      in fair value of derivative
                  
                  
                  277,782
                  
                  
                  
                  (970,281
                  )
                  
                  
                  (324,058
                  )Gain
      on disposition of other assets
                  
                  
                  (2,686,745
                  )
                  
                  
                  —
                  
                  
                  
                  —Provision
      for deferred income taxes
                  
                  
                  983,786
                  
                  
                  
                  (208,771
                  )
                  
                  
                  (114,845
                  )Provision
      for uncollectible revenue
                  
                  
                  193,561
                  
                  
                  
                  225,615
                  
                  
                  
                  416,892Gain
      on early lease termination
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  (121,124
                  )Changes
      in assets and liabilities; net of assets and liabilities
      acquired:Accounts
      receivables
                  
                  
                  (327,129
                  )
                  
                  
                  (422,708
                  )
                  
                  
                  (1,394,629
                  )Material
      and supplies
                  
                  
                  3,385
                  
                  
                  
                  (183,373
                  )
                  
                  
                  (124,010
                  )Prepaid
      expenses and other assets
                  
                  
                  (365,795
                  )
                  
                  
                  (86,233
                  )
                  
                  
                  404,306Income
      tax receivable
                  
                  
                  1,037,395
                  
                  
                  
                  (469,546
                  )
                  
                  
                  287,902Accounts
      payable and accrued liabilities
                  
                  
                  2,757,784
                  
                  
                  
                  (1,843,834
                  )
                  
                  
                  143,552Advance
      billings and payments
                  
                  
                  (110,253
                  )
                  
                  
                  755,510
                  
                  
                  
                  (111,352
                  )Other
      liabilities
                  
                  
                  (22,029
                  )
                  
                  
                  (15,630
                  )
                  
                  
                  (25,909
                  )Net
      cash from operating activities
                  
                  
                  16,497,205
                  
                  
                  
                  14,770,454
                  
                  
                  
                  18,688,529Cash
      flows from investing activities:Deferred
      charges/acquisition
                  
                  
                  (44,296
                  )
                  
                  
                  (110,923
                  )
                  
                  
                  51,222Acquisition
      and construction of property and equipment
                  
                  
                  (5,618,295
                  )
                  
                  
                  (6,572,336
                  )
                  
                  
                  (9,244,137
                  )Proceeds
      from retirement of investment
                  
                  
                  3,224,913
                  
                  
                  
                  7,557
                  
                  
                  
                  (2,453
                  )Payments
      for the purchase of Mid-Maine, net of cash acquired
                  
                  
                  (40,347,339
                  )
                  
                  
                  —
                  
                  
                  
                  —Payments
      for the purchase of CR Companies, net of cash acquired
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  (108,677,338
                  )Net
      cash from investing activities
                  
                  
                  (42,785,017
                  )
                  
                  
                  (6,675,702
                  )
                  
                  
                  (117,872,706
                  )Cash
      flows from financing activities:Cash
      dividends paid
                  
                  
                  (5,116,572
                  )
                  
                  
                  (9,585,120
                  )
                  
                  
                  (8,937,097
                  )Proceeds
      from long-term notes payable
                  
                  
                  40,000,000
                  
                  
                  
                  —
                  
                  
                  
                  108,853,032Loan
      origination costs and transaction costs
                  
                  
                  237,000
                  
                  
                  
                  (1,832,972
                  )
                  
                  
                  —Repayment
      of long-term debt notes payable
                  
                  
                  —
                  
                  
                  
                  (55,353,032
                  )
                  
                  
                  —Proceeds
      from issuance of Income Deposit Securities
                  
                  
                  —
                  
                  
                  
                  59,400,000
                  
                  
                  
                  —Direct
      cost of subsequent public offering
                  
                  
                  —
                  
                  
                  
                  (2,314,980
                  )
                  
                  
                  —Net
      cash from financing activities
                  
                  
                  35,120,428
                  
                  
                  
                  (9,686,104
                  )
                  
                  
                  99,915,935Net
      increase (decrease) in cash and cash equivalents
                  
                  
                  8,832,616
                  
                  
                  
                  (1,591,352
                  )
                  
                  
                  731,758Cash
      and cash equivalents, beginning of period
                  
                  
                  5,569,233
                  
                  
                  
                  14,401,849
                  
                  
                  
                  12,810,497Cash
      and cash equivalents, end of period
                  
                  $
                  14,401,849
                  
                  
                  $
                  12,810,497
                  
                  
                  $
                  13,542,255Supplemental
      disclosures of cash flow information:Interest
      paid
                  
                  $
                  14,284,165
                  
                  
                  $
                  20,636,959
                  
                  
                  $
                  17,267,118Income
      taxes received
                  
                  $
                  (698,336
                  )
                  
                  $
                  (133,218
                  )
                  
                  $
                  (220,221
                  )Dividends
      declared but not paid
                  
                  $
                  1,705,524
                  
                  
                  $
                  —
                  
                  
                  $
                  —
  The
accompanying notes are an integral part of these consolidated financial
statements.
  40
  OTELCO
INC.
  NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  1.
Summary of Significant Accounting Policies
  Nature
of Business
  Otelco
Inc. (the “Company”) provides a broad range of telecommunications services on a
retail and wholesale basis. These services include local and long distance
calling; network access to and from our customers; data transport; digital
high-speed and dialup Internet access; cable, satellite and Internet protocol
television; wireless; and other telephone related services. The principal
markets for these services are residential and business customers residing in
and adjacent to the exchanges the Company serves in Alabama, Massachusetts,
Maine, Missouri and West Virginia. In addition, the Company serves business
customers throughout the state of Maine and provides dial-up Internet service
throughout the states of Maine and Missouri. The Company offers various
communications services that are sold to economically similar customers in a
comparable manner of distribution. The majority of our customers buy multiple
services, often bundled together at a single price. The Company views, manages
and evaluates the results of its operations from the various communications
services as one company and therefore has identified one reporting segment as it
relates to providing segment information.
  Basis
of Presentation and Principles of Consolidation
  The
consolidated financial statements include the accounts of the Company and its
subsidiaries, all of which are wholly owned. These include: Otelco
Telecommunications LLC (“OTC”); Otelco Telephone LLC (“OTP”); Hopper Holding
Company, Inc. (“HHC”) and its wholly owned subsidiary, Hopper Telecommunications
Company, Inc. (“HTC”); Brindlee Holdings LLC (“BH”) and its wholly owned
subsidiary Brindlee Mountain Telephone Company, Inc. (“BMTC”); Page & Kiser
Communications, Inc. (“PKC”) and its wholly owned subsidiary Blountsville
Telephone Company, Inc. (“BTC”); Mid-Missouri Holding Corporation (“MMH”) and
its wholly owned subsidiary Mid-Missouri Telephone Company (“MMT”) and its
wholly owned subsidiary Imagination, Inc.; Mid-Maine Communications, Inc.
(“MMeT” or “Mid-Maine”) and its wholly owned subsidiaries Mid-Maine Telecom,
Inc. (“MMTI”) and Mid-Maine TelPlus (“MMTP”); Granby Holdings, Inc. (“GH”) and
its wholly owned subsidiary The Granby Telephone & Telegraph Co. of Mass.
(“GTT”); War Holding, Inc. (“WH”) and its wholly owned subsidiary War
Acquisition Corp. (“WT”); Pine Tree Holding, Inc. (“PTH”) and its wholly owned
subsidiaries The Pine Tree Telephone and Telegraph Company (“PTT”), Saco River
Telegraph and Telephone Company (“SRT”), CRC Communications of Maine, Inc.
(“PTN”), and Communications Design Acquisition Corporation
(“CDAC”).
  GH,
WH and PTH (collectively, the “CR Companies”) were acquired on October 31, 2008
from Country Road Communications LLC (“CRC”).
  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.
  Use
of Estimates
  The
Company prepares its consolidated financial statements in accordance with
accounting principles generally accepted in the United States of America, which
require management to make estimates and assumptions that affect the reported
amounts of assets, liabilities, revenues and expenses and disclosure of
contingent assets and liabilities. The estimates and assumptions used in the
accompanying consolidated financial statements are based upon management’s
evaluation of the relevant facts and circumstances as of the date of the
financial statements. Actual results may differ from the estimates and
assumptions used in preparing the accompanying consolidated financial
statements.
  Significant
accounting estimates include the recoverability of goodwill and long-term
assets.
  Regulatory
Accounting
  The
Company follows the accounting for regulated enterprises prescribed by Statement
of Financial Accounting Standards (SFAS) No. 71, Accounting for the Effects of
Certain Types of Regulations, or SFAS 71, for our rural local exchange
carriers. This accounting practice recognizes the economic effects of rate
regulation by recording costs and a return on investment as such amounts are
recovered through rates authorized by regulatory authorities. Accordingly, SFAS
71 requires the Company to depreciate telecommunications property and equipment
over the useful lives approved by regulators, which could be different than the
useful lives that would otherwise be determined by management. SFAS 71 also
requires deferral of certain costs and obligations based upon approvals received
from regulators to permit recovery of such amounts in future years. Criteria
that would give rise to the discontinuance of accounting in accordance with SFAS
71 include (1) increasing competition restricting the ability of the Company to
establish prices that allow it to recover specific costs and (2) significant
changes in the manner in which rates are set by regulators from cost-based
regulation to another form of regulation. The Company periodically reviews the
criteria to determine whether the continuing application of SFAS 71 is
appropriate for our rural local exchange carriers.
  41
  OTELCO
INC.
  NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  The
Company is subject to reviews and audits by regulatory agencies. The effect of
these reviews and audits, if any, will be recorded in the period in which they
become known and determinable.
  Intangible
Assets and Goodwill
  Intangible
assets consist primarily of the value of customer related intangibles,
non-compete agreements and long-term customer contracts. Goodwill represents the
excess of total acquisition cost over the assigned value of net identifiable
tangible and intangible assets acquired through various business combinations.
Due to the regulatory accounting required by SFAS 71, the Company did not record
acquired regulated telecommunications property and equipment at fair value as
required by SFAS No.141,Business Combinations, or SFAS 141, through 2004. In accordance with 47
CFR 32.2000, the federal regulation governing acquired telecommunications
property and equipment, such property and equipment is accounted for at original
cost, and depreciation and amortization of property and equipment acquired is
credited to accumulated depreciation.
  For
the acquisition of Mid-Maine and the CR Companies, property has been recorded at
fair value in accordance with SFAS 141, resulting in a plant acquisition
adjustment for MMTI in 2006 and GTT, WT, PTT and SRT in 2008. The Company has
acquired identifiable intangible assets associated with the territories it
serves through its acquisitions of various companies, including non-compete
agreements with the former CEOs of two acquired businesses; the customer lists
of its various businesses; and a multi-year contract to provide
telecommunications services to a large multi-services operator in New England.
Any excess of the total purchase price over the amounts assigned to net tangible
and definable assets is recorded as goodwill.
  Effective
January 1, 2002, the Company adopted SFAS No. 142,Goodwill and Other Intangible
Assets, or SFAS 142, which establishes accounting and reporting standards
for intangible assets and goodwill. SFAS 142 requires that goodwill and
intangible assets with indefinite useful lives no longer be amortized, but
rather tested for impairment at least annually or if an event occurs that
potentially triggers an impairment issue. SFAS 142 also requires that intangible
assets with definite useful lives be amortized over their respective estimated
useful lives and reviewed for impairment in accordance with SFAS No. 144,Accounting for the Impairment or
Disposal of Long-Lived Assets, or SFAS 144. The Company performed the
required transition impairment tests of goodwill and other intangibles in the
first six months of adoption, and determined that no impairment existed. In
addition, the Company performs an annual assessment of impairment each
January.
  The
Company performs a quarterly review of its identified intangible assets to
determine if facts and circumstances exist which indicate that the useful life
is shorter than originally estimated or that the carrying amount of assets may
not be recoverable. If such facts and circumstances do exist, the Company
assesses the recoverability of identified intangible assets by comparing the
projected undiscounted net cash flows associated with the related asset or group
of assets over their remaining lives against their respective carrying amounts.
Impairment, if any, is based on the excess of the carrying amount over the fair
value of those assets.
  Revenue
Recognition
  Local
service revenues. Local service revenue for monthly recurring local
services is billed in advance to a portion of the Company’s customers and in
arrears to the balance of the customers. The Company records revenue for charges
that have not yet been invoiced to its customers as unbilled revenue when
services are rendered. The Company records revenue billed in advance as advance
billings and defers recognition until such revenue is earned. Long distance
service is billed to customers in arrears based on actual usage except when it
is included in service bundles. The Company records unbilled long distance
revenue as unbilled revenue when services are rendered. In bundles, unlimited
usage is billed in arrears at a flat rate.
  42
  OTELCO
INC.
  NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  Network
access services.Network access revenue is derived from several sources.
Revenue for interstate access services is received through tariffed access
charges filed by the National Exchange Carrier Association (“NECA”) with the
Federal Communications Commission (“FCC”) on behalf of the NECA member companies
for our regulated subsidiaries. These access charges are billed by the Company
to interstate interexchange carriers and pooled with like-revenues from all NECA
member companies. A portion of the pooled access charge revenue received by the
Company is based upon its actual cost of providing interstate access service,
plus a return on the investment dedicated to providing that service. The balance
of the pooled access charge revenue received by the Company is based upon the
nationwide average schedule costs of providing interstate access services. Rates
for our competitive subsidiaries are set by FCC rule to be no more than the
interconnecting interstate rate of the predominant local carrier. Revenue for
intrastate access service is received through tariffed access charges billed by
the Company to the originating intrastate carrier using access rates filed with
the Alabama Public Service Commission (“APSC”), the Maine Public Utilities
Commission (“MPUC”), the Massachusetts Department of Telecommunications and
Cable (“MDTC”), the Missouri Public Service Commission (“MPSC”), the New
Hampshire Public Utilities Commission (“NHPUC”) and the West Virginia Public
Service Commission (“WVPSC”) and are retained by the Company. Revenue for the
intrastate/interLATA access service is received through tariffed access charges
as filed with the APSC, MDTC, MPSC, MPUC, NHPUC and WVPSC. These access charges
are billed to the intrastate carriers and are retained by the Company. Revenue
for terminating and originating long distance service is received through
charges for providing usage of the local exchange network. Toll revenues are
recognized when services are rendered.
  Cable
television, Internet and transport services. Cable television, Internet
and transport service revenues are recognized when services are rendered.
Operating revenues from the lease of dark fiber covered by indefeasible
rights-of-use (IRU) agreements are recorded as earned. In some cases, the entire
lease payment is received at inception of the lease and recognized ratably over
the lease term after recognition of expenses associated with lease inception.
The Company has deferred revenue in the consolidated balance sheet as of
December 31, 2007 and 2008 of $797,498 and $739,736, respectively.
  Cash
and Cash Equivalents
  The
Company considers all highly liquid investments purchased with an original
maturity of three months or less to be cash equivalents.
  Accounts
Receivable
  The
Company extends credit to its commercial and residential customers based upon a
written credit policy. Service interruption is the primary vehicle for
controlling losses. Accounts receivable are recorded at the invoiced amount and
do not bear interest. The allowance for doubtful accounts is the Company’s best
estimate for the amount of probable credit losses in the Company’s existing
accounts receivable. The Company establishes an allowance for doubtful accounts
based upon factors surrounding the credit risk of specific customers, historical
trends, and other information. Receivable balances are reviewed on an aged basis
and account balances are charged off against the allowance after all means of
collection have been exhausted and the potential for recovery is considered
remote.
  Materials
and Supplies
  Materials
and supplies are stated at the lower of cost or market value. Cost is determined
using an average cost basis.
  Property
and Equipment
  Regulated
property and equipment is stated at original cost. Unregulated property and
equipment purchased through acquisitions is stated at its fair value at the date
of acquisition. Expenditures for improvements that significantly add to
productive capacity or extend the useful life of an asset are capitalized.
Expenditures for maintenance and repairs are expensed when incurred.
Depreciation of regulated property and equipment is computed principally using
the straight-line method over useful lives determined by the APSC, MDTC, MPSC,
MPUC, NHPUC and WVPSC as discussed above. Depreciation of unregulated property
and equipment primarily employs the straight-line method over industry standard
useful lives.
  Long-Lived
Assets
  The
Company reviews its long-lived assets for impairment at each balance sheet date
and whenever events or changes in circumstances indicate that the carrying
amount of an asset should be assessed. To determine if an impairment exists, the
Company estimates the future undiscounted cash flows expected to result from the
use of the asset being reviewed for impairment. If the sum of these expected
future cash flows is less than the carrying amount of the asset, the Company
recognizes an impairment loss in accordance with SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets. The amount of the impairment recognized is
determined by estimating the fair value of the assets and recording a loss for
the excess of the carrying value over the fair value.
  43
  OTELCO
INC.
  NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  Deferred
Financing Costs
  Deferred
financing and loan costs consist of debt issuance costs incurred in obtaining
long-term financing, which are amortized over the life of the related debt.
Amortization of deferred financing and loan costs is classified as “Interest
expense”. When amendments to debt agreements are considered to extinguish
existing debt per EITF 96-19, Debtor’s Accounting for a
Modification or Exchange of Debt Instruments,the remaining deferred
financing costs are amortized at the time of amendment.
  Derivative
Financial Instruments
  Derivative
financial instruments are accounted for under SFAS No. 133,Accounting for Derivative
Instruments and Hedging Activities, as amended, or SFAS 133. Under SFAS
133, all derivatives are recorded on the balance sheet as assets or liabilities
and measured at fair value. The embedded exchange feature of the Class B common
stock is accounted for as a derivative liability. This liability will be
adjusted to estimated fair value on each balance sheet date until the shares are
converted with the offset to other non-operating income or expense. The model to
estimate the value is prepared by an outside expert and updated annually to
reflect then current market conditions. In addition, the Company has an
effective hedge of its interest rates associated with its long-term senior
debt.
  We
are exposed to the market risk of adverse changes in interest rates. The Company
holds an interest rate cap with a notional amount of $80 million, a three month
LIBOR cap rate of 3.0%, and a termination date of December 21, 2009. The
interest rate cap is used to lock in a maximum interest expense of 3.0 % LIBOR
plus applicable loan margin on up to $80 million of our senior debt through the
cap’s maturity. As of December 31, 2008, the Company had $173.5 million of
senior debt and the applicable margin was 4.0%. The interest rate cap is an
effective hedge in offsetting the potential variability of interest rates and
all critical terms of the interest rate cap are identical to the debt it hedges.
Changes in the fair value of the interest rate cap are not included in earnings
but are reported as a component of accumulated other comprehensive income. From
July 3, 2007 through October 31, 2008, the portion of the interest rate cap that
exceeded the senior debt outstanding during that period of $64.6 million was
treated as an investment.
  The
cost of the interest rate cap is expensed as interest over the five year
effective life of the hedge in accordance with its quarterly future value at the
date of inception.
  Under
our second amended and restated credit agreement as implemented on October 31,
2008, we are required to have interest rate protection equal to at least half of
our senior debt outstanding through October 31, 2010. Hedging must be completed
by February 9, 2009, the next date that the interest rate resets on the
facility. Interest rate swaps for 3 month LIBOR for $90 million notional amount
for three years beginning February 9, 2009 at 1.85% and for $60 million notional
amount for two years beginning February 9, 2010 at 2.0475% will be completed to
meet that requirement and to control interest rate risk.
  Income
Taxes
  The
Company accounts for income taxes using the asset and liability approach in
accordance with SFAS No. 109, Accounting for Income
Taxes,or
SFAS 109. The asset and liability approach requires the recognition of deferred
tax liabilities and assets for the expected future tax consequences of temporary
differences between the carrying amounts and the tax basis of assets and
liabilities. A valuation allowance is provided when it is more likely than not
that some portion or all of the deferred tax assets will not be
realized.
  The
provision for income taxes consists of an amount for the taxes currently payable
and a provision for the tax consequences deferred to future
periods.
  In
July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB
Interpretation No. 48, Accounting for uncertainty in Income Taxes-an
interpretation of FASB Statement No. 109, Accounting for Income Taxes,
or FIN 48.It clarifies
the accounting for uncertainty in income taxes and sets a consistent framework
for preparers to use to determine the appropriate level of tax reserve to
maintain for uncertain tax positions. This interpretation uses a two-step
approach wherein a tax benefit is recognized if a position is
more-likely-than-not to be sustained. The amount of the benefit is then measured
to be the highest tax benefit which is greater than 50% likely to be realized.
FIN 48 also sets out disclosure requirements to enhance transparency of an
entity’s tax reserves. The Company adopted this Interpretation as of January 1,
2007. The adoption of FIN 48 did not have a material impact on our financial
statements.
  Interest
and penalties related to income tax matters would be recognized in income tax
expense. As of December 31, 2008, we did not have an amount recorded for
interest and penalties.
  44
  OTELCO
INC.
  NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  The
Company conducts business in multiple jurisdictions and, as a result, one or
more subsidiaries file income tax returns in the U. S. federal, various state
and local jurisdictions. All tax years since 2001 are open for examination by
various tax authorities.
  Fair
Value of Financial Instruments
  The
carrying value of the Company’s financial instruments, including cash and cash
equivalents, accounts receivable, accounts payable, derivative liabilities and
long-term notes payable approximate their net book value as of December 31, 2007
and 2008.
  Comprehensive
Income
  Comprehensive
income equals net income plus other comprehensive income. Other comprehensive
income refers to revenue, expenses, gains and losses, which are reflected in
retained earnings but excluded from net income.
  Income
per Common Share
  The
Company computes net income per Class A common share in accordance with the
provision of SFAS No. 128, Earnings per Share, or SFAS
128. Under the provision of SFAS 128, basic and diluted income per share is
computed by dividing net income available to stockholders by the weighted
average number of common shares and common share equivalents outstanding during
the period. Basic income per common share excludes the effect of potentially
dilutive securities, while diluted income per common share reflects the
potential dilution that would occur if securities or other contracts to issue
common shares were exercised for, converted into or otherwise resulted in the
issuance of common shares. Net income is adjusted for accretion and Class B
derivative liability in calculating diluted earnings.
  Recent
Accounting Pronouncements
  In
December 2007, the FASB issued SFAS No. 141R,Business Combinations, or
SFAS 141R. SFAS 141R replaces SFAS 141 and establishes principles and
requirements for how the acquirer of a business recognizes and measures in its
financial statements the identifiable assets acquired, the liabilities assumed,
and any non-controlling interest in the acquiree. The statement also provides
guidance for recognizing and measuring the goodwill acquired in the business
combination and determines what information to disclose to enable users of the
financial statements to evaluate the nature and financial effects of the
business combination. SFAS 141R is effective for financial statements issued for
fiscal years beginning after December 15, 2008. Accordingly, any business
combinations the Company engages in will be recorded and disclosed following
existing generally accepted accounting principles until December 31, 2008. The
Company expects SFAS 141R will have an impact on its consolidated financial
statements when effective, but the nature and magnitude of the specific effects
will depend upon the nature, terms and size of acquisitions it consummates after
the effective date.
  Effective
January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements, or
SFAS 157. In February 2008, the FASB issued a staff position (FSP 157-2) that
delays the effective date of SFAS 157 for all non-financial assets and
liabilities except those recognized or disclosed at least annually. 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.
  The
adoption of SFAS 157 did not have a material impact on our consolidated
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,
or 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.
  45
  OTELCO
INC.
  NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  In
March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging
Activities – an amendment of FASB Statement No. 133,or SFAS 161. SFAS
161 expands quarterly disclosure requirements in SFAS 133 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 Asset, or 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. 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
May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally
Accepted Accounting
Principles,or 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
SEC’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
October 2008, the FASB issued FSP 157-3, Determining the Fair Value of a
Financial Asset when the Market of that Asset is not Active,or 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. 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, or 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 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 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. 08-3, Accounting for Lessees for
Maintenance Deposits Under
Lease Arrangements, or 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 implementation of this
standard will not have a material impact on our consolidated financial position
and results of operations.
  In
September 2008, the FASB staff issued FSP FAS 133-1 and FIN 45-4, Disclosures about Credit Derivatives
and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB
Interpretation No. 45; and Clarification of the Effective Date of FASB Statement
No. 161. The FSP applies to credit derivatives within the scope of SFAS
133 and hybrid instruments that have embedded credit derivatives. It deals with
disclosures related to these derivatives and is effective for reporting periods
ending after November 15, 2008. It also clarifies the effective date of SFAS 161
as any reporting period 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.
  Reclassifications
  Certain
items in prior years’ consolidated financial statements have been reclassified
to conform with 2008 presentation. In the Consolidated Statements of Cash Flows,
the extinguishment of loans associated with the acquisition of Mid-Maine in 2006
have been reclassified from financing activities to investing
activities.
  46
  OTELCO
INC.
  NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  2.
Income Deposit Securities Issued
  On
July 5, 2007, the Company completed its offering of 3,000,000 Income Deposit
Securities (IDS) units through an underwritten public offering at $19.80 per
unit. The price per unit is comprised of $11.68 allocated to each share of Class
A common stock and $8.11 allocated to each senior subordinated note, plus $0.01
representing accrued interest from June 30, 2007. The Company used the net
proceeds of approximately $55.4 million to repay senior secured indebtedness
under its credit facility, reducing senior debt from $120.0 million to
approximately $64.6 million. The $8.11 allocated to each senior subordinated
note represents a premium of $0.61 over the $7.50 stated principal amount. The
additional IDS units increase senior subordinated debt by $22.5 million,
bringing senior subordinated debt to approximately $105.4 million. Therefore,
total debt was reduced from approximately $201.1 to $170.0 million as of the
offering date.
  The
following is a summary of the offering receipts and disbursements and related
use of funds:
 ReceiptsProceeds
      from issuance of IDS units
                      
                      $
                      59,400,000DisbursementsDirect
      cost of sebsequent public offering
                      
                      
                      2,314,980Principal
      repayment of long-term debt
                      
                      
                      55,353,032Loan
      origination costs
                      
                      
                      1,832,972Total
                      
                      
                      59,500,984Net
      disbursements
                      
                      $
                      (100,984
                      )
  3.
Acquisitions
  On
October 31, 2008, the Company acquired 100% of the outstanding common stock of
the CR Companies from CRC. GH owns 100% of its operating subsidiary GTT. WH owns
100% of its operating subsidiary WT. PTH owns 100% of its operating
subsidiaries, PTT, SRT, PTN, and CDAC. These operating subsidiaries provide
telecommunications solutions, including voice, data and Internet services, to
residential and business customers in portions of Massachusetts, Maine and West
Virginia and extend the Company’s presence in the New England market. The acquisitionaddedover 24,000 retail access line
equivalentstothe Company’spresence in Maine;almost 5,000retailaccess line equivalents in Massachusetts
and West Virginia;
anda growing wholesale
business in New England.
  The
acquisition agreement relating to the CR Companies provided for cash
consideration of $101,329,000, subject to adjustment as provided in the
acquisition agreement, plus transaction costs. The purchase price was
$109,003,040, including transaction costs and the extinguishment of notes
payable of $67,297,211 and accrued interest of $78,417, which were paid off at
closing. The excess of the purchase price over the market value of assets and
liabilities is reflected as goodwill of $54,764,402. The goodwill related to the
acquisition is not deductible for tax purposes. The aggregate consideration paid
for the acquisition was as follows:
 Cash
                
                $
                150,008Notes
      payable
                
                
                108,853,032Purchase
      price
                
                $
                109,003,040
  The
allocation of the net purchase price for the CR Companies acquisition was as
follows:
 October
      31, 2008Cash
                            
                            $
                            247,285Other
      current assets
                            
                            
                            4,602,298Property
      and equipment
                            
                            
                            24,034,722Intangible
      assets
                            
                            
                            37,800,000Goodwill
                            
                            
                            54,764,402Other
      assets
                            
                            
                            6,142,596Current
      liabilities
                            
                            
                            (2,948,933
                            )Deferred
      income tax liabilities
                            
                            
                            (15,614,962
                            )Other
      liabilities
                            
                            
                            (24,368
                            )Purchase
      price
                            
                            $
                            109,003,040
  47


OTELCO
INC.




NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




Property
and equipment have depreciation lives consistent with those shown in the
Property and Equipment Note. The intangible assets at time of acquisition
included regulated and unregulated customer based assets at fair value of $17
million which had remaining lives of 6 to 9 years and a non-competition
agreement fair valued at $1.2 million which had a remaining life of 1 year.
Unregulated contract based assets have fair value of $19.6 million and remaining
lives of 7 years.




Prior
to the closing of the acquisition, the Company entered into a second amended and
restated credit agreement, dated as of October 20, 2008, to amend and restate
the amended and restated credit agreement, dated as of July 3, 2006, as amended
on July 13, 2007, by and among the Company and the other credit parties to the
agreement and General Electric Capital Corporation, as a lender and agent for
the lenders, and other lenders from time to time party thereto. The credit
facilities under the amended and restated credit agreement are comprised
of:


●
            Term
      loans of $173.5 million due October 31, 2013, consisting of an original
      term loan of $64.6 million, and an additional term loan of $108.9 million,
      used to finance the acquisition and related transaction costs and to
      provide working capital for the Company and its subsidiaries and for other
      corporate purposes; and●
            A
      revolving loan commitment of up to $15
million.




The term
loan facility was fully drawn concurrent with closing. Interest rates applicable
to the term loan and any revolving loans were an index rate plus 3.00% or LIBOR
plus 4.00%. In addition, there are fees associated with undrawn revolver
balances and certain annual fees.




The
acquisition was accounted for using the purchase method of accounting and
accordingly, the accompanying financial statements include the financial
position and results of operations from the date of acquisition.




The
following unaudited pro forma information presents the combined results of
operations of the Company as though the acquisition of the CR Companies had
occurred at the beginning of the preceding year. The results include certain
adjustments, including increased interest expense on notes payable and increased
amortization expense related to intangible assets. The pro forma financial
information does not necessarily reflect the results of operations had the
acquisition been completed at the beginning of the period or those which may be
obtained in the future.


Unaudited2007
                                                
                                                
                                                2008Revenues
                                                
                                                $
                                                101,108,434
                                                
                                                
                                                $
                                                104,797,452Income
      from operations
                                                
                                                
                                                18,335,761
                                                
                                                
                                                
                                                19,552,707Net
      loss
                                                
                                                
                                                (5,394,454
                                                )
                                                
                                                
                                                (5,125,094
                                                )Basic
      net loss per share
                                                
                                                $
                                                (0.43
                                                )
                                                
                                                $
                                                (0.40
                                                )Diluted
      net loss per share
                                                
                                                $
                                                (0.43
                                                )
                                                
                                                $
                                                (0.40
                                                )




4.
Goodwill and Intangible Assets




In
June 2001, FASB issued SFAS No. 142, Goodwill and Other Intangible
Assets, or SFAS 142. SFAS 142 requires that in periods beginning after
December 15, 2001, goodwill shall no longer be amortized. Instead, goodwill
shall be tested for impairment. The Company adopted SFAS 142 in 2002 and ceased
amortizing goodwill, and performs an annual impairment test to determine whether
the carrying value of goodwill exceeds its fair market value. Based on the
results of its impairment test, the Company does not believe that there is an
impairment of the goodwill balance at December 31, 2007 or 2008,
respectively.


48




OTELCO
INC.




NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




Intangible
assets are summarized as follows:


December
      31, 2007
                                                                            
                                                                            
                                                                            December
      31, 2008Carrying
      Value
                                                                            
                                                                            
                                                                            Accumulated
      Amortization
                                                                            
                                                                            
                                                                            Net
      Value
                                                                            
                                                                            
                                                                            Carrying
      Value
                                                                            
                                                                            
                                                                            Accumulated
      Amortization
                                                                            
                                                                            
                                                                            Net
      ValueCustomer
      relationships
                                                                            
                                                                            $
                                                                            10,553,440
                                                                            
                                                                            
                                                                            $
                                                                            (1,498,692
                                                                            )
                                                                            
                                                                            $
                                                                            9,054,748
                                                                            
                                                                            
                                                                            $
                                                                            27,553,440
                                                                            
                                                                            
                                                                            $
                                                                            (2,946,129
                                                                            )
                                                                            
                                                                            $
                                                                            24,607,311Contract
      relationships
                                                                            
                                                                            $
                                                                            —
                                                                            
                                                                            
                                                                            $
                                                                            —
                                                                            
                                                                            
                                                                            $
                                                                            —
                                                                            
                                                                            
                                                                            $
                                                                            19,600,000
                                                                            
                                                                            
                                                                            $
                                                                            (816,667
                                                                            )
                                                                            
                                                                            $
                                                                            18,783,333Non
      competition
                                                                            
                                                                            $
                                                                            1,840,090
                                                                            
                                                                            
                                                                            $
                                                                            (1,380,066
                                                                            )
                                                                            
                                                                            $
                                                                            460,024
                                                                            
                                                                            
                                                                            $
                                                                            1,200,000
                                                                            
                                                                            
                                                                            $
                                                                            (200,000
                                                                            )
                                                                            
                                                                            $
                                                                            1,000,000Total
                                                                            
                                                                            $
                                                                            12,393,530
                                                                            
                                                                            
                                                                            $
                                                                            (2,878,758
                                                                            )
                                                                            
                                                                            $
                                                                            9,514,772
                                                                            
                                                                            
                                                                            $
                                                                            48,353,440
                                                                            
                                                                            
                                                                            $
                                                                            (3,962,796
                                                                            )
                                                                            
                                                                            $
                                                                            44,390,644




These
intangible assets have a range of 1 to 15 years of useful lives and
utilize both the sum-of-the-years’ digits and straight-line methods of
amortization, as appropriate.The following table presents current and
expected amortization expense of the existing intangible assets as of December
31, 2008 for each of the following periods:


Aggregate
      amortization expense:For
      the year ended December 31, 2006
                              
                              $
                              1,254,014For
      the year ended December 31, 2007
                              
                              $
                              2,594,943For
      the year ended December 31, 2008
                              
                              $
                              3,835,534Expected
      amortization expense for the years ending December 31,
  2009
                                
                                $
                                10,433,9052010
                                
                                
                                8,207,8742011
                                
                                
                                6,979,2522012
                                
                                
                                5,670,0962013
                                
                                
                                4,444,066Thereafter
                                
                                
                                8,655,451Total
                                
                                $
                                44,390,644
  Changes
      in the carrying amount of goodwill were as follows:Balance,
      December 31, 2007
                                                    
                                                    $
                                                    134,570,435Acquisition
      of the CR Companies
                                                    
                                                    
                                                    54,764,402Balance,
      December 31, 2008
                                                    
                                                    $
                                                    189,334,837


5.
Property and Equipment




A
summary of property and equipment from continuing operations is shown as
follows:




EstimatedLife
                                              
                                              
                                              December
      31,2007
                                              
                                              
                                              2008Land
                                              
                                              
                                              
                                              
                                              
                                              $
                                              850,257
                                              
                                              
                                              $
                                              1,181,338Building
      and improvements
                                              
                                              
                                              20-40
                                              
                                              
                                              
                                              8,547,430
                                              
                                              
                                              
                                              11,244,234Telephone
      equipment
                                              
                                              
                                              6-20
                                              
                                              
                                              
                                              137,092,149
                                              
                                              
                                              
                                              201,217,430Cable
      television equipment
                                              
                                              
                                              7
                                              
                                              
                                              
                                              5,935,970
                                              
                                              
                                              
                                              8,963,865Furniture
      and equipment
                                              
                                              
                                              8-14
                                              
                                              
                                              
                                              2,018,704
                                              
                                              
                                              
                                              2,827,769Vehicles
                                              
                                              
                                              7-9
                                              
                                              
                                              
                                              3,930,174
                                              
                                              
                                              
                                              5,414,286Computer
      software equipment
                                              
                                              
                                              5-7
                                              
                                              
                                              
                                              9,343,969
                                              
                                              
                                              
                                              12,851,152Internet
      equipment
                                              
                                              
                                              5
                                              
                                              
                                              
                                              2,772,383
                                              
                                              
                                              
                                              3,061,251Total
      property, plant and equipment
                                              
                                              
                                              
                                              
                                              
                                              
                                              170,491,036
                                              
                                              
                                              
                                              246,761,325Accumulated
      depreciation
                                              
                                              
                                              
                                              
                                              
                                              
                                              (115,880,681
                                              )
                                              
                                              
                                              (171,354,263
                                              )Net
      property, plant and equipment
                                              
                                              
                                              
                                              
                                              
                                              $
                                              54,610,355
                                              
                                              
                                              $
                                              75,407,062


49




OTELCO
INC.




NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




The
Company’s composite depreciation rate for property and equipment was 19.0%,
21.5% and 20.2% in 2006, 2007 and 2008, respectively. Depreciation expense from
continuing operations for the years ended December 31, 2006, 2007 and 2008 was
$9,527,319, $11,751,673 and $11,772,191, respectively.




6.
Other Accounts Receivable




Other
accounts receivable consist of the following:


December
      31,2007
                                          
                                          
                                          2008Carrier
      access bills receivable
                                          
                                          $
                                          1,210,834
                                          
                                          
                                          $
                                          3,110,123Receivables
      from Alabama Service Fund
                                          
                                          
                                          462,555
                                          
                                          
                                          
                                          453,159Wholesale
      contracts receivable
                                          
                                          
                                          —
                                          
                                          
                                          
                                          735,013Other
      miscellaneous
                                          
                                          
                                          86,818
                                          
                                          
                                          
                                          49,749$
                                          1,760,207
                                          
                                          
                                          $
                                          4,348,044




The
Company completed the acquisition of the CR Companies on October 31, 2008. The
accounts receivable include the balances as of December 31, 2008 for the CR
Companies while the statement of income reflects revenue from the date of
acquisition until the balance sheet date. See note 16 – Revenue Concentrations –
for related contract information.




7.
Investments




Investments
consist of the following:


December
      31,2007
                                    
                                    
                                    2008Investment
      in CoBank stock
                                    
                                    $
                                    650,017
                                    
                                    
                                    $
                                    1,474,830Rental
      property
                                    
                                    
                                    499,682
                                    
                                    
                                    
                                    474,173Other
      miscellaneous
                                    
                                    
                                    57,484
                                    
                                    
                                    
                                    66,580$
                                    1,207,183
                                    
                                    
                                    $
                                    2,015,583




The
investment in CoBank stock is carried at historical cost due to no readily
determinable fair value for those instruments being available. This investment
consists of patronage certificates that represent ownership in the financial
institution where the Company has, and in the past, had, debt. These
certificates yield dividends on an annual basis and the investment is redeemed
ratably subsequent to the repayment of the debt.




8.
Long-Term Debt




The
Company’s credit agreement with General Electric Capital Corporation, originally
dated December 21, 2004, has been amended and restated on several occasions to
reflect requirements for funds to complete two acquisitions and the use of
proceeds from the Company’s successful offering of 3,000,000 IDS units on July
5, 2007. On July 13, 2007, the Company amended that agreement to, among other
things, reduce the margin it pays on the loan to vary with the Company’s total
leverage ratio. At that time, the variable margin based on leverage was 2% over
LIBOR. On October 20, 2008, the Company completed its second amendment and
restatement, increasing the principal balance from $64.6 million to $173.5
million on October 31, 2008 for the acquisition of the CR Companies, changing
the variable margin, and extending the maturity from July 3, 2011 to October 31,
2013. At closing, the variable margin based on leverage was 4% over
LIBOR.


50


OTELCO
INC.




NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




Long-term
notes payable consists of the following:


December 31,2007
                
                2008Term
      credit facility, General Electric Capital Corporation; variable interest
      rate of 7.11% and 6.22% at December 31, 2007 and 2008, respectively. There
      are no principal payments. Interest payments are due on the last day of
      each LIBOR period or at three month intervals, whichever date comes first.
      Interest rate is the index rate plus the applicable term loan index margin
      or the applicable LIBOR rate plus the applicable term loan LIBOR margin.
      On July 5, 2007, the Company repaid $55,353,032 in senior debt with the
      proceeds from its offering of 3,000,000 IDS units.The unpaid balance will
      be due on October 31, 2013
                
                $
                64,646,968
                
                $
                173,500,00013%
      Senior subordinated notes, due 2019; interest payments are due quarterly.
      On July 5, 2007, the Company sold 3,000,000 IDS units that included
      $22,500,000 in senior subordinated debt and $1,830,791 in premium paid for
      debt. Premium amortization for the six months ended December 31, 2007, and
      year ended December 31, 2008 was $33,552 and $73,224,
      respectively.
                
                
                96,872,737
                
                
                96,799,51313%
      Senior subordinated notes, held separately, due 2019; interest payments
      are due quarterly.
                
                
                8,500,000
                
                
                8,500,000Total
      long-term notes payable
                
                $
                170,019,705
                
                $
                278,799,513Less:
      current portion
                
                
                —
                
                
                —Long-term
      notes payable
                
                $
                170,019,705
                
                $
                278,799,513




Associated
with these long-term notes payable, the Company capitalized $8.1 million in
deferred financing costs associated with the credit facility and the 13% senior
subordinated notes put in place on December 21, 2004. On July 3, 2006, an
additional $1,545,743 in deferred financing costs was capitalized. On July 5,
2007, $1,064,526 in deferred finance costs were written off associated with the
reduction in long-term notes payable from the proceeds of its offering of
3,000,000 IDS units. On October 31, 2008, an additional $5,311,138 in deferred
financing costs was capitalized associated with the acquisition of the CR
Companies. $1,406,088 in deferred financing costs were written-off associated
with the effective extinguishment of the existing indebtedness at time of
closing. The credit facility is secured by the total assets of the subsidiary
guarantors.




The
Company has a revolving credit facility of $15,000,000 available as of December
21, 2004. There was no balance as of December 31, 2007 and 2008. The interest
rate is the index rate plus a variable margin or LIBOR rate plus a variable
margin, whichever is applicable. The margin at December 31, 2007 and 2008 was
2.0% and 4.0%, respectively. The range of margins can vary from 1.5% to 2.5%,
depending on our total debt leverage. The Company pays a commitment fee of 0.50%
per annum, payable quarterly in arrears, on the unused portion of the revolver
loan. The commitment fee expense was $76,042 and $76,250 for the years ended
December 31, 2007 and 2008, respectively.




The
deferred financing costs related to the issuance of debt are capitalized and
amortized over the life of the debt obligation. Amortization of deferred
financing costs is reflected in interest expense. The amortization of deferred
loan costs also includes unamortized loan cost that is expensed due to the
related debt being extinguished. The unamortized loan cost that was expensed and
included in amortization expense for both years ended December 31, 2007 and 2008
was $1,064,526 and $1,406,088, respectively.


51




OTELCO
INC.




NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




Maturities
of long-term debt for the next five years are as follows:




2009
                  
                  $
                  —2010
                  
                  
                  —2011
                  
                  
                  —2012
                  
                  
                  —2013
                  
                  
                  173,500,000Thereafter
                  
                  
                  103,575,498Total
      principal
                  
                  $
                  277,075,498Unamortized
      premium
                  
                  
                  1,724,015Total
                  
                  $
                  278,799,513




The
above schedule of maturities of long-term debt excludes the $4.1 million
liquidation value of Class B common shares convertible into senior subordinated
notes in the mezzanine section of the consolidated balance sheet and includes
the premium paid for the debt associated with the 3,000,000 IDS units issued
July 5, 2007.




The
Company’s long-term notes payable agreement is subject to certain financial
covenants and restrictions on indebtedness, financial guarantees, business
combinations and other related items. As of December 31, 2008, the Company is in
compliance with all covenants.




9.
Derivative and Hedge Activities




An
interest rate cap was purchased on December 21, 2004, coincident with the
closing of our initial public offering and the recapitalization of our senior
notes payable. The interest rate cap was purchased to mitigate the risk of
rising interest rates to limit or cap the rate at 3% for the three month LIBOR
index plus the applicable margin on $80 million in senior debt for five years.
On July 5, 2007, the Company repaid $55,353,032 in debt, reducing its senior
debt below the level of the rate cap. The cap was considered an effective hedge
for the remaining senior debt as all critical terms of the interest rate cap are
identical to the underlying debt it hedges. The balance of the cap at that time
was considered as an investment and adjustments were made to Accumulated Other
Comprehensive Income to reflect this change. On October 31, 2008, the Company
implemented its second amended and restated credit agreement, increasing senior
debt to $173.5 million in conjunction with the acquisition of the CR Companies.
The full $80 million rate cap became effective as a hedge.




The
second amended and restated credit agreement requires that the Company acquire
interest rate protection by February 9, 2009 for at least half of the $173.5
million senior debt through at least October 31, 2010. In addition to the
existing rate cap hedge, the Company is completing interest rate swaps with
approved counterparties that will fix the three month LIBOR interest rate on $90
million of senior debt from February 9, 2009 through February 8, 2012 and on an
additional $60 million of senior debt from February 9, 2010 through February 8,
2012.




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. For the year ended December 31, 2007 and 2008, the change
in the fair value of the effective portion of the interest rate cap was
$(1,816,777) and $(222,027), respectively. The change in the fair value of the
swap agreements will also be reported as a component of accumulated other
comprehensive income.




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 year ended December 31, 2007 and 2008, the cost of
the effective portion of the interest rate cap was $890,842 and $1,029,264,
respectively.




The
corresponding other comprehensive income related to the ineffective portion of
the hedge at July 5, 2007, which totaled approximately $254,000, has been
reclassified from other comprehensive income to other income to reflect this
change.


52




OTELCO
INC.




NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




10.
Income Taxes




Income
tax expense for the years ended December 31, 2006, 2007 and 2008 is summarized
below.


For
      the years ended December 31,2006
                                              
                                              
                                              2007
                                              
                                              
                                              2008Federal
      income taxesCurrent
                                              
                                              $
                                              134,177
                                              
                                              
                                              $
                                              (237,619
                                              )
                                              
                                              $
                                              —Deferred
                                              
                                              
                                              819,045
                                              
                                              
                                              
                                              (135,813
                                              )
                                              
                                              
                                              (230,915
                                              )Total
      federal tax expense (benefit)
                                              
                                              
                                              953,222
                                              
                                              
                                              
                                              (373,432
                                              )
                                              
                                              
                                              (230,915
                                              )State
      income taxesCurrent
                                              
                                              
                                              13,559
                                              
                                              
                                              
                                              72,015
                                              
                                              
                                              
                                              85,470Deferred
                                              
                                              
                                              244,488
                                              
                                              
                                              
                                              (72,958
                                              )
                                              
                                              
                                              174,255Total
      state tax expense (benefit)
                                              
                                              
                                              258,047
                                              
                                              
                                              
                                              (943
                                              )
                                              
                                              
                                              259,725Total
      tax expense (benefit)
                                              
                                              $
                                              1,211,269
                                              
                                              
                                              $
                                              (374,375
                                              )
                                              
                                              $
                                              28,810




Total
income tax expense (benefit) from continuing operations was different than that
computed by applying U.S. federal income tax rates to income from continuing
operations before income taxes for the years ended December 31, 2006, 2007 and
2008. The reasons for the differences are presented below:


For
      the years ended December 31,2006
                                                      
                                                      
                                                      2007
                                                      
                                                      
                                                      2008Federal
      income tax at statutory rate
                                                      
                                                      
                                                      34
                                                      %
                                                      
                                                      
                                                      34
                                                      %
                                                      
                                                      
                                                      35
                                                      %Federal
      income tax provision (benefit) at statutory rate
                                                      
                                                      $
                                                      952,626
                                                      
                                                      
                                                      $
                                                      (66,299
                                                      )
                                                      
                                                      $
                                                      84,939Change
      in fair value of derivative
                                                      
                                                      
                                                      97,900
                                                      
                                                      
                                                      
                                                      (329,896
                                                      )
                                                      
                                                      
                                                      (113,421
                                                      )State
      income tax (provision), net of federal income tax effects
                                                      
                                                      
                                                      170,311
                                                      
                                                      
                                                      
                                                      (622
                                                      )
                                                      
                                                      
                                                      168,821Other
                                                      
                                                      
                                                      (9,568
                                                      )
                                                      
                                                      
                                                      22,442
                                                      
                                                      
                                                      
                                                      (111,529
                                                      )Provision
      (benefit) on income taxes
                                                      
                                                      $
                                                      1,211,269
                                                      
                                                      
                                                      $
                                                      (374,375
                                                      )
                                                      
                                                      $
                                                      28,810Effective
      income tax rate
                                                      
                                                      
                                                      43.2
                                                      %
                                                      
                                                      
                                                      192.0
                                                      %
                                                      
                                                      
                                                      11.9
                                                      %




As
of December 31, 2008 the Company has U.S. federal and state net operating loss
carryforwards of $13.2 million and $9.5 million, respectively. These net
operating loss carryforwards expire at various times beginning in 2020 through
2028. Included in these losses are $7.6 million of federal and $2.3 million of
state losses related to the acquisition of the CR Companies referenced in Note
3. These acquired losses are subject to annual limitations imposed by rules
under the Internal Revenue Code.




In
connection with the acquisition of the CR Companies referenced in Note 3, the
purchase price allocation included deferred tax liabilities of
$15,614,962.


53




OTELCO
INC.




NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




The
tax effects of temporary differences that give rise to significant portions of
the deferred tax assets and deferred tax liabilities as of December 31, 2007 and
2008 are presented below:


December
      31,2007
                                              
                                              
                                              2008Deferred
      tax liabilities:Amortization
                                              
                                              $
                                              (14,888,608
                                              )
                                              
                                              $
                                              (19,660,737
                                              )Depreciation
                                              
                                              
                                              (7,175,218
                                              )
                                              
                                              
                                              (11,576,537
                                              )Amortized
      intangibles
                                              
                                              
                                              (2,721,733
                                              )
                                              
                                              
                                              (14,511,446
                                              )Prepaid
      expense
                                              
                                              
                                              (438,097
                                              )
                                              
                                              
                                              (213,682
                                              )Total
      deferred tax liabilities
                                              
                                              $
                                              (25,223,656
                                              )
                                              
                                              $
                                              (45,962,402
                                              )Deferred
      tax assets:Deferred
      compensation
                                              
                                              $
                                              210,580
                                              
                                              
                                              $
                                              329,785Federal
      net operating loss carryforwards
                                              
                                              
                                              674,010
                                              
                                              
                                              
                                              4,599,500Alternative
      minimum credits carryforwards
                                              
                                              
                                              —
                                              
                                              
                                              
                                              254,458State
      net operating loss carryforwards
                                              
                                              
                                              250,012
                                              
                                              
                                              
                                              495,212Advance
      payments
                                              
                                              
                                              123,455
                                              
                                              
                                              
                                              304,637Bad
      debt
                                              
                                              
                                              —
                                              
                                              
                                              
                                              435,600Other
                                              
                                              
                                              228,382
                                              
                                              
                                              
                                              305,876Total
      deferred tax assets
                                              
                                              $
                                              1,486,439
                                              
                                              
                                              $
                                              6,725,068




The
Company does not expect to owe federal income tax for 2008.




Effective
January 1, 2007, the Company adopted the provision of FIN 48, Accounting for Uncertainty in income
Taxes. FIN 48 clarifies the accounting for uncertainty in income taxes
recognized in an enterprise’s financial statements in accordance with SFAS No.
109, Accounting for Income
Taxes.FIN 48 prescribes a recognition threshold and measurement
attribute for the financial statement recognition and measurement of a tax
position taken or expected to be taken in a tax return. This pronouncement also
provides guidance on de-recognition, classification, interest and penalties,
accounting in interim periods, disclosure and transition. The adoption of FIN 48
did not result in the identification of material uncertain tax positions through
December 31, 2008.




11.
Employee Benefit Program




Employees
of OTC, HTC, BMTC, MMH and MMeT participate in a defined contribution savings
plan under Section 401(k) of the Internal Revenue Code, which is sponsored by
the Company. The terms of the plan provide for an elective contribution from
employees not to exceed $15,000, $15,500 and $15,500 for 2006, 2007 and 2008,
respectively. The Company matches the employee’s contribution up to 6% of the
employee’s annual compensation. For the years ended December 31, 2006, 2007 and
2008, the total expense associated with this plan was $385,718, $515,750 and
$486,737, respectively.




Employees
of MMeT participated in a defined contribution savings plan under Section 401(k)
of the Internal Revenue Code for the year 2006 which was sponsored by the
Company. Terms of the plan provide for an elective contribution from employees
not to exceed $15,000 for 2006. The Company matches the employee’s contribution
up to 4.5% of the employee’s annual compensation. For the period ending July 3,
2006 to December 31, 2006, the total expense associated with this plan was
$65,062.




The
employees of BTC participate in a multiemployer Retirement and Security Program
(“RSP”) as a defined benefit plan and a Savings Plan (“SP”) provided through the
National Telecommunications Cooperative Association (“NTCA”). Participation in
the RSP requires a minimum employee contribution of 1% of their annual
compensation. The Company contributes 10.1%, 10.1% and 10.5% for 2006, 2007 and
2008, respectively of their annual compensation for every participating
employee. SP is a defined contribution savings plan under Section 401(k) of the
Internal Revenue Code to which the Company contributes 1%, 1% and 0% for 2006,
2007 and 2008, respectively, of employee earnings and the employee can make
additional voluntary contributions as desired with no additional Company
contribution. For the years ended December 31, 2006, 2007 and 2008, the total
expense associated with these plans was $102,641, $119,880 and $ 85,003,
respectively. The reduced contribution in 2008 was partially the result of the
NTCA suspension of a contribution surcharge imposed in 2006 and
2007.


54




OTELCO
INC.




NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




Employees
of the CR Companies participate in a defined contribution savings plan under
Section 401(k) of the Internal Revenue Code, which is sponsored by the Company.
The terms of the plan provide for elective contributions from employees not to
exceed $15,500 for 2008. The Company matches 50% of the employee’s contribution
up to 6% of employee’s annual pay excluding any bonus. From the date of
acquisition through December 31, 2008, the total expense associated with this
plan was $22,271.




12.
Income per Common Share and Potential Common Share




Basic
income per common share is computed by dividing net income by the
weighted-average number of shares outstanding for the period. Diluted income per
common share reflects the potential dilution that could occur if the Class B
common stock were exercised into IDSs. Class B common stock is convertible on a
one-for-one basis into IDSs, each of which includes a Class A common
share.




A
reconciliation of the common shares for the Company’s basic and diluted income
per common share calculation is as follows. Diluted income per share for the
year ended December 31, 2006 does not include potential common shares as their
effect would be anti-dilutive. The amount reported for net income per diluted
share for 2006 has been corrected to show that the Class B common shares were
anti-dilutive.




For
      the Years Ended December 31,2006
                              
                              
                              2007
                              
                              
                              2008Weighted
      average of common shares-basic
                              
                              
                              9,676,733
                              
                              
                              
                              11,156,185
                              
                              
                              
                              12,676,733Effect
      of dilutive securities
                              
                              
                              —
                              
                              
                              
                              544,671
                              
                              
                              
                              544,671Weighted
      average common shares and potential common shares-diluted
                              
                              
                              9,676,733
                              
                              
                              
                              11,700,856
                              
                              
                              
                              13,221,404Net
      income available to common shareholders
                              
                              $
                              1,160,997
                              
                              
                              $
                              179,379
                              
                              
                              $
                              213,874Net
      income per basic share
                              
                              $
                              0.12
                              
                              
                              $
                              0.02
                              
                              
                              $
                              0.02Net
      income available to common stockholders
                              
                              $
                              1,160,997
                              
                              
                              $
                              179,379
                              
                              
                              $
                              213,874Change
      in fair value of derivative
                              
                              
                              —
                              
                              
                              
                              (1,293,872
                              )
                              
                              
                              (575,951
                              )Net
      income (loss) available for diluted shares
                              
                              $
                              1,160,997
                              
                              
                              $
                              (1,114,493
                              )
                              
                              $
                              (362,077
                              )Net
      income (loss) per diluted share
                              
                              $
                              0.12
                              
                              
                              $
                              (0.10
                              )
                              
                              $
                              (0.03
                              )




13.
Selected Quarterly Financial Data (unaudited)


First
                    Quarter
                  
                  
                  Second
                    Quarter
                  
                  
                  Third
                    Quarter
                  
                  
                  Fourth
                    QuarterFiscal
      2007:Revenue
                  
                  $
                  17,172,394
                  
                  
                  $
                  17,118,202
                  
                  
                  $
                  17,594,300
                  
                  
                  $
                  17,864,539Operating
      income
                  
                  
                  4,770,446
                  
                  
                  
                  4,388,653
                  
                  
                  
                  5,116,972
                  
                  
                  
                  4,989,349Net
      income (loss)
                  
                  
                  (118,206
                  )
                  
                  
                  (104,578
                  )
                  
                  
                  (667,712
                  )
                  
                  
                  1,069,875Net
      income (loss) per share, basic
                  
                  $
                  (0.01
                  )
                  
                  $
                  (0.01
                  )
                  
                  $
                  (0.05
                  )
                  
                  $
                  0.08Net
      income (loss) per share, diluted
                  
                  $
                  (0.03
                  )
                  
                  $
                  (0.03
                  )
                  
                  $
                  (0.07
                  )
                  
                  $
                  0.04Fiscal
      2008:Revenue
                  
                  $
                  17,859,420
                  
                  
                  $
                  17,668,730
                  
                  
                  $
                  18,237,574
                  
                  
                  $
                  23,349,214Operating
      income
                  
                  
                  5,140,078
                  
                  
                  
                  5,005,928
                  
                  
                  
                  5,664,615
                  
                  
                  
                  5,276,019Net
      income (loss)
                  
                  
                  408,039
                  
                  
                  
                  406,135
                  
                  
                  
                  789,243
                  
                  
                  
                  (1,389,543
                  )Net
      income (loss) per share, basic
                  
                  $
                  0.03
                  
                  
                  $
                  0.03
                  
                  
                  $
                  0.06
                  
                  
                  $
                  (0.11
                  )Net
      income (loss) per share, diluted
                  
                  $
                  0.03
                  
                  
                  $
                  0.02
                  
                  
                  $
                  0.04
                  
                  
                  $
                  (0.13
                  )




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. Based on the Company’s performance in 2008 and its
budget for 2009, the likelihood of early conversion is low. This change in
estimate, combined with market changes, causes a reduction in the valuation of
the B share derivative, with the effect of increasing net income before taxes by
$1,293,872 for the year ended December 31, 2007.


55




OTELCO
INC.




NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




Net
income in the third quarter of 2007 includes a write-off of $1,064,526 of
deferred financing costs and an increase of the income tax provision by
approximately $420,000 as a result of a change in the expected annual income tax
rate. Net loss in the fourth quarter of 2008 included a write-off of $1,406,088
of deferred financing costs and an increase of the income tax provision by
approximately $166,903 as a result of a change in the expected annual income tax
rate. Net loss per diluted share in first quarter 2008 does not reflect the
Class B shares, as the effect would have been anti-dilutive.




14.
Fair Value Measurement




In
accordance with SFAS 157, the following table represents the Company’s fair
value hierarchy for its financial assets and liabilities as of December 31,
2008:


December
      31, 2008Fair
      Value
                  
                  
                  Level
      1 (1)
                  
                  
                  Level
      2 (2)
                  
                  
                  Level
      3 (3)AssetsCash
      and cash equivalents
                  
                  $
                  13,542,255
                  
                  
                  $
                  13,542,255
                  
                  
                  $
                  —
                  
                  
                  $
                  —Interest
      rate cap
                  
                  
                  7,765
                  
                  
                  
                  —
                  
                  
                  
                  7,765
                  
                  
                  
                  —Co-operative
      patronage shares
                  
                  
                  1,474,830
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  1,474,830Total
      assets
                  
                  $
                  15,024,850
                  
                  
                  $
                  13,542,255
                  
                  
                  $
                  7,765
                  
                  
                  $
                  1,474,830LiabilitiesClass
      B derivative liability
                  
                  $
                  238,054
                  
                  
                  $
                  —
                  
                  
                  $
                  —
                  
                  
                  $
                  238,054Total
      liabilities
                  
                  $
                  238,054
                  
                  
                  $
                  —
                  
                  
                  $
                  —
                  
                  
                  $
                  238,054





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




15.
Subsidiary Guarantees




The
Company has no independent assets or operations separate from its operating
subsidiaries. The guarantees of its senior subordinated notes by twelve of its
fourteen operating subsidiaries are full and unconditional, joint and several.
The operating subsidiaries have no independent long-term notes payable. There
are no significant restrictions on the ability of the Company to obtain funds
from its operating subsidiaries by dividend or loan. The condensed consolidated
financial information is provided for the guarantor entities. The following
tables present condensed consolidating balance sheets as of December 31, 2008
and 2007; condensed consolidating statements of operations for the years ended
December 31, 2008 and 2007; and condensed consolidating statements of cash flows
for the years ended December 31, 2008 and 2007.


56




OTELCO
INC.




NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Otelco
      Inc.Condensed
      Consolidating Balance Sheet
                    December
      31, 2008Parent
                  
                  
                  Guarantor
                    Subsidiaries
                  
                  
                  Non-Guarantor
                    Subsidiaries
                  
                  
                  Eliminations
                  
                  
                  ConsolidatedASSETSCurrent
      assetsCash
      and cash equivalents
                  
                  $
                  —
                  
                  
                  $
                  13,521,138
                  
                  
                  $
                  21,117
                  
                  
                  $
                  —
                  
                  
                  $
                  13,542,255Accounts
      receivable, net
                  
                  
                  —
                  
                  
                  
                  10,869,233
                  
                  
                  
                  1,254,272
                  
                  
                  
                  —
                  
                  
                  
                  12,123,505Materials
      and supplies
                  
                  
                  —
                  
                  
                  
                  1,029,214
                  
                  
                  
                  1,276,541
                  
                  
                  
                  —
                  
                  
                  
                  2,305,755Prepaid
      and other current assets
                  
                  
                  66,560
                  
                  
                  
                  994,500
                  
                  
                  
                  80,848
                  
                  
                  
                  —
                  
                  
                  
                  1,141,908Income
      tax receivables
                  
                  
                  181,644
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  181,644Deferred
      income taxes
                  
                  
                  827,686
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  827,686Investment
      in subsidiaries
                  
                  
                  99,481,692
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  (99,481,692
                  )
                  
                  
                  —Intercompany
      receivables
                  
                  
                  155,535,369
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  (155,535,369
                  )
                  
                  
                  —Total
      current assets
                  
                  
                  256,092,951
                  
                  
                  
                  26,414,085
                  
                  
                  
                  2,632,778
                  
                  
                  
                  (255,017,061
                  )
                  
                  
                  30,122,753Property
      and equipment, net
                  
                  
                  —
                  
                  
                  
                  62,507,141
                  
                  
                  
                  12,899,921
                  
                  
                  
                  —
                  
                  
                  
                  75,407,062Goodwill
                  
                  
                  —
                  
                  
                  
                  191,271,477
                  
                  
                  
                  (1,936,640
                  )
                  
                  
                  —
                  
                  
                  
                  189,334,837Intangibles
      assets, net
                  
                  
                  —
                  
                  
                  
                  41,286,088
                  
                  
                  
                  3,104,556
                  
                  
                  
                  —
                  
                  
                  
                  44,390,644Investments
                  
                  
                  1,000
                  
                  
                  
                  1,686,908
                  
                  
                  
                  327,675
                  
                  
                  
                  —
                  
                  
                  
                  2,015,583Deferred
      income taxes
                  
                  
                  5,897,382
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  5,897,382Other
      long-term assets
                  
                  
                  8,879,424
                  
                  
                  
                  (506,198
                  )
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  8,373,226Total
      assets
                  
                  $
                  270,870,757
                  
                  
                  $
                  322,659,501
                  
                  
                  $
                  17,028,290
                  
                  
                  $
                  (255,017,061
                  )
                  
                  $
                  355,541,487LIABILITIES
      AND STOCKHOLDERS’ EQUITYCurrent
      liabilitiesAccounts
      payables and accrued expenses
                  
                  $
                  3,316,323
                  
                  
                  $
                  4,543,542
                  
                  
                  $
                  1,085,342
                  
                  
                  $
                  —
                  
                  
                  $
                  8,945,207Intercompany
      payables
                  
                  
                  —
                  
                  
                  
                  146,585,645
                  
                  
                  
                  8,949,724
                  
                  
                  
                  (155,535,369
                  )
                  
                  
                  —Other
      current liabilities
                  
                  
                  —
                  
                  
                  
                  2,129,257
                  
                  
                  
                  75,448
                  
                  
                  
                  —
                  
                  
                  
                  2,204,705Total
      current liabilities
                  
                  
                  3,316,323
                  
                  
                  
                  153,258,444
                  
                  
                  
                  10,110,514
                  
                  
                  
                  (155,535,369
                  )
                  
                  
                  11,149,912Deferred
      income taxes
                  
                  
                  10,316,819
                  
                  
                  
                  31,595,332
                  
                  
                  
                  4,050,251
                  
                  
                  
                  —
                  
                  
                  
                  45,962,402Other
      liabilities
                  
                  
                  —
                  
                  
                  
                  928,082
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  928,082Long-term
      notes payables
                  
                  
                  238,536,037
                  
                  
                  
                  40,263,476
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  278,799,513Derivative
      liability
                  
                  
                  238,054
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  238,054Class
      B common convertible to senior subordinated notes
                  
                  
                  4,085,033
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  4,085,033Stockholders’
      equity
                  
                  
                  14,378,491
                  
                  
                  
                  96,614,167
                  
                  
                  
                  2,867,525
                  
                  
                  
                  (99,481,692
                  )
                  
                  
                  14,378,491Total
      liabilities and stockholders’ equity
                  
                  $
                  270,870,757
                  
                  
                  $
                  322,659,501
                  
                  
                  $
                  17,028,290
                  
                  
                  $
                  (255,017,061
                  )
                  
                  $
                  355,541,487


57


OTELCO
INC.




NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Otelco
      Inc.Condensed
      Consolidating Balance Sheet
                    December
      31, 2007Parent
                  
                  
                  Guarantor
                    Subsidiaries
                  
                  
                  Non-Guarantor
                    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
                  
                  
                  435,852
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  435,852Investment
      in subsidiaries
                  
                  
                  84,166,351
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  (84,166,351
                  )
                  
                  
                  —Intercompany
      receivables
                  
                  
                  70,984,187
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  (70,984,187
                  )
                  
                  
                  —Total
      current assets
                  
                  
                  156,088,433
                  
                  
                  
                  20,510,298
                  
                  
                  
                  2,539,131
                  
                  
                  
                  (155,150,538
                  )
                  
                  
                  23,987,324Property
      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
                  
                  
                  
                  —
                  
                  
                  
                  1,207,183Deferred
      income taxes
                  
                  
                  1,050,587
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  1,050,587Other
      long-term assets
                  
                  
                  8,052,863
                  
                  
                  
                  (507,396
                  )
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  7,545,467Total
      assets
                  
                  $
                  165,192,883
                  
                  
                  $
                  202,670,621
                  
                  
                  $
                  19,773,157
                  
                  
                  $
                  (155,150,538
                  )
                  
                  $
                  232,486,123LIABILITIES
      AND STOCKHOLDERS’ EQUITY (DEFICIT)Current
      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 (deficit)
                  
                  
                  23,323,741
                  
                  
                  
                  83,008,317
                  
                  
                  
                  1,158,034
                  
                  
                  
                  (84,166,351
                  )
                  
                  
                  23,323,741Total
      liabilities and stockholders’ equity
      (deficit)
                  
                  $
                  165,192,883
                  
                  
                  $
                  202,670,621
                  
                  
                  $
                  19,773,157
                  
                  
                  $
                  (155,150,538
                  )
                  
                  $
                  232,486,123




Otelco
      Inc.Condensed
      Consolidated Statement of IncomeFor
      the Twelve Months Ended December 31, 2008Parent
                        
                        
                        Guarantor
      Subsidiaries
                        
                        
                        Non-GuarantorSubsidiaries
                        
                        
                        Eliminations
                        
                        
                        ConsolidatedRevenue
                        
                        $
                        3,113,485
                        
                        
                        $
                        70,986,248
                        
                        
                        $
                        12,441,820
                        
                        
                        $
                        (9,426,613
                        )
                        
                        $
                        77,114,940Operating
      expenses
                        
                        
                        (3,113,485
                        )
                        
                        
                        (52,706,074
                        )
                        
                        
                        (9,635,352
                        )
                        
                        
                        9,426,613
                        
                        
                        
                        (56,028,298
                        )Income
      from operations
                        
                        
                        —
                        
                        
                        
                        18,280,174
                        
                        
                        
                        2,806,468
                        
                        
                        
                        —
                        
                        
                        
                        21,086,642Other
      income (expense)
                        
                        
                        (20,483,939
                        )
                        
                        
                        (363,814
                        )
                        
                        
                        3,795
                        
                        
                        
                        —
                        
                        
                        
                        (20,843,958
                        )Earnings
      from subsidiaries
                        
                        
                        15,165,333
                        
                        
                        
                        —
                        
                        
                        
                        —
                        
                        
                        
                        (15,165,333
                        )
                        
                        
                        —Income
      before income tax
                        
                        
                        (5,318,606
                        )
                        
                        
                        17,916,360
                        
                        
                        
                        2,810,263
                        
                        
                        
                        (15,165,333
                        )
                        
                        
                        242,684Income
      tax (expense) benefit
                        
                        
                        5,532,480
                        
                        
                        
                        (4,460,513
                        )
                        
                        
                        (1,100,777
                        )
                        
                        
                        —
                        
                        
                        
                        (28,810
                        )Net
      income (loss) to common stockholders
                        
                        $
                        213,874
                        
                        
                        $
                        13,455,847
                        
                        
                        $
                        1,709,486
                        
                        
                        $
                        (15,165,333
                        )
                        
                        $
                        213,874







58




OTELCO
INC.




NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Otelco
      Inc.Condensed
      Consolidated Statement of IncomeFor
      the Twelve Months Ended December 31, 2007Parent
                                      
                                      
                                      GuarantorSubsidiaries
                                      
                                      
                                      Non-GuarantorSubsidiaries
                                      
                                      
                                      Eliminations
                                      
                                      
                                      ConsolidatedRevenue
                                      
                                      $
                                      3,077,356
                                      
                                      
                                      $
                                      62,709,874
                                      
                                      
                                      $
                                      12,684,625
                                      
                                      
                                      $
                                      (8,722,421
                                      )
                                      
                                      $
                                      69,749,434Operating
      expenses
                                      
                                      
                                      (3,077,356
                                      )
                                      
                                      
                                      (46,185,177
                                      )
                                      
                                      
                                      (9,943,902
                                      )
                                      
                                      
                                      8,722,421
                                      
                                      
                                      
                                      (50,484,014
                                      )Income
      from operations
                                      
                                      
                                      —
                                      
                                      
                                      
                                      16,524,697
                                      
                                      
                                      
                                      2,740,723
                                      
                                      
                                      
                                      —
                                      
                                      
                                      
                                      19,265,420Other
      income (expense)
                                      
                                      
                                      (15,709,801
                                      )
                                      
                                      
                                      (3,751,967
                                      )
                                      
                                      
                                      1,352
                                      
                                      
                                      
                                      —
                                      
                                      
                                      
                                      (19,460,416
                                      )Earnings
      from subsidiaries
                                      
                                      
                                      8,414,425
                                      
                                      
                                      
                                      —
                                      
                                      
                                      
                                      —
                                      
                                      
                                      
                                      (8,414,425
                                      )
                                      
                                      
                                      —Income
      before income tax
                                      
                                      
                                      (7,295,376
                                      )
                                      
                                      
                                      12,772,730
                                      
                                      
                                      
                                      2,742,075
                                      
                                      
                                      
                                      (8,414,425
                                      )
                                      
                                      
                                      (194,996
                                      )Income
      tax (expense) benefit
                                      
                                      
                                      7,474,755
                                      
                                      
                                      
                                      (6,051,135
                                      )
                                      
                                      
                                      (1,049,245
                                      )
                                      
                                      
                                      —
                                      
                                      
                                      
                                      374,375Net
      income (loss) to common stockholders
                                      
                                      $
                                      179,379
                                      
                                      
                                      $
                                      6,721,595
                                      
                                      
                                      $
                                      1,692,830
                                      
                                      
                                      $
                                      (8,414,425
                                      )
                                      
                                      $
                                      179,379





Otelco
      Inc.Condensed
      Consolidating Statement of Cash Flows
                For
      the Twelve Months Ended December 31, 2008Parent
              
              
              Guarantor
                Subsidiaries
              
              
              Non-Guarantor
                Subsidiaries
              
              
              Eliminations
              
              
              ConsolidatedCash
      flows from operating activities:Net
      income (loss)
              
              $
              213,874
              
              
              $
              13,455,847
              
              
              $
              1,709,486
              
              
              $
              (15,165,333
              )
              
              $
              213,874Adjustment
      to reconcile net income (loss) to cash flows from operating
      activities
              
              
              3,187,007
              
              
              
              12,636,002
              
              
              
              3,471,784
              
              
              
              —
              
              
              
              19,294,793Changes
      in assets and liabilities, net of assets and liabilities
      acquired
              
              
              (82,872,572
              )
              
              
              86,250,017
              
              
              
              (4,197,584
              )
              
              
              —
              
              
              
              (820,139
              )Net
      cash provided by operating activities
              
              
              (79,471,691
              )
              
              
              112,341,866
              
              
              
              983,686
              
              
              
              (15,165,333
              )
              
              
              18,688,528Cash
      flows from investing activities
              
              
              (5,278,911
              )
              
              
              (111,528,403
              )
              
              
              (1,065,392
              )
              
              
              —
              
              
              
              (117,872,706
              )Cash
      flows from financing activities
              
              
              84,750,602
              
              
              
              1
              
              
              
              —
              
              
              
              15,165,333
              
              
              
              99,915,936Net
      increase (decrease) in cash and cash equivalents
              
              
              —
              
              
              
              813,464
              
              
              
              (81,706
              )
              
              
              —
              
              
              
              731,758Cash
      and cash equivalents, beginning of period
              
              
              —
              
              
              
              12,707,674
              
              
              
              102,823
              
              
              
              —
              
              
              
              12,810,497Cash
      and cash equivalents, end of period
              
              $
              —
              
              
              $
              13,521,138
              
              
              $
              21,117
              
              
              $
              —
              
              
              $
              13,542,255





Otelco
      Inc.Condensed
      Consolidating Statement of Cash Flows
                    for
      the Twelve Months Ended December 31, 2007Parent
                  
                  
                  Guarantor
                    Subsidiaries
                  
                  
                  Non-Guarantor
                    Subsidiaries
                  
                  
                  Eliminations
                  
                  
                  ConsolidatedCash
      flows from operating activities:Net
      income (loss)
                  
                  $
                  179,379
                  
                  
                  $
                  6,721,595
                  
                  
                  $
                  1,692,830
                  
                  
                  $
                  (8,414,425
                  )
                  
                  $
                  179,379Adjustment
      to reconcile net income (loss) to cash flows from operating
      activities
                  
                  
                  1,327,794
                  
                  
                  
                  9,125,207
                  
                  
                  
                  6,403,888
                  
                  
                  
                  —
                  
                  
                  
                  16,856,889Changes
      in assets and liabilities, net of assets and liabilities
      acquired
                  
                  
                  (40,338,032
                  )
                  
                  
                  42,719,978
                  
                  
                  
                  (6,353,284
                  )
                  
                  
                  1,705,524
                  
                  
                  
                  (2,265,814
                  )Net
      increase (decrease) in cash and cash equivalents
                  
                  
                  (38,830,859
                  )
                  
                  
                  58,566,780
                  
                  
                  
                  1,743,434
                  
                  
                  
                  (6,708,901
                  )
                  
                  
                  14,770,454Cash
      flows from investing activities
                  
                  
                  (220,349
                  )
                  
                  
                  (4,789,736
                  )
                  
                  
                  (1,665,617
                  )
                  
                  
                  —
                  
                  
                  
                  (6,675,702
                  )Cash
      flows from financing activities
                  
                  
                  39,051,208
                  
                  
                  
                  (55,446,213
                  )
                  
                  
                  —
                  
                  
                  
                  6,708,901
                  
                  
                  
                  (9,686,104
                  )Net
      increase (decrease) in cash and cash equivalents
                  
                  
                  —
                  
                  
                  
                  (1,669,169
                  )
                  
                  
                  77,817
                  
                  
                  
                  —
                  
                  
                  
                  (1,591,352
                  )Cash
      and cash equivalents, beginning of period
                  
                  
                  —
                  
                  
                  
                  14,376,843
                  
                  
                  
                  25,006
                  
                  
                  
                  —
                  
                  
                  
                  14,401,849Cash
      and cash equivalents, end of period
                  
                  $
                  —
                  
                  
                  $
                  12,707,674
                  
                  
                  $
                  102,823
                  
                  
                  $
                  0
                  
                  
                  $
                  12,810,497


59




OTELCO
INC.




NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




16.
Revenue Concentrations




Revenues
for interstate access services are based on reimbursement of costs and an
allowed rate of return. Revenues of this nature are received from NECA in the
form of monthly settlements. Such revenues amounted to 17.7%, 14.3%, and 13.7%
of the Company’s total revenues from continuing operations for the years ended
December 31, 2006, 2007 and 2008, respectively.




The
Company acquired a multi-year contract with a large multiple system operator for
the provision of wholesale network connections to its customers in Maine and in
future years, New Hampshire. Associated with closing the acquisition of the CR
Companies, various terms of the agreement were amended, including extending the
contract through 2012. The customer represented approximately 1.5% of the
consolidated revenue for 2008.




17.
Commitments and Contingencies




From
time to time, we may be involved in various claims, legal actions and regulatory
proceedings incidental to and in the ordinary course of business, including
administrative hearings of the APSC, MDTC, MPSC, MPUC, NHPUC and WVPSC relating
primarily to rate making. Currently, none of the legal proceedings are expected
to have a material adverse effect on our business.




18.
Subsequent Events




The
Company executed two interest rate swap agreements as the fixed rate
counterparty to hedge its exposure to changes in interest rate costs associated
with its senior credit facility. Both swap agreements hedge the 3 month LIBOR
rate. The first agreement is effective February 9, 2009 for three years with a
notional amount of $90 million and a fixed interest rate of 1.85%. The second
agreement is effective February 9, 2010 for two years with a notional amount of
$60 million and a fixed interest rate of 2.0475%. Both swaps are expected to be
effective interest rate hedges for accounting purposes.


60




Item
9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure




None.




Item
9A. Controls and Procedures




Disclosure
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 Chief
Financial Officer concluded that our disclosure controls and procedures were
effective as of December 31, 2008.




Management’s
Annual Report on Internal Control over Financial Reporting




The
management of the Company is responsible for establishing and maintaining
adequate internal control over financial reporting. The Securities Exchange Act
of 1934 defines internal control over financial reporting in Rule 13a-15(f) and
15d-15(f) as a process designed by, or under the supervision of, the Company’s
principal executive and principal financial officers and effected by the
Company’s board of directors, management and other personnel, to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles and includes those policies and
procedures that:


●
            Pertain
      to the maintenance of records that in reasonable detail accurately and
      fairly reflect the transactions and dispositions of the assets of the
      Company;●
            Provide
      reasonable assurance that transactions are recorded as necessary to permit
      preparation of financial statements in accordance with generally accepted
      accounting principles, and that receipts and expenditures of the Company
      are being made only in accordance with authorizations of management and
      directors of the Company; and●
            Provide
      reasonable assurance regarding prevention or timely detection of
      unauthorized acquisition, use or disposition of the Company’s assets that
      could have a material effect on the consolidated financial
      statements.




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




The
Company’s management assessed the effectiveness of the Company’s internal
control over financial reporting as of December 31, 2008. In making this
assessment, the Company’s management used the criteria set forth by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO) inInternal Control-Integrated
Framework. Management’s assessment did not include
the internal controls of theCR Companies and their
subsidiaries, which were
acquired on October 31, 2008, and whichareincluded in the consolidated balance
sheet of Otelco Inc. as of December 31, 2008, and the related consolidated
statements of income, stockholders’ equity, and cash flows for the year then
ended because of the timing of the acquisition.


Based
upon its assessment, management concluded that, as of December 31, 2008, the
Company’s internal control over financial reporting is effective based upon
those criteria.




The
effectiveness of our internal control over financial reporting as at December
31, 2008 has been independently audited by BDO Seidman, LLP, an independent
registered public accounting firm, as stated in their report included in Item 8
of this report.




Changes
in Internal Control over Financial Reporting




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 fourth
quarter of fiscal 2008 that materially affected, or are reasonably likely to
materially affect, our internal control over financial reporting.




Item
9B. Other Information




None.


61




PART
III




Item
10. Directors, Executive Officers and Corporate Governance




We
have a code of ethics that applies to each director and employee of the Company,
including the executive, financial, and accounting officers. Our code of conduct
is available on our website athttp://www.OtelcoInc.com under the Investor Relations section titled
Corporate Governance. We intend to disclose any amendment to, or waiver from, a
provision of the code of ethics that applies to our chief executive officer or
chief financial officer and principal accounting officer in the investor
relations section of our web site.




The
other information required by this Item is incorporated herein by reference to
the applicable information in the proxy statement for our 2009 annual meeting of
stockholders, including the information set forth under the captions “Election
of Directors,” “Section 16(a) Beneficial Ownership Reporting Compliance” and
“Governance of the Company — Audit Committee.” See Item X in Part I of this
report regarding our executive officers.




Item
11. Executive Compensation




The
information required by this Item is incorporated herein by reference to the
applicable information in the proxy statement for our 2009 annual meeting of
stockholders, including the information set forth under the captions “Executive
Compensation,” “Compensation of Directors,” “Compensation Committee Report” and
“Compensation Committee Interlocks and Insider Participation.”




Item
12. Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters




The
Company currently has no securities authorized for issuance under an equity
compensation plan. The other information required by this Item is incorporated
herein by reference to the applicable information in the proxy statement for our
2009 annual meeting of stockholders, including the information set forth under
the caption “Beneficial Ownership of Common Stock.”




Item
13. Certain Relationships and Related Transactions, and Director
Independence




The
information required by this Item is incorporated herein by reference to the
applicable information in the proxy statement for our 2009 annual meeting of
stockholders, including the information set forth under the caption “Election of
Directors” and “Other Relationships and Transactions with
Executives.”




Item
14. Principal Accountant Fees and Services




The
information required by this Item is incorporated herein by reference to the
applicable information in the proxy statement for our 2009 annual meeting of
stockholders, including the information set forth under the caption “Our
Relationship with Our Independent Registered Public Accounting
Firm.”


62




PART
IV




Item
15. Exhibits and Financial Statement Schedules




(a)(1)
Financial Statements


Reports
      of Independent Registered Public Accounting FirmConsolidated
      Balance SheetsConsolidated
      Statements of IncomeConsolidated
      Statements of Changes in Stockholders’ EquityConsolidated
      Statements of Cash FlowsNotes
      to Consolidated Financial
Statements




(a)(2)
Financial Statement Schedules




None




(a)(3)
Exhibits


Exhibit
              No.
            
            Description3.1
            
            
            Certificate
      of Incorporation of Otelco Inc. (filed as Exhibit 3.1 to the Company’s
      Annual Report on Form 10-K for the year ended December 31, 2004 and
      incorporated herein by reference)3.2
            
            
            Third
      Amended and Restated By-laws of Otelco Inc.(filed as Exhibit 3.2 to the
      Company’s Annual Report on Form 10- K for the year ended December 31, 2004
      and incorporated herein by reference)4.1
            
            
            Indenture,
      dated as of December 21, 2004, among Otelco Inc., each subsidiary listed
      on the signature pages thereto and Wells Fargo Bank, National Association,
      as trustee, relating to the 13% Senior Subordinated Notes dues 2019 (filed
      as Exhibit 4.1 to the Company’s Annual Report on Form 10-K for the year
      ended December 31, 2004 and incorporated herein by
    reference)4.2
            
            
            Supplemental
      Indenture, dated as of July 3, 2006, by and among Mid-Maine
      Communications, Inc., Mid-Maine TelPlus, the Existing Guarantors listed on
      the signature pages thereto, and Wells Fargo Bank, NA, as trustee (filed
      as Exhibit 10.2 to the Company’s Current Report on Form 8-K filed on July
      5, 2006 and incorporated herein by reference)4.3
            
            
            Second
      Supplemental Indenture, dated as of July 5, 2007, by and among Otelco
      Inc., certain of its subsidiaries and Wells Fargo Bank, National
      Association, as trustee (filed as Exhibit 4.1 to the Company’s Current
      Report on Form 8-K filed on July 5, 2007 and incorporated herein by
      reference)4.4
            
            
            Third
      Supplemental Indenture, dated as of October 31, 2008, by and among Pine
      Tree Holdings, Inc., The Pine Tree Telegraph and Telephone Company, CRC
      Communications of Maine, Inc., Saco River Telegraph and Telephone Company,
      Communications Design Acquisition Corporation, Granby Holdings, Inc., The
      Granby Telegraph and Telephone Co. of Mass., Inc., the Existing Guarantors
      listed on the signature pages thereto, Otelco Inc. and Wells Fargo Bank,
      National Association, as trustee4.5
            
            
            Form
      of 13% Senior Subordinated Note due 2019 (included in Exhibit
      4.1)4.6
            
            
            Investor
      Rights Agreement, dated December 21, 2004, among Otelco Inc., Seaport
      Capital Partners II, L.P., Seaport Investments, LLC, CEA Capital Partners
      USA, L.P., CEA Capital Partners USA CI, L.P., BancBoston Ventures Inc.,
      Mid-Missouri Parent LLC, Michael D. Weaver, Sean Reilly, Kevin Reilly and
      Sternberg Consulting Inc. (filed as Exhibit 4.3 to the Company’s Annual
      Report on Form 10-K for the year ended December 31, 2004 and incorporated
      herein by reference)4.7
            
            
            Form
      of stock certificate for Class A common stock (filed as Exhibit 4.4 to
      Amendment No. 4 to Registration Statement on Form S-1 (file no.
      333-115341) and incorporated herein by
  reference)


63




Exhibit
      No.
                
                Description4.8
                
                
                Form
      of global Income Deposit Security (filed as Exhibit 4.5 to Amendment No. 4
      to Registration Statement on Form S-1 (file no. 333-115341) and
      incorporated herein by reference)10.1
                
                
                Amended
      and Restated Employment Agreement, dated as of June 21, 2004, between
      Otelco Telephone LLC and Michael D. Weaver (filed as Exhibit 10.2 to
      Amendment No. 1 to Registration Statement on Form S-1 (file no. 333-
      115341) and incorporated herein by reference)*10.2
                
                
                Employment
      Agreement, dated as of June 9, 2004, between Otelco Telephone LLC and
      Curtis L. Garner, Jr. (filed as Exhibit 10.3 to Amendment No. 1 to
      Registration Statement on Form S-1 (file no. 333-115341) and incorporated
      herein by reference)*10.3
                
                
                Long-term
      Incentive Compensation Plan approved May 12, 2005 (filed as Exhibit 10.4
      to the Company’s Quarterly Report on Form 10-Q for the quarter ended June
      30, 2005 and incorporated herein by reference)*10.4
                
                
                Employment
      Agreement, dated as of July 3, 2006, between Mid-Maine and Nicholas A.
      Winchester (filed as Exhibit 10.3 to the Company’s Current Report on Form
      8-K filed on July 5, 2006 and incorporated herein by
      reference)*10.5
                
                
                Employment
      Agreement, dated as of August 24, 2006, between Otelco Inc. and Dennis
      Andrews (filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K
      filed on August 29, 2006 and incorporated herein by
      reference)*10.6
                
                
                Employment
      Agreement, dated as of November 15, 2006, between Otelco Inc. and Gary B.
      Romig (filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K
      filed on November 15, 2006 and incorporated herein by
      reference)*10.7
                
                
                Employment
      Agreement, dated as of November 15, 2006, between Otelco Inc. and Jerry C.
      Boles (filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K
      filed on November 15, 2006 and incorporated herein by
      reference)*10.8
                
                
                Stock
      Purchase Agreement, dated as of August 7, 2008, between Country Road
      Communications LLC and Otelco Inc. (filed as Exhibit 10.1 to the Company’s
      Current Report on Form 8-K filed on August 7, 2008 and incorporated herein
      by reference)10.9
                
                
                Second
      Amended and Restated Credit Agreement, dated as of October 20, 2008, by
      and among Otelco Inc. and the other credit party signatories thereto and
      General Electric Capital Corporation, as a lender and as an agent for the
      lenders, and the other lenders from time to time party thereto (filed as
      Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on October
      21, 2008 and incorporated herein by reference)10.10
                
                
                Amendment,
      dated as of December 17, 2008, to the Employment Agreement, dated as of
      August 24, 2006, between Otelco Inc. and Dennis
Andrews*10.11
                
                
                Amendment,
      dated as of December 17, 2008, to the Employment Agreement, dated as of
      November 15, 2006, between Otelco Inc. and Jerry C.
  Boles*10.12
                
                
                Amendment,
      dated as of December 18, 2008, to the Employment Agreement, dated as of
      November 15, 2006, between Otelco Inc. and Gary B.
  Romig*10.13
                
                
                Amendment,
      dated as of December 19, 2008, to the Employment Agreement, dated as of
      June 9, 2004, between Otelco Telephone LLC and Curtis L. Garner,
      Jr.*10.14
                
                
                Amendment,
      dated as of December 22, 2008, to the Amended and Restated Employment
      Agreement, dated as of June 21, 2004, between Otelco Telephone LLC and
      Michael D. Weaver*10.15
                
                
                Employment
      Agreement, dated as of July 30, 2002, between Pine Tree Holdings, Inc. and
      Robert Souza, as amended on October 31, 2008 and December 31,
      2008*10.16
                
                
                Amendment,
      dated as of December 31, 2008, to the Employment Agreement, dated as of
      July 3, 2006, between Mid- Maine and Nicholas A.
    Winchester*12.1
                
                
                Computation
      of Ratio of Earnings to Fixed Charges21.1
                
                
                List
      of subsidiaries of Otelco Inc.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
Officer


64




Exhibit
              No.
            
            Description32.1
            
            
            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


65




SIGNATURES




Pursuant
to the requirements of Section 13 or 15(d) 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.


OTELCO
      INC.By:
              /s/
      Michael D. WeaverMichael
      D. WeaverPresident
      and Chief Executive Officer




Date:
March 11, 2009




Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the
capacities and on the dates indicated:


Signature
                                  
                                  Title
                                  
                                  Date/s/
      Michael D. Weaver
                                  
                                  
                                  
                                  President,
      Chief Executive Officer and
                                  
                                  March
      11, 2009Michael
      D. Weaver
                                  
                                  Director(Principal
      Executive Officer)/s/
      Curtis L. Garner, Jr.
                                  
                                  
                                  
                                  Chief
      Financial Officer
                                  
                                  March
      11, 2009Curtis
      L. Garner, Jr.
                                  
                                  (Principal
      Financial and Accounting Officer)/s/
      William Bak
                                  
                                  
                                  Director
                                  
                                  March
      11, 2009William
      Bak/s/
      Howard J. Haug
                                  
                                  
                                  Director
                                  
                                  March
      11, 2009Howard
      J. Haug/s/
      John P. Kunz
                                  
                                  
                                  Director
                                  
                                  March
      11, 2009John
      P. Kunz/s/
      Stephen P. McCall
                                  
                                  
                                  Director
                                  
                                  March
      11, 2009Stephen
      P. McCall/s/
      Andrew Meyers
                                  
                                  
                                  Director
                                  
                                  March
      11, 2009Andrew
      Meyers/s/
      William F. Reddersen
                                  
                                  
                                  Director
                                  
                                  March
      11, 2009William
      F. Reddersen