**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**




**WASHINGTON,
      D.C. 20549**




**FORM
      10-K**





ý
            ANNUAL
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES
                EXCHANGE ACT OF 1934For
                the fiscal year ended December 31, 2005ORo
            TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES
                EXCHANGE 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
            
            (I.R.S.
                Employerincorporation
                or organization)
            
            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)




**None**


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




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
            
            American
                Stock Exchange




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 Exchange 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, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange
      Act.


Large
      accelerated filer o   Accelerated
      filer x   Non-accelerated
      filer 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, 2005, the aggregate market value of the registrant’s Income Deposit
      Securities (IDSs) held by non-affiliates of the registrant was $146.0 million
      based on the closing sale price as reported on the American Stock Exchange.
      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, 2006, the registrant had 9,676,333 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 2006 annual meeting of
      stockholders.












**TABLE
      OF CONTENTS**


**Page**PART
                  I
              
              
              
              2Item
                  1.
              
              Business
              
              2Item
                  1A.
              
              Risk
                  Factors
              
              8Item
                  1B.
              
              Unresolved
                  Staff Comments
              
              13Item
                  2.
              
              Properties
              
              13Item
                  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
              
              17Item
                  7.
              
              Management's
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              
              18Item
                  7A.
              
              Quantitative
                  and Qualitative Disclosures about Market Risk
              
              32Item
                  8.
              
              Financial
                  Statements and Supplementary Data
              
              32Item
                  9.
              
              Changes
                  in and Disagreements with Accountants on Accounting and Financial
                  Disclosure
              
              57Item
                  9A.
              
              Controls
                  and Procedures
              
              57Item
                  9B.
              
              Other
                  Information
              
              57PART
                  III
              
              
              
              57Item
                  10.
              
              Directors
                  and Executive Officers of the Registrant
              
              57Item
                  11.
              
              Executive
                  Compensation
              
              57Item
                  12.
              
              Security
                  Ownership of Certain Beneficial Owners and Management and Related
                  Stockholder Matters
              
              57Item
                  13.
              
              Certain
                  Relationships and Related Transactions
              
              57Item
                  14.
              
              Principal
                  Accounting Fees and Services
              
              58PART
                  IV
              
              
              
              58Item
                  15.
              
              Exhibits,
                  Financial Statement Schedules
              
              58
 
 i


*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.




1




**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 five RLEC
      businesses, four of which serve contiguous territories in north central Alabama,
      and one which serves a portion of central Missouri. The company completed an
      initial public offering of income deposit securities 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.




The
      following table shows the aggregate number of our access line equivalents (which
      we define as access lines, cable modems and digital subscriber lines), cable
      television, long distance, and dial-up Internet customers as of
      December 31, 2005:




Access
                line equivalents
            
            
            38,539Long
                distance customers
            
            
            14,438Cable
                television customers
            
            
            4,220Dial-up
                Internet customers
            
            
            12,149





The
      five
      companies we acquired can trace their history as local communications providers
      as far back as the early 1900s. 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
      access and cable television, thereby increasing customer loyalty and average
      revenue per access line.




Our
      rural
      local exchange carriers have historically experienced relatively stable
      operating results and strong cash flows and operate in supportive regulatory
      environments. Each of our rural local exchange carriers 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. This exemption helps us maintain our strong
      competitive position. Direct competition is typically limited because rural
      local exchange carriers primarily serve low customer density communities with
      predominantly residential customers, and the cost of operations and capital
      investment requirements for new entrants is high.




*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
      access line equivalents.




*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 access line equivalents.




*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 access line equivalents.




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




*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 access line
      equivalents.




2




**Service
      Offerings**




The
      following table reflects the percentage of total revenues derived from each
      of
      our service offerings for the year ended December 31, 2005:




**Revenue** **Mix**




**Source
                of Revenue**Local
                service
            
            
            30.2
            %Network
                access
            
            
            46.6Long
                distance and other telephone services
            
            
            7.0Cable
                television
            
            
            4.4Internet
            
            
            11.8Total
            
            
            100.0
            %





*Local
      Services*




We
      are
      the sole provider of wireline telephone services in the territories served
      by
      our five rural local exchange carriers. Local services enable customers to
      originate and receive telephone calls within a defined exchange area, or
      territory. The maximum amount that we can charge a customer for local services
      in Alabama and Missouri is regulated by the Alabama Public Service Commission,
      or APSC, and the Missouri Public Service Commission, or MPSC,
      respectively.




Revenue
      derived from local services includes monthly recurring charges for access lines
      providing local dial tone and calling features, including caller identification,
      call waiting, call forwarding and voicemail. We provide local services on a
      retail basis to residential and business customers, in most cases for a fixed
      monthly charge that varies by the selected features.




*Network
      Access*




Network
      access revenue relates primarily to services provided by us to 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 originating or terminating their calls on our networks pursuant to our
      interconnection agreements with those wireless carriers. Hopper, Blountsville
      and Mid-Missouri also receive Universal Service Fund High Cost, or USF HC,
      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 with respect to our Alabama rural local exchange carriers and by the MPSC
      with respect to Mid-Missouri.




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 in a local calling area outside of that
      state, or vice versa. We bill interstate access charges in a manner similar
      to
      intrastate access charges. Our 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.




3




Federal
      Universal Service Fund High Cost Revenue.    Hopper,
      Blountsville and Mid-Missouri recover a portion of their costs through the
      USF
      HC, 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 HC support. Although
      all
      of our rural local exchange carriers have been designated as eligible
      telecommunications carriers or ETCs, Otelco Telephone and Brindlee do not
      receive USF HC support because their cost per loop does not exceed the national
      average. The USF HC, 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 HC
      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.




*Long
      Distance and Other Telephone Services*




We
      offer
      long distance telephone services to our local telephone customers. The majority
      of our long distance revenue is derived from reselling long distance services
      purchased from a long distance provider. At December 31, 2005,
      approximately 44.3% of our 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 marketing to
      our
      local telephone customers.




We
      derive
      revenue from other telephone related services, including leasing, selling,
      installing, maintaining and repairing 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.




*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 59 to 184 channels, depending upon the location in which the services
      are
      offered. We intend to expand our cable services selectively by extending our
      cable networks into areas adjacent to our existing cable network facilities
      within our telephone service area. With this strategy, we believe we will be
      able to capture additional customers with minimal capital expenditures. Of
      the
      more than 8,200 homes we pass, we are the cable television provider to
      approximately 4,200 of these homes.




*Internet
      Services*




We
      provide two forms of Internet access to our customers: digital high-speed and
      dial-up. Digital high-speed Internet access is provided via DSL or cable modems,
      depending upon the location in which the service is offered. 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 high-speed Internet
      access to over 90% of our access 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 Missouri, we also
      offer internet services outside of but adjacent to our telephone service
      area.




4




**Network
      Assets**




Our
      telephone networks include carrier grade advanced switching capabilities
      provided by four digital switches, fiber rings and network software, 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 and Internet access
      services through dial-up, DSL and cable modems. As of December 31, 2005,
      our networks included the following elements, all of which are owned by
      us:




·
            Three
                Lucent 5ESS digital switches and one Siemens EWSD
                switch;




·
            More
                than 615 route miles of high-quality, high-speed fiber optic cable;
                and




·
            DSL
                and cable modem equipment.




Our
      cable
      television networks in Alabama and Missouri provide cable television and cable
      modem services with approximately 89 route miles of fiber optic cable and
      approximately 317 route miles of coaxial cable in Alabama and approximately
      10
      route miles of coaxial cable in Missouri, each of which has been upgraded to
      a
      transmission capacity of 750 MHz.




**Sales,
      Marketing & Customer Service**




Our
      marketing approach emphasizes locally managed, customer-oriented sales,
      marketing and service. We are able to differentiate ourselves from our
      competition by providing a superior level of service in our territories. We
      believe that most telecommunications companies devote their resources and
      attention primarily toward customers in more densely populated markets, thereby
      providing relatively poor service to rural customers.




Each
      of
      our rural local exchange carriers 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 or automatic withdrawal from their bank
      account, a substantial portion of the customer base elects 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.




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 Alabama and Missouri territories, we identify each of our rural
      local exchange carriers as a division of Otelco. In each territory, both the
      name of the local rural local exchange carrier and the name of Otelco appear
      on
      the customers’ bills and our marketing materials. 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
      dial-up and digital high-speed Internet access, cable 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.




Prior
      to
      their acquisition by us, many of our rural local exchange carriers had not
      engaged in significant sales and marketing activities. Upon their acquisition,
      we have provided additional sales and marketing support that has enhanced the
      introduction of new services and the continued marketing of existing services
      and products.




5




**Competition**




*Local
      Services*




We
      believe that many of the competitive threats now confronting larger telephone
      companies do not currently exist in our rural local exchange carrier service
      areas. Our rural local exchange carriers have never experienced wireline
      telephone competition because the demographic characteristics of rural
      telecommunications markets generally would 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. However, in
      the
      future, we may face direct competition from cable providers in a portion of
      our
      territory; new market entrants, such as providers of wireless and satellite
      broadband or voice over electric lines; and indirect competition such as voice
      over Internet protocol, or VoIP.




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 or MPSC terminates this exemption for our rural
      local exchange carriers, we may face competition from resellers and other
      wireline carriers.




In
      our
      markets, we face competition from wireless carriers. To date, we believe that
      we
      have experienced only a limited decrease in access lines as a result of
      customers switching their residential wireline telephone service to a wireless
      service. Although we believe we have experienced a minor decrease in our minutes
      of use primarily due to flat rate “free minutes and long distance calling
      offers” from wireless carriers, we have also experienced an increase in network
      access revenue associated with terminating wireless calls on our telephone
      network. We do not expect wireless technology to represent a meaningful threat
      to our business in the near term due in part to the topography of our telephone
      territories and the current inconsistent wireless coverage. However, as wireless
      carriers continue to build-out their networks, we may experience increased
      competition from this technology. The FCC has adopted regulations requiring
      wireline telephone carriers to provide portability of telephone numbers to
      wireless carriers, which may in the future increase the competition we face
      from
      wireless carriers. Our rural local exchange carriers are currently capable
      of
      providing portability of telephone numbers to wireless carriers.




In
      addition, under the Communications Act, a competitor can obtain USF HC 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 HC support by our competitors does
      not
      significantly reduce our current USF HC revenue, such economic support could
      facilitate competition in our rural local exchange carrier territories,
      particularly from wireless carriers. To date, one wireless carrier serving
      our
      Alabama territory has received ETC status and will be eligible for USF HC funds
      within our rural local exchange carrier territories. Two other wireless carriers
      have applied for ETC status in our Alabama territories. In Missouri, one
      wireless carrier applied for ETC status and was denied by the MPSC.




*Long
      Distance and Other Telephone Services*




The
      long
      distance market is highly competitive in all of our rural local exchange carrier
      territories. We compete with major national and regional interexchange carriers,
      including AT&T, Verizon (formerly MCI, Inc.). and Sprint Nextel Corporation
      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, 2005, customers representing approximately 44.3% of our
      access lines subscribed to our long distance services. Most of these customers
      added our long distance services since our acquisition of the related rural
      local exchange carrier.




6




*Cable
      Television Services*




We
      offer
      cable television services in select areas of our territories. In the northern
      portion of our Alabama territory, Charter Communications, Inc. provides
      cable service, passing about 10,000 of our subscribers. In addition, in all
      of
      our cable television territories, we compete against digital broadcast satellite
      providers including Dish Network and DirecTV, Inc.




*Internet
      Services*




Competition
      in the provision of Internet services currently comes from alternative dial-up
      and digital high-speed Internet service providers. Individual competitors vary
      on a market-to-market basis and include Earthlink, Inc., Charter
      Communications, Inc., the AOL division of Time Warner, and a number of
      small, local competitors. At December 31, 2005, we provided Internet
      services to approximately 26.0% of our access lines. In Missouri, we also
      provide Internet services outside our telephone services territory.




**Information
      Technology and Support Systems**




We
      have
      an integrated software system that functions as an operational support and
      customer care/billing system. Our system includes automated provisioning and
      service activation, mechanized line record and trouble reporting. These services
      are provided through the use of licensed third-party software. By utilizing
      an
      integrated software system, we are able to reduce individual company costs
      and
      standardize functions resulting in greater efficiencies and
      profitability.




Our
      system allows us to provide a single, unified bill for all our services which
      we
      believe is a significant competitive advantage. Additionally, our system
      provides 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.




**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, 2005, we employed a total of approximately 137 full-time and 5
      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 annual, quarterly
      and
      current reports, proxy and information statements and other information with
      the
      Securities and Exchange Commission, or SEC. You may read and copy any document
      we file with 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.




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 is *http://www.otelco.net* .




7




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.otelco.net* .
      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 concentrated geographically and dependent on regional economic
      conditions.**




Our
      business is conducted primarily in north central Alabama and central Missouri
      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 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 no wireline telephone competition in our rural
      local exchange carrier 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. We believe that we have
      experienced a decrease in our minutes of use, primarily due to flat rate “free
      minutes and long distance calling” offers from certain wireless carriers. As
      wireless carriers continue to build-out their networks, we may experience
      increased competition, which could have an adverse effect on our business,
      revenue and cash flow.




Our
      current and potential competitors could include competitive local exchange
      carriers and other providers of telecommunications and information services,
      including Internet and voice over Internet protocol, or VoIP, service providers,
      wireless carriers, satellite television companies, alternate access providers,
      neighboring incumbent local exchange carriers, long distance companies, electric
      utilities and cable television companies that may provide services competitive
      with those products and services that we provide or intend to
      provide.




Although
      our long distance operations have historically been modest in relation to our
      competitors, we intend to continue to expand our long distance business within
      our territories, through marketing to our existing telephone services customers.
      Our existing long distance competitors can be expected to respond to such
      initiatives, including those with significantly greater resources than us.
      There
      can be no assurance that our revenue from long distance services will not
      decrease in the future as competition and/or the cost of providing long distance
      services increase or should market prices potentially decline.




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. We have implemented the
      changes necessary to support these regulations. Wireline to wireless portability
      may enhance the competitive position of wireless carriers.




8




**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
      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.




**We
      may have difficulty acquiring businesses, managing growth and integrating
      acquired businesses.**




We
      have
      grown rapidly by acquiring other businesses. Since 1999, we have acquired five
      rural local exchange carriers businesses. We face competition acquiring rural
      local exchange carriers, including from businesses that are larger or have
      access to more financing than us. There can be no assurance that owners of
      rural
      local exchange carriers will want to sell at all or to us. If we fail to expand
      our business, make acquisitions or successfully integrate the operations of
      any
      acquired companies with our own operations, the rate of our future growth,
      if
      any, will likely be lower than our historical growth rate. There can be no
      assurance that we will be able to successfully expand our business through
      acquisitions or otherwise. In addition, the pursuit of future acquisitions
      could
      lead to a diversion of resources and management attention from operational
      matters.




**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 incur expenses, and thereby adversely
      affect our business, revenue and cash flow. In addition, the ASPC and/or MPSC
      could require us to issue credits on customer bills for such service
      interruptions, further impacting revenue and cash.




**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 from metropolitan areas. 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 access line loss due to challenging economic
      conditions, loss of second lines when we sell high-speed Internet access service
      and increased competition. Our access line count declined by 3.2% during 2005.
      We may continue to experience net access line loss in our markets for an
      unforeseen period of time. Continued access line losses could adversely affect
      our business and results of operations.




9




**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.




Although
      our performance is affected by the general condition of the economy, not all
      of
      our services are affected equally. Local services revenue is generally linked
      to
      relatively consistent variables such as population changes, housing starts
      and
      general economic activity levels in the areas served. Internet 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 heavily regulated industry. The majority of our revenue has been
      generally supported by and subject to regulation at the federal, state and
      local
      level. Certain federal, Alabama and Missouri 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 HC), 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
      21.0% of our revenue for the year ended December 31, 2005 was derived from
      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
      APSC
      and the MPSC. 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, APSC or MPSC may adopt.
      Such
      regulatory developments could adversely affect our business, revenue and cash
      flow.




10




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 APSC or the MPSC, we may face revocation of our
      authorizations in Alabama or Missouri, as applicable, or other conditions and
      penalties. The APSC is considering several proposals that would result in
      greater pricing flexibility for our Alabama rural local exchange carriers in
      regard to most services, as well as the expansion of local calling options.
      It
      is possible that a new plan 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 outcome
      of
      the review process or the impact that it will have on our business, revenue
      and
      cash flow.




Mid-Missouri
      Telephone charges rates for local services and intrastate access service based
      in part upon a rate-of-return authorized by the MPSC. These authorized rates
      are
      subject to audit by the MPSC at any time and may be reduced if the MPSC finds
      them excessive. If Mid-Missouri Telephone 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.




**A
      reduction in Universal Service Fund High Cost support would adversely affect
      our
      business, revenue and cash flow.**




Hopper,
      Blountsville and Mid-Missouri receive federal USF HC revenue to support their
      high cost of operations. Such support payments represented approximately 11.2%
      of our revenue for the year ended December 31, 2005, 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 HC,
      or
      if such support is reduced, our business, revenue and cash flow would be
      negatively affected.




During
      the past two years, the FCC made certain modifications to the USF HC support
      system that changed the sources of support and the method for determining the
      level of support. There is a cap on the total USF HC payments 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 HC support that we have
      received in the past. In addition, a number of issues regarding source and
      amount of contributions to, and eligibility for, payments from USF HC are
      currently being reviewed by the FCC. On February 25, 2005, the FCC adopted
      several Federal-State Joint Board recommendations to augment the requirements
      for telecommunications carriers seeking designation as eligible
      telecommunications carriers, or “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 Commission will be
      required to demonstrate compliance with these standards by October 1, 2006.
      Additional annual certification and reporting requirements were also adopted.
      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. The outcome of these proceedings or
      other
      regulatory changes could affect the amount of USF HC 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 HC could decline under current rules, and under some proposed
      USF
      HC rule changes, could be significantly reduced. Recently, 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. Sec. 1341)
      (2000)). Some analysts have suggested that disbursements under the USF HC could
      also be suspended to comply with the Anti-Deficiency Act. We cannot predict
      the
      impact these actions may have on us, including on our receipts from, and
      contributions to, the universal service fund.




11




**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 APSC or MPSC,
      as applicable, determines 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.




**Changes
      in the regulation of cable television franchises and services may adversely
      impact our cable television operations.**




Cable
      television systems are operated under franchises granted by local government
      authorities. Franchises may contain various conditions, including time
      limitations on commencement or completion of construction, approval of initial
      fees charged to customers for basic service, the number of channels offered
      and
      the types of programming to be provided. The regulation of cable television
      at
      the federal, state and local levels is subject to a political process and has
      been in constant flux over the past decade. This process continues in the
      context of new legislative proposals and the adoption or deletion of
      administrative regulations and policies. We anticipate further material
      developments in these areas, but cannot anticipate their direction or impact
      on
      our cable television operations. In addition, the regulatory approach to the
      utilization of cable television facilities for the provision of services beyond
      video programming is also in flux, rendering it impossible to anticipate the
      extent or scope of future regulatory requirements or limitations. The impact
      of
      pending requirements for content providers to utilize only digital format may
      impact delivery system requirements for cable operators.




**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
      be retained by us. 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.




**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;




12




·
            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 equipment,
      telephone lines and related equipment. Our telephone lines include aerial and
      underground cable, conduit, poles and wires. Our central office equipment
      includes digital switches and peripheral equipment. We own substantially all
      our
      real property, including our corporate office. We also lease certain of our
      real
      property, including land in Oneonta, Alabama, pursuant to a long-term, renewable
      lease. Substantially all our cable television service equipment is located
      on
      this leased property. Our real property is all located in Alabama and Missouri.
      As of December 31, 2005, our property and equipment consisted of the
      following:




**(in
                thousands)**Land
            
            $
            772Buildings
                and improvements
            
            
            6,961Telephone
                equipment
            
            
            92,122Cable
                television equipment
            
            
            5,572Furniture
                and equipment
            
            
            1,379Vehicles
            
            
            3,134Computer
                hardware and software
            
            
            2,951Internet
                equipment
            
            
            2,147Total
                property and equipment
            
            
            115,038Accumulated
                depreciation
            
            
            (70,482
            )Net
                property and equipment
            
            $
            44,556





**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 and MPSC relating primarily to rate making.
      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 2005, 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 ecember 31, 2005.




**Name**
            
            **Age**
            
            **Position**Michael
                D. Weaver
            
            53
            
            President,
                Chief Executive Officer and DirectorCurtis
                L. Garner, Jr.
            
            58
            
            Chief
                Financial OfficerDennis
                Andrews
            
            49
            
            Senior
                Vice President and General Manager, BrindleeJerry
                C. Boles
            
            53
            
            Vice
                President and ControllerGary
                B. Romig
            
            55
            
            Vice
                President and General Manager, Mid-MissouriKenneth
                W. Gross
            
            54
            
            Vice
                President, Regulatory Operations




13




*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.




*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 its Premiere
      Communications division, and later as Chief Administrative Officer of its
      VoiceCom division. Prior thereto, he spent approximately 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* has
      served as our Senior 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.




*Kenneth
      W. Gross* has
      served as our Vice President, Regulatory Operations since July 2000. From
      March 1988 to July 2000, he served as Vice President/Manager,
      Marketing and Commercial Operations of Brindlee. Prior to joining Brindlee,
      he
      held several positions with two commercial lending institutions.




*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 certified as a CPA by the State of Alabama, and is a member in
      good standing of the AICPA.




*Gary
      B. Romig* has
      served as our Vice President and General Manager of Mid-Missouri since its
      acquisition in December 2004. He served as Co-President of the company 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.




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
      Income Deposit Securities (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 under the symbol “OTT” on
      December 16, 2004. The high and low for the stock during the quarters since
      its issuance are as follows:




For
                the three months ended
            
            High
                ($US)
            
            Low
                ($US)December
                31, 2004
            
            $
            16.05
            
            $
            15.20March
                31, 2005
            
            $
            16.00
            
            $
            15.05June
                30, 2005
            
            $
            15.43
            
            $
            14.55September
                30, 2005
            
            $
            16.48
            
            $
            14.95December
                31, 2005
            
            $
            16.90
            
            $
            15.19







Prior
      to
      December 16, 2004, the company was privately held and there was no trading
      in
      the company’s equity.




There
      is
      no established trading market for our Class B common stock.




**Holders**




As
      of
      March 1, 2006 there were approximately 9,400 record holders of our IDSs.
      Holders of our IDSs have the right to separate each IDS 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 1, 2006, 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 2005 for a total of $0.705 per share
      for 2005. No dividends were paid in the prior year.




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.




15




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
                1.4x;




·
            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 Adjusted EBITDA 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 1.2x; and




·
            “senior
                leverage ratio” (defined as senior secured debt as of the last day of any
                period divided by our Adjusted EBITDA for any period of four consecutive
                fiscal quarters) of not more than
                3.1x.




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
      new
      credit facility, (b) any default or event of default exists under the new
      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 and
      (e) there is insufficient excess cash, as defined in our credit
      facility.




**Securities
      Authorized for Issuance under Equity Compensation Plans**




No
      securities have been issued for any equity compensation plan and no such plan
      is
      currently in place.




**Recent
      Sales of Unregistered Securities**




During
      the fiscal year ended December 31, 2005, 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 IDS for each share of Class B
      common stock, subject to compliance with law and applicable
      agreements.




**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,
      2003, 2004, and 2005 and for each of the three years in the period ended
      December 31, 2005 have 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, 2001 and 2002 and for each of the two years in the period
      ended December 31, 2002 have 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.




17


**At
                  and For The Year Ended December 31,****2001**
              
              **2002**
              
              **2003(1)**
              
              **2004(1)**
              
              **2005****(in
                  thousands except per share amounts)****Income
                  Statement Data**Revenues:Local
                  service
              
              $
              13,251
              
              $
              12,882
              
              $
              13,090
              
              $
              13,998
              
              $
              14,176Network
                  access
              
              
              11,750
              
              
              12,003
              
              
              14,701
              
              
              16,602
              
              
              21,873Long
                  distance and other telephone services
              
              
              2,113
              
              
              2,197
              
              
              2,571
              
              
              2,659
              
              
              3,269Cable
                  television
              
              
              1,361
              
              
              1,586
              
              
              1,748
              
              
              1,818
              
              
              2,087Internet
              
              
              806
              
              
              1,202
              
              
              1,645
              
              
              2,189
              
              
              5,567Total
              
              $
              29,281
              
              $
              29,870
              
              $
              33,755
              
              $
              37,266
              
              $
              46,972Income
                  from operations
              
              $
              7,924
              
              $
              14,847
              
              $
              14,719
              
              $
              13,529
              
              $
              18,065Income
                  before income tax and accretion expense
              
              $
              1,752
              
              $
              11,017
              
              $
              11,600
              
              $
              10,074
              
              $
              3,246Net
                  income (loss)
              
              $
              (405
              )
              $
              7,199
              
              $
              7,493
              
              $
              6,114
              
              $
              1,792Net
                  income per share(2)Basic
              
              $
              (0.05
              )
              $
              0.89
              
              $
              0.93
              
              $
              0.75
              
              $
              0.19Diluted
              
              $
              (0.05
              )
              $
              0.84
              
              $
              0.88
              
              $
              0.71
              
              $
              0.12**Balance
                  Sheet Data**Cash
                  and cash equivalents
              
              $
              5,695
              
              $
              2,322
              
              $
              1,650
              
              $
              5,407
              
              $
              5,569Property
                  and equipment, net
              
              
              32,897
              
              
              32,672
              
              
              37,919
              
              
              48,196
              
              
              44,556Total
                  assets
              
              
              139,396
              
              
              135,138
              
              
              150,721
              
              
              196,227
              
              
              192,126Long-term
                  notes payable (including current portion)
              
              
              97,622
              
              
              81,493
              
              
              83,073
              
              
              161,075
              
              
              161,075




(1)
            During
                fiscal 2003 and 2004, we acquired Blountsville and Mid-Missouri
                respectively, both rural local telephone companies. 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 per share is restated to reflect the relevant
                shares
                that would have been outstanding in the respective
                periods.




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




**Overview**




*General*




Since
      1999, we have acquired and operated five rural local exchange carriers serving
      twenty exchanges through four central offices and thirteen remote switches
      in
      approximately 1,540 square miles of north central Alabama and central Missouri.
      We are the sole wireline telephone services provider in the rural communities
      we
      serve. Our services include local telephone, network access, long distance
      and
      other telephone related services, cable television and Internet access. We
      view,
      manage and evaluate the results of operations from the various telephony
      products and services as one company and therefore have identified one reporting
      segment as it relates to providing segment information. As of December 31,
      2005, we operated approximately 38,500 access line equivalents.




Our
      core
      businesses are local service 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 76.7% of our total
      revenues in 2005. We also provide long distance and other telephone related
      services, cable television and dial-up and digital high-speed Internet
      access.




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, included in Item 8. The following discussion
      and analysis discusses our financial condition and results of operations on
      a
      consolidated basis, including the acquisitions of Blountsville as of
      June 30, 2003 and Mid-Missouri as of December 21, 2004.




18




*Impact
      of Changes in Capital Structure 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 increased significantly at the end of 2004 and remained at
      a
      high level in 2005. We will be required to refinance our credit facility upon
      its maturity in four years and, if interest rates are higher at that time,
      interest expense will increase further.




Our
      board
      of directors has adopted a dividend policy for our Class A common stock
      which, in the event and to the extent we have 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 the increase in our 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 expansion of our digital high-speed Internet access service area,
      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.




Our
      current dividend policy, the increase in our indebtedness 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 telephone services.
                These
                revenues include monthly subscription charges for basic service,
                calling
                to adjacent communities on a per minute basis, local private line
                services
                and enhanced calling features, such as voicemail, caller identification,
                call waiting and call forwarding.




·
            *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
                and
                Missouri are based on rates approved by the APSC and MPSC respectively.
                Switched and special access charges for interstate and international
                services are based on rates approved by the
                FCC.




·
            *Long
                distance and other telephone services*.    We
                receive revenues for providing long distance services to our customers.
                We
                also provide billing and collections services for other carriers
                under
                contract and receive revenues from directory
                advertising.




·
            *Cable
                television services.*We
                offer basic, digital and pay per view cable television services to
                a
                portion of our telephone service territory in both Alabama and
                Missouri.




19




·
            *Internet
                services.*We
                receive revenues from monthly recurring charges for dial-up and digital
                high-speed Internet access.




*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 access lines we serve
      has
      been decreasing gradually when normalized for territory acquisitions. We expect
      that either this trend will continue or the number of access lines that we
      serve
      in the future will remain relatively flat. In addition to the impact of the
      economy on our customers, the growth of our digital high-speed Internet access
      services will continue to have an impact on residential and small business
      customers’ requirements for second access lines. Our response to this trend will
      have an important impact on our future revenues. Our primary strategy consists
      of leveraging our strong incumbent market position to increase revenue per
      access line by selling additional services to our customer base.


**Year
                  Ended December 31,****2003**
              
              
              **2004**
              
              
              **2005**Access
                  line equivalents(1):Residential
                  access lines
              
              
              22,100
              
              
              25,237
              
              
              24,541Business
                  access lines
              
              
              7,355
              
              
              8,414
              
              
              8,036Access
                  lines
              
              
              29,455
              
              
              33,651
              
              
              32,577Digital
                  high-speed lines
              
              
              2,185
              
              
              3,488
              
              
              5,962Total
                  access line equivalents
              
              
              31,640
              
              
              37,139
              
              
              38,539Long
                  distance customers
              
              
              11,374
              
              
              13,641
              
              
              14,438Cable
                  television customers
              
              
              3,628
              
              
              3,959
              
              
              4,220Dial-up
                  Internet customers
              
              
              2,331
              
              
              15,348
              
              
              12,149




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




We
      will
      continue our strategy of increasing revenues by cross-selling to our existing
      customer base, in the form of bundled service packages and individual additional
      services as they become available. Our digital high-speed Internet customers
      have grown rapidly from 502 customers at December 31, 2001 to 5,962
      customers at December 31, 2005. We expect continued revenue growth in this
      area of our business. This growth in our digital high-speed Internet customers
      is expected to have a negative effect on our dial-up Internet customers as
      some
      customers migrate to high-speed Internet access. In addition, we expect the
      growth in our digital high-speed Internet access customers will have a negative
      effect on our access lines as some customers will no longer have a need for
      second lines for purposes of dial-up Internet access. During 2005, we added
      more
      than two digital high-speed Internet customers for every access line lost.




Our
      long
      distance and cable customers increased by 797 and 261, respectively, in 2005.
      While we have experienced annual increases in our cable television programming
      costs, and expect this trend to continue in the future, we expect these
      increases will be offset by a corresponding increase in the price that we charge
      our cable television customers for cable television service offerings. Our
      dial-up internet customers decreased 1,049 within our local telephone service
      areas and 2,150 outside of our local telephone service area.




The
      following is a discussion of the major factors affecting our access line
      count:




*Cyclical
      Economic and Industry Factors.* We
      believe that the general downturn in economic conditions and its related impact
      on residential and small business customers from 2000 through 2004 had a
      negative effect on our access line count. In 2005, the improved performance
      of
      the Alabama and Missouri local economies was partially offset by the impact
      of
      higher energy prices.




20




*Competition.* There
      are currently no wireline telephone competitors operating within our
      territories. We believe we have experienced an impact on our local toll and
      long
      distance minutes of use due to flat rate “free minutes and long distance
      calling” offers from wireless carriers. While originating minutes have declined,
      terminating minutes have increased. We believe that our access line losses
      to
      wireless carriers have been minimal in 2005. In addition, we have responded
      to
      potential wireless competition by offering bundled minutes packages at industry
      competitive rates and are developing service bundles to meet the broader
      communications needs of our customers which will include “unlimited” local and
      long-distance minutes.




*Acquisitions.* In
      June 2003, we purchased Blountsville, a rural local exchange carrier
      serving 4,080 access line equivalents that is contiguous to our other Alabama
      rural local exchange carriers. This acquisition allowed us to cross-sell
      additional services to these customers, including high-speed and dial-up
      Internet access and long distance services.




In
      December 2004, we purchased Mid-Missouri Telephone, a rural local exchange
      carrier serving 4,700 access line equivalents in central Missouri.




*Ancillary
      Effects of our Internet Services.* As
      we increase penetration of our high-speed Internet services, customer demand
      for
      second access lines for dial-up Internet access decreases. We believe that
      the
      revenue potential of our high-speed Internet businesses outweighs the effect
      of
      the potential access line loss.




*Our
      Rate and Pricing Structure*




In
      1995,
      the APSC rebalanced the formula for service rates within Alabama as part of
      the
      move from rate-of-return regulation to a price cap regulation. Under this price
      cap plan, local service rates for residential and business customers increased
      annually for five years. At the same time, the APSC reduced access rates paid
      by
      carriers. The plan was intended to be revenue neutral for telephone companies.
      The Alabama Service Fund (which later became the Alabama Transition Service
      Fund, or TSF) was established to insure this goal was met. We raised monthly
      rates for residential and business customers to their current levels of $16.30
      and $32.60, respectively, under this plan. The ability to increase basic
      residential and business rates, while still available through the APSC, is
      significantly limited through this rebalancing effort to material changes in
      the
      cost of providing services. Four of our operating subsidiaries continue to
      receive compensation from the TSF. We received total compensation of
      $2.8 million, representing 5.9% of our total revenue, from the TSF for the
      year ended December 31, 2005. We do not expect material changes in the
      amount of revenue we receive from the TSF.




Under
      the
      1995 Plan, selected local telecommunications services not classified as basic
      communications services, such as caller identification, call waiting, call
      forwarding and other enhanced calling services, are regulated by the APSC as
      non-basic communications services. We are allowed to increase our rates each
      year for some or all of the non-basic communications services we provide by
      amounts that are up to 10.0% higher than the rates for such services during
      the
      prior year.




The
      APSC
      approved a proposal that would provide each of our Alabama rural local exchange
      carriers with the option of being regulated under one of two new cap plans,
      neither of which imposed rate of return regulation. On
      September 2, 2005, Otelco filed to move each of our Alabama rural local exchange
      carriers from
      the
      1995 Plan to the
      Price Flexibility Plan. This filing was subsequently approved by the APSC on
      January 10, 2006.




Under
      the
      Price Flexibility Plan option, local exchange carriers are granted much broader
      rate flexibility than under the 1995 Plan, subject to a two year prohibition
      on
      rate increases for one party residential service, one party business service
      and
      certain vertical services. Local exchange carriers participating in the Price
      Flexibility Plan are required to offer an optional expanded residential calling
      plan at an additional charge not to exceed $22.00. Existing
      calling plans that were deemed to be reasonably equivalent and to reasonably
      meet the APSC’s objectives were used to satisfy this requirement. Pricing caps
      do not apply to bundled services or regulated services offered to customers
      under special contracts. Local exchange carriers are required to meet certain
      minimum service quality standards in areas such as trouble input and clearance;
      quality of plant and equipment; emergency procedures; and handling of commission
      appeals. The company has consistently met these standards.




21




In
      May
      2005, the Alabama Legislature passed the Alabama Communications Reform Act
      of
      2005, which took effect on August 1, 2005. The Reform Act eliminates, over
      time,
      the APSC’s jurisdiction over retail telephone rates and service terms with the
      exception of limited authority to enforce a statutory cap on certain non-bundled
      basic residential and business services and optional calling features. Effective
      August 1, 2005, the APSC has no jurisdiction over any aspect of broadband
      services, broadband enabled services or information services by otherwise
      regulated carriers. Beginning February 1, 2008, the APSC’s jurisdiction over
      telephone rate and service terms will be limited to enforcing an annual
      inflation factor cap on rate increases for basic non-bundled residential and
      business service (up to four lines), and a separate percentage cap on certain
      optional calling features offered on a stand-alone basis. Rates and terms and
      conditions for all other retail services, or combination of services, will
      be
      detariffed and set at the discretion of the carrier. The APSC retains
      jurisdiction over interconnection arrangements, access charges and other
      wholesale arrangements; however, it is prevented from imposing unbundling or
      reporting requirements in excess of those required by FCC. The APSC also retains
      exclusive jurisdiction over residential service complaints, but its authority
      is
      limited to enforcing the terms of service agreements and federal truth in
      billing requirements.





Under
      this legislation, all telecommunications carriers that were regulated by the
      APSC may make an annual election every August to become regulated under the
      Reform Act or under the pre-existing state law. Rural ILECs may elect to be
      regulated under the Reform Act only if they: (1) waive their automatic exemption
      under the Telecommunications Act of 1996 from certain interconnection
      requirements and agree to limit the duration of any future suspensions or
      modifications of Telecommunications Act interconnection obligations; or (2)
      file
      a certification attesting that they meet certain specified competitive criteria.
      All of our Alabama RLECs met the competitive criteria for regulation under
      the
      Reform Act upon the FCC’s granting of ETC status in January 2006 to certain
      wireless carriers within each of the Alabama RLECs’ service areas. Accordingly,
      the company is regulated under the Reform Act as discussed above.




In
      Missouri, local exchange and exchange access telecommunications services are
      regulated under rate of return regulation. Since 1996, Missouri law provides
      for
      three degrees of regulation for local exchange telecommunications companies:
      traditional rate of return regulation for certain incumbent local exchange
      companies; “price cap” regulation for certain exchanges of incumbent local
      exchange companies; and “competitive classification” for certain services in
      certain exchanges of incumbent local exchange companies as well as for
      competitive local exchange companies.




Mid-Missouri
      Telephone is an incumbent local exchange company operating as a traditional
      rate
      of return company. Its rates were set in its last rate case or earnings review
      in 1999. Those rates were reviewed in 2002 and remain in effect for the
      Company’s local and exchange access services. They will remain effect until a
      subsequent rate proceeding. The Company has no ability to change prices for
      regulated local exchange and exchange access services without completing a
      rate
      case. The Company is ineligible to convert to price cap regulation, and is
      ineligible for competitive classification at this time.




Since
      1996, Missouri law has authorized a Missouri Universal Service Fund to ensure
      just, reasonable, and affordable rates for reasonably comparable essential
      local
      telecommunications services throughout the state. In 2005, the Fund became
      operational, on a revenue neutral basis to the company, for low income and
      disabled customers. A high cost component of the Fund has not been
      determined **.**




Our
      rates
      for other services we provide in Alabama and Missouri, including cable,
      long-distance, and dial-up and high-speed Internet access, are not price
      regulated. The combined revenues from these non-price regulated services were
      $10.9 million in 2005, up from $6.7 million in 2004 and
      $6.0 million in 2003. In 2005, 23.2% of our total revenues were generated
      from these services, up from 17.9% in 2004 and 17.7% in 20032.




*Categories
      of Operating Expenses*




Our
      operating expenses are categorized as cost of services; selling, general and
      administrative expenses; and depreciation and amortization. In addition, we
      had
      a one-time write-off of capitalized transaction costs in 2003.




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




22




*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; stock option compensation expense; insurance
      premiums; stock exchange and banking fees; and postage. Included in selling,
      general and administrative expenses in 2004 was $1.0 million in management
      fees
      to Seaport Capital Partners II, L.P. and its affiliates, or Seaport Capital.
      The
      agreements under which these fees were payable were terminated on
      December 21, 2004 in conjunction with our initial public offering. The
      incremental selling, general and administrative expenses associated with being
      a
      public company replaced these fees in 2005.




*Depreciation
      and amortization.* This
      includes depreciation of our telecommunications, cable and Internet networks
      and
      equipment, and amortization of intangible assets. Prior to January 1, 2002,
      when we implemented the Statement of Financial Accounting Standards
      No. 142, *Goodwill
      and Other Intangible Assets,* or
      SFAS 142, this expense category also included amortization of goodwill
      relating to our acquisitions of Otelco, Brindlee and Hopper. 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, operating margins decrease reflecting
      the lower margins associated with these more competitive services. As an
      example, the cost of services as a percentage of revenue has increased each
      year
      from 2003 to 2005, but the absolute dollars available to cover all other
      expenses after these service costs increased $8.1 million. 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.




**Years
                Ended December 31****2003**
            
            **2004**
            
            **2005**RevenuesLocal
                service
            
            
            38.8
            %
            
            37.6
            %
            
            30.2
            %Network
                access
            
            
            43.5
            
            
            44.5
            
            
            46.6Long
                distance and other telephone services
            
            
            7.6
            
            
            7.1
            
            
            7.0Cable
                television
            
            
            5.2
            
            
            4.9
            
            
            4.4Internet
            
            
            4.9
            
            
            5.9
            
            
            11.8Total
                revenues
            
            
            100.0
            %
            
            100.0
            %
            
            100.0
            %Operating
                expensesCost
                of services and products
            
            
            22.2
            %
            
            23.7
            %
            
            26.8
            %Selling,
                general and administrative expenses
            
            
            15.0
            
            
            20.6
            
            
            14.3Write-off
                of capitalized transaction costs
            
            
            3.0
            
            
            --
            
            
            --Depreciation
                and amortization
            
            
            16.2
            
            
            19.4
            
            
            20.4Total
                operating expenses
            
            
            56.4
            
            
            63.7
            
            
            61.5Income
                from operations
            
            
            43.6
            
            
            36.3
            
            
            38.5Other
                income (expense)Interest
                expense
            
            
            (10.0
            )
            
            (9.9
            )
            
            (34.8
            )Change
                in fair value of derivative
            
            
            --
            
            
            --
            
            
            2.0Other
                income
            
            
            0.8
            
            
            0.6
            
            
            1.2Total
                other expense
            
            
            (9.2
            )
            
            (9.3
            )
            
            (31.6
            )Income
                before income tax and accretion expense
            
            
            34.4
            
            
            27.0
            
            
            6.9Income
                tax expense
            
            
            (12.2
            )
            
            (10.6
            )
            
            (2.2
            )Income
                before accretion expense
            
            
            22.2
            
            
            16.4
            
            
            4.8Accretion
                of Class B common convertible to senior subordinated notes
            
            
            --
            
            
            --
            
            
            (1.0
            )Net
                income available to common stockholders
            
            
            22.2
            %
            
            16.4
            %
            
            3.8
            %




23




*Year
      ended December 31, 2005 compared to year ended December 31,
      2004*




*Total
      Revenues.* Total
      revenues grew 26.0% in 2005 to $47.0 million from $37.2 million in
      2004. The table below provides the components of our revenues for 2005 compared
      to 2004.




**Year
                Ended December 31,**
            
            **Change****2004**
            
            
            **2005**
            
            
            **Amount**
            
            
            **Percent****(dollars
                in thousands)**Local
                service
            
            $
            13,998
            
            $
            14,176
            
            $
            178
            
            
            1.3
            %Network
                access
            
            
            16,602
            
            
            21,873
            
            
            5,271
            
            
            31.7Long
                distance and other telephone services
            
            
            2,659
            
            
            3,269
            
            
            610
            
            
            22.9Cable
                television
            
            
            1,818
            
            
            2,087
            
            
            269
            
            
            14.8Internet
            
            
            2,189
            
            
            5,567
            
            
            3,378
            
            
            154.3Total
            
            $
            37,266
            
            $
            46,972
            
            $
            9,706
            
            
            26.0




Local
      service.    Local service revenue in 2005 grew 1.3% to
      $14.2 million from $14.0 million in 2004. This increase was
      attributable to an increase of $0.6 million from the acquisition of
      Mid-Missouri and $0.1 million increase in local cellular termination revenue.
      These were partially offset by a decrease of $0.2 million from an access
      line loss of 2.9%, or 855 lines, by our Alabama rural local exchange carriers,
      partially caused by the loss of some secondary access lines as customers
      migrated from dial-up to high-speed Internet access and thereby eliminated
      the
      need for certain second access lines, as well as a decrease of $0.3 million
      in area calling service due to a decline in minutes of use from our local
      calling plans.




Network
      access.    Network access revenue in 2005 increased 31.7% to
      $21.9 million from $16.6 million in 2004. This growth was attributable
      to an increase of $6.0 million from the acquisition of Mid-Missouri, offset
      by a reduction of $0.7 million from reduced access revenue in the Alabama
      companies and higher end user access fees.




Long
      distance and other telephone services.    Long distance and
      other telephone services revenue in 2005 increased 22.9% to $3.3 million
      from $2.7 million in 2004. This increase was primarily due to the
      acquisition of Mid-Missouri. In the Alabama companies, a small decrease in
      various toll services was offset by an increase in directory and other telephone
      services.




Cable
      television.    Cable television revenue in 2005 increased
      14.8% to $2.1 million from $1.8 million in 2004. This increase was
      primarily due to the acquisition of Mid-Missouri, growth in revenue from our
      Alabama cable television customers and price increases to reflect the increase
      in cable content costs.




Internet.    Internet
      revenue in 2005 increased 154.3% to $5.6 million from $2.2 million in
      2004. The acquisition of Mid-Missouri increased revenue by almost $2.8 million
      and growth in Alabama digital high-speed subscribers increased revenue by $0.6
      million.




*Operating
      expenses.* Operating
      expenses for 2005 increased 21.8% to $28.9 million from $23.7 million
      in 2004. This increase was primarily attributable to the acquisition of
      Mid-Missouri, and increased costs associated with higher Internet and cable
      television revenues, offset by the absence of non-cash stock option compensation
      expense.




24




**Year
                Ended December 31,**
            
            **Change****2004**
            
            
            **2005**
            
            
            **Amount**
            
            
            **Percent****(dollars
                in thousands)**Cost
                of services
            
            $
            8,832
            
            $
            12,611
            
            $
            3,779
            
            
            42.8
            %Selling,
                general and administrative expenses
            
            
            7,677
            
            
            6,711
            
            
            (966
            )
            
            (12.6
            )Depreciation
                and amortization
            
            
            7,228
            
            
            9,585
            
            
            2,357
            
            
            32.6Total
            
            $
            23,737
            
            $
            28,907
            
            $
            5,170
            
            
            21.8




Cost
      of
      services.    The cost of services increased 42.8% to
      $12.6 million in 2005 from $8.8 million in 2004. The acquisition of
      Mid-Missouri increased cost of services by $3.7 million. The balance of the
      increase was attributable to higher costs associated with the increase in
      Internet and cable customers and higher cable programming costs, offset
      partially by operational efficiencies and decreased telephone directory
      costs.




Selling,
      general and administrative expenses.    Selling, general and
      administrative expenses decreased 12.6% to $6.7 million in 2005 from
      $7.7 million in 2004. The acquisition of Mid-Missouri increased selling,
      general and administrative expenses by $1.2 million. The absence of one-time
      expenses associated with our initial public offering and non-cash stock option
      expense in 2005 reduced expenses by $3.0 million. In addition, public company
      expenses in 2005 were $0.8 million higher than management fees paid to a
      related party in 2004.




Depreciation
      and amortization.    Depreciation and amortization increased
      32.6% to $9.6 million in 2005 from $7.2 million in 2004. The
      acquisition of Mid-Missouri accounted for $1.6 million of the increase and
      amortization of loan costs associated with our new capital structure accounted
      for $0.5 million. The balance consisted of increased depreciation associated
      with our Alabama companies.




*Interest
      expense.* Interest
      expense in 2005 increased 344.6% to $16.4 million from $3.7 million in
      2004. The new senior and senior subordinated debt associated with our initial
      public offering generated approximately $12.3 million in additional
      interest expense. The 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 was approximately $0.3 million.




*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 combination
      of
      these factors changed the value of the derivative by $1.0 million when compared
      with the end of 2004.




*Other
      income.* Other
      income in 2005 increased 159.0% to $0.6 million from $0.2 million in
      2004. This increase was primarily attributable to the increase in patronage
      dividend income from CoBank in the first quarter of 2005.




*Income
      taxes.* Provision
      for income taxes in 2005 decreased 74.4% to $1.0 million from
      $3.9 million in 2004. This reflected the expected lower income generated
      from the capital structure associated with our initial public offering. In
      calculating the effective tax rate, the change in fair value of the derivative
      associated with the Class B common convertible to Class A common was excluded
      as
      a permanent difference. This can cause the effective rate to vary between
      periods. The effective income tax rate decreased to 31.1% in 2005 from 39.2%
      in
      2004. The effective rate difference was primarily due from the 2004
      non-deductible IPO cost and the 2005 change in fair value of
      derivative.




*Accretion
      of Class B common convertible to senior subordinated
      notes.* Our
      Class B common stock was issued to the existing 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 is being 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 higher
      in 2005 than in 2004.




25




*Net
      income.* As
      a result of the foregoing, net income in 2005 decreased to $1.8 million
      from $6.1 million in 2004.




*Year
      ended December 31, 2004 compared to year ended December 31,
      2003*




*Total
      Revenues.* Total
      revenues grew 10.4% in 2004 to $37.3 million from $33.8 million in
      2003. The table below provides the components of our revenues for 2004 compared
      to 2003.




**Year
                Ended December 31,**
            
            **Change****2003**
            
            
            **2004**
            
            
            **Amount**
            
            
            **Percent****(dollars
                in thousands)**Local
                service
            
            $
            13,090
            
            $
            13,998
            
            $
            908
            
            
            6.9
            %Network
                access
            
            
            14,701
            
            
            16,602
            
            
            1,901
            
            
            12.9Long
                distance and other telephone services
            
            
            2,571
            
            
            2,659
            
            
            88
            
            
            3.4Cable
                television
            
            
            1,748
            
            
            1,818
            
            
            70
            
            
            4.0Internet
            
            
            1,645
            
            
            2,189
            
            
            544
            
            
            33.1Total
            
            $
            33,755
            
            $
            37,266
            
            $
            3,511
            
            
            10.4




Local
      service.    Local service revenue in 2004 grew 6.9% to
      $14.0 million from $13.1 million in 2003. This increase was
      attributable to an increase of $1.1 million from the full year effect of
      the acquisition of Blountsville offset by a reduction of $0.2 million from
      an access line loss by our other rural local exchange carriers. The company
      lost
      1.2% of its access lines, partially caused by increased penetration of our
      high-speed Internet service which resulted in the loss of some second access
      lines used by customers for dial-up Internet access.




Network
      access.    Network access revenue in 2004 grew 12.9% to
      $16.6 million from $14.7 million in 2003. This increase was
      attributable to an increase of $1.3 million from the full year effect of
      the acquisition of Blountsville, $0.2 million from the acquisition of
      Mid-Missouri, and $0.4 million associated with special access trunks,
      interexchange carrier traffic, and other miscellaneous items.




Long
      distance and other telephone services.    Long distance and
      other telephone services revenue in 2004 increased 3.4% to $2.7 million
      from $2.6 million in 2003. This increase was due to the addition of over
      1,200 long distance customers in Alabama, the addition of almost 1,000 customers
      associated with the acquisition of Mid-Missouri on December 21, 2004, and
      an increase in directory advertising and inside wire maintenance revenue,
      partially offset by a reduction on other carrier billing and collection
      agreements.




Cable
      television.    Cable television revenue in 2004 increased
      4.0% to $1.8 million from $1.7 million in 2003. The increase was due
      to growth in premium and pay per view services, the partial year impact of
      a
      $2.00 per month increase in basic cable prices, and the addition of 370
      customers associated with the acquisition of Mid-Missouri on December 21,
      2004.




Internet.    Internet
      revenue in 2004 increased 33.1% to $2.2 million from $1.6 million in
      2003. This increase was attributable to the addition of almost 1,200 new
      high-speed Internet customers in Alabama and the addition of 115 high-speed
      and
      13,079 dial-up Internet customers associated with the acquisition of
      Mid-Missouri on December 21, 2004.




*Operating
      expenses.* Operating
      expenses in 2004 increased 24.7% to $23.7 million from $19.0 million
      2003. The increase was primarily attributable to the purchase of Blountsville,
      one-time initial public offering and debt retirement costs, employee stock
      option expenses, and increased costs associated with higher Internet and long
      distance revenues.




26




**Year
                  Ended December 31,**
              
              **Change****2003**
              
              
              **2004**
              
              
              **Amount**
              
              
              **Percent****(dollars
                  in thousands)**Cost
                  of services
              
              $
              7,488
              
              $
              8,832
              
              $
              1,344
              
              
              17.9
              %Selling,
                  general and administrative expenses
              
              
              5,061
              
              
              7,677
              
              
              2,616
              
              
              51.7Write-off
                  of capitalized transaction costs
              
              
              1,005
              
              
              —
              
              
              (1,005
              )
              
              (100.0
              )Depreciation
                  and amortization
              
              
              5,482
              
              
              7,228
              
              
              1,746
              
              
              31.8Total
              
              $
              19,036
              
              $
              23,737
              
              $
              4,701
              
              
              24.7




Cost
      of
      services.    The cost of services increased 17.9% to
      $8.8 million in 2004 from $7.5 million in 2003. The full year effect
      of the acquisition of Blountsville and partial year of Mid-Missouri accounted
      for $0.9 million of this increase. The balance of the increase was
      attributable to the higher costs associated with the increase in Internet and
      long distance customers.




Selling,
      general and administrative expenses.    Selling, general and
      administrative expenses increased 51.7% to $7.7 million in 2004 from
      $5.1 million in 2003. One-time selling shareholder expenses associated with
      our initial public offering, stock options expense, and increased public company
      insurance costs accounted for $2.1 million of the increase. The full year
      effect of the acquisition of Blountsville and the associated management fees
      paid to a related party accounted for $0.6 million of this
      increase.




Depreciation
      and amortization.    Depreciation and amortization increased
      31.8% to $7.2 million in 2004 from $5.5 million in 2003. The write-off
      of existing loan costs associated with the replacement of long term notes
      payable accounted for $1.0 million of the increase. The balance of the
      increase was due to the acquisition of Blountsville and increased high-speed
      Internet equipment.




*Interest
      expense.* Interest
      expense increased 8.7% to $3.7 million in 2004 from $3.4 million in
      2003. The average outstanding balance declined by $6.1 million on our
      existing long-term notes payable prior to their repayment on December 21,
      2004. Coupled with relatively stable interest rates, this reduced interest
      expense by $0.2 million. The new senior and senior subordinated debt
      associated with our initial public offering generated approximately
      $0.5 million in additional interest expense.




*Other
      income.* Other
      income decreased 16.0% to $0.2 million in 2004 from $0.3 million in
      2003. The decline was primarily attributable to the reduced patronage dividend
      income from the Rural Telephone Finance Cooperative as a result of our
      refinancing of our notes payable with another institution.




*Income
      taxes.* Income
      taxes in 2004 declined 3.9% to $3.9 million from $4.1 million in the
      2003. Our 2004 effective income tax rate increased significantly due to the
      impact of the non-deductible initial public offering expenses of
      $1.5 million. Our effective tax rate, exclusive of these expenses, was
      approximately 35.4% and 39.2% for 2003 and 2004 respectively.




*Accretion
      of Class B common convertible to senior subordinated
      notes.* Our
      Class B common stock was issued to the existing 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 will be 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.




*Net
      income.* As
      a result of the foregoing, net income in 2004 decreased 18.4% to
      $6.1 million from $7.5 million in 2003.




27




**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
      expenditure; (iii) working capital requirements; and (iv) dividend
      payments on our Class A common stock.




Cash
      flows from operating activities for 2005 amounted to $10.9 million compared
      to $18.4 million for 2004. The decrease was primarily due to the lower net
      income inherent in our new capital structure and the accrued expenses related
      to
      completing our initial public offering that were paid in the beginning of
      2005.




Cash
      used
      in investing activities for 2005 amounted to $3.6 million compared to
      $7.7 million for 2004. In 2004, we purchased an interest rate cap
      associated with our senior credit facility for $4.7 million. The
      acquisition and construction of property and equipment increased cash used
      in
      investing activities by $0.8 million and were primarily associated with the
      acquisition of Mid-Missouri. The balance of the change was associated with
      the
      elimination of a liability associated with the purchase of
      Blountsville.




Cash
      used
      in financing activities for 2005 amounted to $7.1 million compared to $6.9
      million in 2004. In 2005, the company paid dividends amounting to $6.8 million
      to the holders of its Class A common stock. In 2004, the company repaid
      $99.8 million in long-term notes payable and issued $88.5 million in 5
      and 15 year long-term notes payable. We received $12.7 million in
      proceeds and incurred fees and costs of $8.0 million in connection with the
      sale of IDSs.




Total
      capital expenditures in 2005 were $4.1 million, up $0.8 million from
      $3.3 million in 2004, reflecting the acquisition of Mid-Missouri. In 2005,
      $1.0 million was spent for upgrades to our telephone network and expansion
      of our cable network and $3.1 million was spent for upgrades to extend the
      life of existing wireline, cable and Internet facilities.




We
      currently have outstanding $80.0 million under the term loan portion of our
      credit facility that matures in 2009. Borrowings under term loan the bear
      interest at three-month LIBOR plus 4.0% (8.50% as of December 31, 2005).
      The company purchased a five year rate cap as an effective hedge against any
      increase in interest rates, capping the overall cost at 7% per year for the
      five
      years. We also have outstanding an aggregate of $81.1 million senior
      subordinated notes due 2019 which bear interest at a rate of 13%, payable
      quarterly. Our Class B common stock will be exchanged for IDSs not later
      than 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,
      2005. If unused balances on this credit facility exceed $7.5 million, we
      are charged with a .75% fee on the unused balance.




Both
      our
      credit facility and the 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 Adjusted 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, 2005, 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
                years**New
                credit facilityTerm
            
            $
            80.0
            
            $
            —
            
            $
            —
            
            $
            80.0
            
            $
            —Revolver(1)
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Senior
                subordinated notes(2)
            
            
            85.2
            
            
            —
            
            
            —
            
            
            —
            
            
            85.2Expected
                interest expense(3)
            
            
            192.9
            
            
            16.1
            
            
            33.3
            
            
            27.6
            
            
            99.6Total
                contractual cash obligations
            
            $
            358.1
            
            $
            16.1
            
            $
            33.3
            
            $
            107.6
            
            $
            184.8




(1)
            We
                have a $15.0 million revolving credit facility with a four year
                maturity available. No amounts were drawn on this facility on
                December 31, 2005 or during 2005. The company pays a commitment fee
                of 0.75% 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, 2006, the earliest date they can be exchanged
                for IDSs on a one-for-one basis.




(3)
            Expected
                interest payments to be made in future periods reflect anticipated
                interest payments related to our $80.0 million senior credit facility
                at 7.0% and our $85.2 million senior subordinated notes at 13.0%,
                including those associated with our IDSs and those sold separately.
                We
                have assumed in the presentation above that we will hold the senior
                credit
                facility until maturity in 2009 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.




**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 SFAS No. 71, *Accounting
      for The Effects of Certain Types of Regulations* ,
      or SFAS
      71. This accounting 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 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.




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. 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 telecommunications property and equipment at fair value as
      required by SFAS No. 141, *Business
      Combinations,* or
      SFAS 141. 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. We
      have
      acquired identifiable intangible assets associated with the territories we
      serve
      through our acquisitions of various companies. Any excess of the total purchase
      price over the amounts assigned to net tangible and intangible assets is
      recorded as goodwill.




29




*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.




Network
      access revenue is derived from several sources. Compensation for interstate
      access services is received through tariffed access charges filed by the
      National Exchange Carrier Association, or NECA, with the FCC on behalf of the
      NECA member companies. These access charges are billed by us to interstate
      interexchange carriers and pooled with like-revenues from all NECA member
      companies. A portion of the pooled access charge revenue received by us is
      based
      upon our 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 us is based upon the nationwide average
      schedule costs of providing interstate access services. In Alabama and Missouri,
      compensation for intrastate access services is received through tariffed access
      charges filed with the APSC and MPSC respectively. These access charges are
      billed by us to intrastate interexchange carriers and retained by us. In
      addition, our Alabama companies receive payments for access services provided
      to
      BellSouth Telecommunications, Inc., or BellSouth, which serves as the
      primary intraLATA toll provider to our customers. In addition, Otelco Telephone,
      Hopper, Brindlee and Blountsville recover a portion of their costs for providing
      access through the TSF, which is administered by the APSC.




Long
      distance service is billed to customers in arrears based on actual usage. We
      record unbilled long distance revenue as unbilled revenue when services are
      rendered.




Cable
      television and Internet service revenues are recognized when services are
      rendered.




*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* ,
      or
      SFAS 144. 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.




*Option-Based
      Compensation.* We
      accounted for our option-based compensation plan based on variable accounting
      in
      accordance with Accounting Principles Board (APB) Opinion No. 25, *Accounting
      for Stock Issued to Employees* ,
      or APB
      25. The option plan included a cashless exercise feature that allowed option
      holders to provide payment upon exercise of vested options in the form of cash,
      units or options for units. As a result of applying variable accounting, we
      recognized compensation expense based on the estimated fair market value of
      a
      membership unit at each period and at the offering price of the IDSs upon
      conversion coincident with our initial public offering on December 21,
      2004, at which time all options were exercised. As of December 31, 2005, we
      do not have an option plan.




*Accounting
      Treatment for Class B Common Stock.* In
      connection with our initial public offering, we issued shares of Class B
      common stock. In general, beginning on December 21, 2006, and subject to a
      financial test and other conditions, our Class B common stock will be
      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
      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 based upon the present value of the par amount of
      the
      senior subordinated notes discounted for the two year period from their issuance
      to the date the exchange option is exercisable using the interest rate of the
      senior subordinated notes. This obligation is labeled “Class B common
      convertible to senior subordinated notes.” During this period, the Class B
      common convertible to senior subordinated notes will be 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 operations 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.




*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.




*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
      five
      year interest rate cap agreement 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 7.0% per annum for the five year term of our credit facility.
      This
      hedge is considered to be effective as all the critical terms noted in the
      interest rate cap are be 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.




31




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
      derivative asset will be reflected in other comprehensive income in each
      respective period.




**New
      Accounting Standards**




*FASB
      Statement No. 123 (R), Share Based Payment.* In
      December 2004, the FASB issued a revision to SFAS No. 123, “Accounting for
      Stock-Based Compensation” (SFAS No. 123R, “Share Based Payment”). SFAS 123R
      requires that all share-based compensation expense be recognized in an amount
      equal to the fair value of share-based payments as of the grant date fair value
      of the payment. Companies will be required to use an option pricing model to
      determine compensation expense, consistent with the model in the already
      required disclosures of SFAS No. 148, “Accounting for Sotck-Based Compensation -
      Transition and Disclosure.” This standard is effective for the company in 2006,
      however it will not have a material effect on the company as there are no
      outstanding options or warrants.




*Exposure
      Draft - Uncertain Tax Positions - Interpretation of FASB No. 109.* On
      July
      14, 2005, the FASB issued an exposure draft, “Accounting for Uncertain Tax
      Positions,” of the proposed interpretation of FASB No. 109, “Accounting for
      Income Taxes.” Companies would be required to recognize in the financial
      statements, the best estimate of the impact of a tax position only if it is
      probable that the position would be sustained on audit based solely on the
      technical merits of the position. The term probable is used in this proposed
      Interpretation as it is used in FASB Statement No. 5, “Accounting for
      Contingencies,” to mean “the future event or events are likely to occur.” This
      proposed Interpretation would require the presumption that the tax position
      will
      be evaluated during an audit by taxing authorities. A final Interpretation
      is
      expected to be released in first quarter of 2006. We are in the process of
      evaluating the impact of this interpretation.




*FASB
      Statement No. 154, Accounting Changes and Error Corrections.* In
      May
      2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections.”
This Statement replaces APB Opinion No.20, “Accounting Changes” and FAS No.3,
“Reporting Accounting Changes in Interim Financial Statements,” and changes the
      accounting for and reporting of a change in accounting principle. This Statement
      applies to all voluntary changes in accounting principle and changes required
      by
      accounting pronouncement when specific transition provisions are not provided.
      Retrospective application to all prior periods’ financial statements is required
      for a change in accounting principle, unless it is impracticable to determine
      the prior period specific effects or cumulative effect of the change. This
      Statement carries forward without change the guidance from APB 20 regarding
      the
      correction of error in previously issued financial statements and the reporting
      of a change in accounting estimate. SFAS 154 is effective for the accounting
      changes and corrections of errors made in fiscal years beginning after December
      15, 2005.




**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. 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 the change in LIBOR or a base rate. Currently, we have
      no
      loans drawn under this facility.




**Item
                8.**
            **Financial
                Statements and Supplementary
                Data**




**Management’s
      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 and 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:




32




§
            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 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, 2005. In making this
      assessment, the company’s management used the criteria set forth by the
      Committee of Sponsoring Organizations of the Treadway Commission (COSO) in *Internal
      Control−Integrated Framework* .




Based
      upon its assessment, management concluded that, as of December 31, 2005, the
      company’s internal control over financial reporting is effective based upon
      those criteria.




Management’s
      assessment of the effectiveness of the company’s internal control over financial
      reporting as at December 31, 2005 has been audited by BDO Seidman, LLP, an
      independent registered public accounting firm, as stated in their report which
      appears herein.




33




**Report
      Of Independent Registered Public Accounting Firm**


**On
      Internal Control Over Financial Reporting**




To
      the
      Board of Directors and Stockholders


of
      Otelco
      Inc.


Oneonta,
      Alabama




We
      have
      audited management’s assessment, included in Management’s Annual Report on
      Internal Control Over Financial Reporting in Item 8 of Form 10-K, that Otelco
      Inc. (the “Company”) maintained effective internal control over financial
      reporting as of December 31, 2005, based on criteria established in *Internal
      Control - Integrated Framework* issued
      by
      the Committee of Sponsoring Organizations of the Treadway Commission. The
      Company’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. Our responsibility is to express an opinion
      on
      management’s assessment and an opinion on the effectiveness of 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, evaluating management’s assessment, testing and evaluating
      the design and operating effectiveness of internal control, and 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; and
      (2)
      provide reasonable assurance that transactions are recorded as necessary to
      permit preparation of financial statements 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.




In
      our
      opinion, management’s assessment that the Company maintained effective internal
      control over financial reporting as of December 31, 2005, is fairly stated,
      in
      all material respects, based on *Internal
      Control - Integrated Framework* issued
      by the Committee of Sponsoring Organizations of the Treadway Commission. Also
      in
      our opinion, the Company maintained, in all material respects, effective
      internal control over financial reporting as of December 31, 2005, based on *Internal
      Control - Integrated Framework* issued
      by the Committee of Sponsoring Organizations of the Treadway
      Commission.




We
      have
      also 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, 2005 and 2004 and the related consolidated statements of
      income, stockholder’s equity and cash flows for each of the three years in the
      period ended December 31, 2005 and our report dated February 16, 2006 expressed
      an unqualified opinion thereon.





Atlanta,
      Georgia


February
      16, 2006




34




**Consolidated
      Financial Statements:**


PageReport
                  of Independent Registered Public Accounting Firm
              36Consolidated
                  Balance Sheets
              37Consolidated
                  Statements of Income
              38Consolidated
                  Statements of Changes in Stockholders’ Equity
              39Consolidated
                  Statements of Cash Flow
              40Notes
                  to Consolidated Financial Statements
              41




35


**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, 2005 and 2004 and the related consolidated statements of income,
      stockholders’ equity, and cash flows for each of the three years in the period
      ended December 31, 2005. 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,
      2005 and 2004, and the results of its operations and its cash flows for each
      of
      the three years in the period ended December 31, 2005 **,** 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), the effectiveness of Otelco Inc.’s internal
      control over financial reporting as of December 31, 2005, based on criteria
      established in *Internal
      Control - Integrated Framework* issued
      by
      the Committee of Sponsoring Organizations of the Treadway Commission (COSO)
      and
      our report dated February 16, 2006 expressed an unqualified opinion
      thereon.








Atlanta,
      Georgia


February
      16, 2006




36


**OTELCO
      INC.**




**CONSOLIDATED
      BALANCE SHEETS**




**December
                31,****2004**
            
            **2005****Assets**Current assetsCash
                and cash equivalents
            
            $
            5,406,545
            
            $
            5,569,233Accounts
                receivable:Due
                from subscribers, net of allowance for doubtful accounts of $160,270
                and
                $163,028 respectively
            
            
            1,179,074
            
            
            1,212,909Unbilled
                receivables
            
            
            1,884,405
            
            
            1,828,104Other
            
            
            1,522,945
            
            
            1,482,171Materials
                and supplies
            
            
            1,039,910
            
            
            932,861Prepaid
                expenses
            
            
            537,784
            
            
            504,256Income
                tax receivables
            
            
            —
            
            
            749,591Deferred
                income taxes
            
            
            652,625
            
            
            872,675Total
                current assets
            
            
            12,223,288
            
            
            13,151,800Property
                and equipment, net
            
            
            48,195,568
            
            
            44,555,611Goodwill
            
            
            119,714,094
            
            
            119,431,993Intangible
                assets, net
            
            
            2,050,943
            
            
            1,588,079Investments
            
            
            1,298,852
            
            
            1,108,249Deferred
                financing costs
            
            
            8,020,743
            
            
            6,971,610Interest
                rate cap
            
            
            4,723,135
            
            
            5,318,728Total
                assets
            
            $
            196,226,623
            
            $
            192,126,070**Liabilities
                and Stockholders’ Equity**Current
                liabilitiesAccounts
                payable
            
            
            2,690,351
            
            
            1,106,114Accrued
                expenses
            
            
            1,862,604
            
            
            1,692,841Advance
                billings and payments
            
            
            1,141,013
            
            
            1,204,680Customer
                deposits
            
            
            220,209
            
            
            213,524Total
                Current Liabilities
            
            
            5,914,177
            
            
            4,217,159Deferred
                income taxes
            
            
            13,053,226
            
            
            15,345,890Other
                liabilities
            
            
            196,644
            
            
            192,769Total
                deferred tax and other liabilities
            
            
            13,249,870
            
            
            15,538,659Long-term
                notes payable
            
            
            161,075,498
            
            
            161,075,498Derivative
                liability
            
            
            2,788,716
            
            
            1,830,095Class
                B common convertible to senior subordinated notes
            
            
            3,212,528
            
            
            3,655,454Stockholders’
                EquityClass
                A Common Stock, $.01 par value-authorized 20,000,000 shares; issued
                and
                outstanding, 9,676,733 shares
            
            
            96,767
            
            
            96,767Class
                B Common Stock, $.01 par value-authorized 800,000 shares; issued
                and
                outstanding, 544,671 shares
            
            
            5,447
            
            
            5,447Additional
                paid in capital
            
            
            12,435,800
            
            
            5,613,703Retained
                earnings (deficit)
            
            
            (2,597,315
            )
            
            (805,731
            )Accumulated
                other comprehensive income
            
            
            45,135
            
            
            899,019Total
                stockholders’ equity
            
            
            9,985,834
            
            
            5,809,205Total
                liabilities and stockholders’ equity
            
            $
            196,226,623
            
            $
            192,126,070




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





37


**OTELCO
      INC.**




**CONSOLIDATED
      STATEMENTS OF INCOME**




**Years
                Ended December 31,****2003**
            
            **2004**
            
            **2005**RevenuesLocal
                service
            
            $
            13,090,059
            
            $
            13,997,938
            
            $
            14,175,743Network
                access
            
            
            14,700,862
            
            
            16,602,572
            
            
            21,873,485Long
                distance and other telephone services
            
            
            2,571,311
            
            
            2,659,418
            
            
            3,269,490Cable
                television
            
            
            1,747,514
            
            
            1,817,711
            
            
            2,086,854Internet
            
            
            1,645,118
            
            
            2,188,703
            
            
            5,566,650Total
                revenues
            
            
            33,754,864
            
            
            37,266,342
            
            
            46,972,222Operating
                expensesCost
                of services and products
            
            
            7,488,091
            
            
            8,831,951
            
            
            12,611,499Selling,
                general and administrative expenses
            
            
            5,061,499
            
            
            7,676,496
            
            
            6,710,542Write-off
                of capitalized transaction costs
            
            
            1,004,965
            
            
            —
            
            
            —Depreciation
                and amortization
            
            
            5,481,779
            
            
            7,228,472
            
            
            9,585,299Total
                operating expenses
            
            
            19,036,334
            
            
            23,736,919
            
            
            28,907,340Income
                from operations
            
            
            14,718,530
            
            
            13,529,423
            
            
            18,064,882Other
                income (expense)Interest
                expense
            
            
            (3,383,876
            )
            
            (3,678,691
            )
            
            (16,355,087
            )Change
                in fair value of derivative
            
            
            —
            
            
            —
            
            
            958,621Other
                income
            
            
            265,537
            
            
            223,104
            
            
            577,769Total
                other expense
            
            
            (3,118,339
            )
            
            (3,455,587
            )
            
            (14,818,697
            )Income
                before income tax and accretion expense
            
            
            11,600,191
            
            
            10,073,836
            
            
            3,246,185Income
                tax expense
            
            
            (4,107,275
            )
            
            (3,946,625
            )
            
            (1,011,675
            )Income
                before accretion expense
            
            $
            7,492,916
            
            $
            6,127,211
            
            $
            2,234,510Accretion
                of Class B common convertible to senior subordinated notes
            
            
            —
            
            
            (13,348
            )
            
            (442,926
            )Net
                income available to common stockholders
            
            $
            7,492,916
            
            $
            6,113,863
            
            $
            1,791,584Weighted
                average shares outstanding:Basic
            
            
            8,054,841
            
            
            8,103,720
            
            
            9,676,733Diluted
            
            
            8,557,304
            
            
            8,607,455
            
            
            10,221,404Basic
                net income per share
            
            $
            0.93
            
            $
            0.75
            
            $
            0.19Diluted
                net income per share
            
            $
            0.88
            
            $
            0.71
            
            $
            0.12Dividends
                declared per share
            
            
            —
            
            
            —
            
            $
            0.71





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




38


**OTELCO
      INC.**




**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY**




**Members’**
              
              **Class
                    A**
                  **Common
                    Stock**
              
              **Class
                    B**
                  **Common
                    Stock**
              
              
              **Additional
                  Paid In**
              
              
              **Retained
                  Earnings**
              
              
              **Accumulated
                  Other Comprehensive**
              
              
              **Total**
                **Stockholders’****Equity**
              
              
              **Shares**
              
              
              **Amount**
              
              
              **Shares**
              
              
              **Amount**
              
              
              **Capital**
              
              
              **(Deficit)**
              
              
              **Income**
              
              
              **Equity**Balance,
                  December 31, 2002
              
              $
              39,000,010
              
              
              
              
              $
              —
              
              
              
              
              $
              —
              
              $
              —
              
              $
              7,425,496
              
              $
              —
              
              $
              46,425,506Comprehensive
                  income:Net
                  income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              7,492,916
              
              
              
              
              
              7,492,916Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              7,492,916Balance,
                  December 31, 2003
              
              $
              39,000,010
              
              
              
              
              $
              —
              
              
              
              
              $
              —
              
              $
              —
              
              $
              14,918,412
              
              $
              —
              
              $
              53,918,422Comprehensive
                  income:Net
                  income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              6,113,863
              
              
              
              
              
              6,113,863Interest
                  rate cap
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              45,135
              
              
              45,135Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              6,158,998*Conversion
                  Of Equity*Conversion
                  of membership units into IDSs and Class B common
                  stock
              
              
              (39,000,010
              )
              
              7,853,994
              
              
              78,540
              
              
              489,926
              
              
              4,899
              
              
              (22,866,228
              )
              
              —
              
              
              —
              
              
              (61,782,799
              )Embedded
                  exchange feature of Class B common stock
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              —
              
              
              (2,572,611
              )
              
              —
              
              
              (2,572,611
              )Vesting
                  and conversion into IDSs and Class B common stock of option
                  shareholders
              
              
              
              
              
              200,847
              
              
              2,008
              
              
              12,537
              
              
              125
              
              
              (1,581,919
              )
              
              
              
              
              
              
              
              (1,579,786
              )Stock
                  options exercised
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              3,391,168
              
              
              
              
              
              
              
              
              3,391,168Adjust
                  for negative balance APIC
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              21,056,979
              
              
              (21,056,979
              )
              
              
              
              
              —*Acquisition
                  of Mid Missouri*Issuance
                  of IDSs and Class B common stock for acquisition and conversion of
                  option holders
              
              
              
              
              
              856,234
              
              
              8,562
              
              
              53,413
              
              
              534
              
              
              6,884,642
              
              
              —
              
              
              —
              
              
              6,893,738Embedded
                  exchange feature of Class B common stock
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (273,475
              )
              
              —
              
              
              —
              
              
              (273,475
              )*Initial
                  Public Offering*Issuance
                  of IDSs
              
              
              
              
              
              830,776
              
              
              8,308
              
              
              —
              
              
              —
              
              
              6,388,667
              
              
              —
              
              
              —
              
              
              6,396,975Repurchase
                  and retirement of IDSs and Class B common stock
              
              
              
              
              
              (65,118
              )
              
              (651
              )
              
              (11,205
              )
              
              (111
              )
              
              (671,725
              )
              
              —
              
              
              —
              
              
              (672,487
              )Embedded
                  exchange feature of Class B common stock
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              57,370
              
              
              —
              
              
              —
              
              
              57,370Discount
                  on repurchase of shares
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              193,553
              
              
              
              
              
              
              
              
              193,553Capitalized
                  transactions costs offset against proceeds of offering
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (143,232
              )
              
              —
              
              
              —
              
              
              (143,232
              )Balance,
                  December 31, 2004
              
              $
              —
              
              
              9,676,733
              
              $
              96,767
              
              
              544,671
              
              $
              5,447
              
              $
              12,435,800
              
              $
              (2,597,315
              )
              $
              45,135
              
              $
              9,985,834Comprehensive
                  income:Net
                  Income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,791,584
              
              
              
              
              
              1,791,584Interest
                  rate cap
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              853,884
              
              
              853,884Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              2,645,468Dividends
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (6,822,097
              )
              
              
              
              
              
              
              
              (6,822,097
              )Balance,
                  December 31, 2005
              
              $
              —
              
              
              9,676,733
              
              $
              96,767
              
              
              544,671
              
              $
              5,447
              
              $
              5,613,703
              
              $
              (805,731
              )
              $
              899,019
              
              $
              5,809,205




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




39


**OTELCO
      INC.**




**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**





**2003**
            
            **2004**
            
            **2005**Cash
                flows from operating activities:Net
                income (loss)
            
            $
            7,492,916
            
            $
            6,113,863
            
            $
            1,791,584Adjustments
                to reconcile net income to cash flows from operating
                activities:Depreciation
            
            
            5,107,110
            
            
            5,837,033
            
            
            7,748,687Amortization
            
            
            374,669
            
            
            1,391,438
            
            
            1,836,612Interest
                rate caplet
            
            
            —
            
            
            —
            
            
            258,291Stock
                based compensation expense
            
            
            1,025,934
            
            
            1,493,985
            
            
            —Accretion
                expense
            
            
            —
            
            
            13,348
            
            
            442,924Change
                in fair value of derivative
            
            
            —
            
            
            —
            
            
            (958,621
            )Loss
                on sale of assets
            
            
            50,459
            
            
            —
            
            
            —Provision
                for deferred income taxes
            
            
            3,152,980
            
            
            3,042,751
            
            
            2,072,614Provision
                for uncollectible revenue
            
            
            31,243
            
            
            107,224
            
            
            124,367Changes
                in assets and liabilities; net of assets and liabilities
                acquired:Accounts
                receivables
            
            
            795,801
            
            
            214,940
            
            
            (61,126
            )Material
                and supplies
            
            
            42,001
            
            
            200,232
            
            
            107,049Prepaid
                expenses and other assets
            
            
            (213,230
            )
            
            (16,716
            )
            
            33,531Income
                tax receivables
            
            
            —
            
            
            —
            
            
            (749,591
            )Accounts
                payable and accrued liabilities
            
            
            (756,822
            )
            
            (28,271
            )
            
            (1,501,584
            )Advance
                billings and payments
            
            
            36,702
            
            
            (2,583
            )
            
            63,667Other
                liabilities
            
            
            (17,927
            )
            
            (23,014
            )
            
            (10,561
            )Net
                cash from operating activities
            
            
            17,121,836
            
            
            18,344,230
            
            
            11,197,843Cash
                flows from investing activities:Purchase
                of interest rate cap
            
            
            —
            
            
            (4,678,000
            )
            
            —Acquisition
                and construction of property and equipment
            
            
            (3,838,477
            )
            
            (3,261,177
            )
            
            (4,083,222
            )Cash
                received from acquisition
            
            
            —
            
            
            50,633
            
            
            —Proceeds
                from retirement of investment
            
            
            —
            
            
            116,334
            
            
            165,094Payments
                for the purchase of Mid-Missouri Holding Corp., net of cash
                acquired
            
            
            —
            
            
            —
            
            
            29,683Payment
                for the purchase of Page & Kiser Communications, Inc., net of cash
                acquired
            
            
            (15,207,565
            )
            
            47,858
            
            
            —Net
                cash from investing activities
            
            
            (19,046,042
            )
            
            (7,724,352
            )
            
            (3,888,445
            )Cash
                flows from financing activities:Cash
                dividends paid
            
            
            —
            
            
            —
            
            
            (6,822,097
            )Proceeds
                from long-term notes payable
            
            
            12,000,000
            
            
            88,500,000
            
            
            —Loan
                origination costs and transaction costs
            
            
            (327,836
            )
            
            (8,060,735
            )
            
            (324,613
            )Repayment
                of long-term notes payable
            
            
            (10,419,840
            )
            
            (99,787,468
            )
            
            —Repurchase
                and retirement of IDSs and Class B common stock
            
            
            —
            
            
            (1,090,503
            )
            
            —Proceeds
                from issuances of Income Deposit Securities
            
            
            —
            
            
            13,718,298
            
            
            —Direct
                cost of initial public offering
            
            
            —
            
            
            (143,232
            )
            
            —Net
                cash from financing activities
            
            
            1,252,324
            
            
            (6,863,640
            )
            
            (7,146,710
            )Net
                (decrease) increase in cash and cash equivalents
            
            
            (671,882
            )
            
            3,756,238
            
            
            162,688Cash
                and cash equivalents, beginning of period
            
            
            2,322,189
            
            
            1,650,307
            
            
            5,406,545Cash
                and cash equivalents, end of period
            
            $
            1,650,307
            
            $
            5,406,545
            
            $
            5,569,233Supplemental
                disclosures of cash flow information:Interest
                paid
            
            $
            4,426,187
            
            $
            3,114,381
            
            $
            16,343,237Income
                taxes paid (received)
            
            $
            948,000
            
            $
            1,581,026
            
            $
            (651,536
            )Supplemental
                disclosures of noncash financing activities:Issuance
                of IDSs and assumption of notes payable in connection with
                acquisition
            
            $
            —
            
            $
            30,540,774
            
            $
            —Issuance
                of IDSs in connection with option plan
            
            $
            —
            
            $
            3,391,168
            
            $
            —Embedded
                exchange feature of Class B common stock
            
            $
            —
            
            $
            2,788,716
            
            $
            —Supplemental
                disclosures of noncash investing activities:Adjustment
                for the purchase price of Page & Kiser Communications,
                Inc.
            
            $
            —
            
            $
            —
            
            $
            252,418





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




40




**1.**  **Summary
      of Significant Accounting Policies**




***Nature
      of Business***




Otelco’s
      principal line of business is providing local telephone service, long distance,
      cable television and high-speed and dial-up Internet access. The principal
      markets for these services are local residential and business customers residing
      in and adjacent to the exchanges the Company serves in rural Alabama and
      Missouri. The Company offers various communications services that are sold
      to
      economically similar customers in a comparable manner of distribution. 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 Otelco Inc. (the
      “Company”), its wholly owned subsidiaries Otelco Telecommunications LLC (“OTC”),
      Otelco Telephone LLC (“OTP”), Hopper Holding Company, Inc. (“HHC”), and Brindlee
      Holdings LLC (“BH”). HHC’s wholly owned subsidiary is Hopper Telecommunications
      Company, Inc. (“HTC”). BH’s wholly owned subsidiary is Brindlee Mountain
      Telephone Company, Inc. (“BMTC”). On June 30, 2003, the Company purchased Page
& Kiser Communications, Inc. (“PKC”), which is reflected in the 2003 results
      from the date acquired. PKC’s wholly owned subsidiary is Blountsville Telephone
      Company, Inc. (“BTC”). On December 21, 2004, the Company purchased Mid-Missouri
      Holding Corporation (“MMH”), which is reflected in the 2004 results from the
      date acquired. MMH’s wholly owned subsidiary is Mid-Missouri Telephone Company
      (“MMT”). MMT is the sole stockholder of Imagination, Inc., which provides
      internet services in certain locations in Missouri. The accompanying
      consolidated financial statements include the accounts of the Company and all
      of
      its 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 SAFS
      71. This accounting 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.




41




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. 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 telecommunications property and equipment at fair value
      as required by SFAS No.141, *Business
      Combinations* .
      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. The Company
      has
      acquired identifiable intangible assets associated with the territories it
      serves through its acquisitions of various companies. Any excess of the total
      purchase price over the amounts assigned to tangible and definable assets is
      recorded as goodwill.




Effective
      January 1, 2002, the Company adopted SFAS No. 142, Goodwill and Other Intangible
      Assets, 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 in the event that triggers an impairment event. 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. 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 its
      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. 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.




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. 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. Revenue for intrastate/intraLATA
      access service is received under a Primary Carrier Plan. These access charges
      are billed by the Company to the primary intraLATA interexchange carriers using
      tariffed access rates filed with the Alabama Public Service Commission (“APSC”)
      and the Missouri Public Service Commission (“MPSC”) and are retained by the
      Company. Revenue for the intrastate/interLATA access service is received through
      tariffed access charges as filed with the APSC and MPSC. These access charges
      are billed to the interLATA interchange 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.




42




Long
      distance services. Long distance service is billed to customers in arrears
      based
      on actual usage. The Company records unbilled long distance revenue as unbilled
      revenue when services are rendered.




Cable
      television and Internet services. Cable television and Internet service revenues
      are recognized when services are rendered.




***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 a first-in, first-out method of valuation.




***Property
      and Equipment***




Property
      and equipment is stated at original cost. 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 is computed principally using the straight-line method
      over useful lives determined by the APSC and MPSC, as discussed
      above.




***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.




***Deferred
      Financing Costs***




Deferred
      financing costs consist of debt issuance costs incurred in obtaining long-term
      financing, which are amortized over the life of the related debt.




***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 and adjusted
      to
      fair value as of December 21, 2004 at the time of our initial public offering
      with an offsetting entry to retained earnings. This liability will be adjusted
      to estimated fair value on each subsequent balance sheet date until the shares
      are converted with the offset to other non-operating income or expense. In
      addition, the company has an effective hedge of its interest rates - see Note
      9.




43




We
      are
      exposed to the market risk of adverse changes in interest rates. On December
      21,
      2004, the Company purchased an interest rate cap with a notional amount of
      $80
      million, 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 7% should
      variable interest rates rise, but enable us otherwise to take advantage of
      current lower market interest rates. The interest rate cap is an effective
      hedge
      in offsetting the potential variability of interest rates and all critical
      terms
      of 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. The cost of the interest
      rate cap is expensed as interest over the effective life of the hedge in
      accordance with its quarterly future value at the date of
      inception.




***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.




***Fair
      Value of Financial Instruments***




The
      carrying value of the Company’s financial instruments, including cash and cash
      equivalents, accounts receivable, accounts payable and long-term notes payable
      approximate their net book value as of December 31, 2004 and 2005.




***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
      the
      retained earnings but excluded from net income.




***Option-Based
      Compensation***




Until
      December 21, 2004, the Company had one member unit-based employee compensation
      plan, which is described more fully in Note 14. The Company accounted for its
      plan under the intrinsic value recognition and measurement principles of
      Accounting Principles Board (“APB”) Opinion No. 25 (“APB 25”), *Accounting
      for Stock Issued to Employees,* or APB
      25 and related interpretation. On December 21, 2004, under the terms of the
      plan, a change in ownership caused the options to fully vest. The options under
      this plan were converted into IDSs and the plan was terminated.




***Income
      per Common Share***




The
      Company computes net income (loss) 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.




44




***Recent
      Accounting Pronouncements***




*FASB
      Statement No. 123 (R), Share Based Payment.* In
      December 2004, the FASB issued a revision to SFAS No. 123, “Accounting for
      Stock-Based Compensation” (SFAS No. 123R, “Share Based Payment”). SFAS 123R
      requires that all share-based compensation expense be recognized in an amount
      equal to the fair value of share-based payments as of the grant date fair value
      of the payment. Companies will be required to use an option pricing model to
      determine compensation expense, consistent with the model in the already
      required disclosures of SFAS No. 148, “Accounting for Sotck-Based Compensation -
      Transition and Disclosure.” This standard interpretation is effective for the
      company in 2006, however it will not have a material effect on the Company
      as
      there are no outstanding options or warrants.




*Exposure
      Draft - Uncertain Tax Positions - Interpretation of FASB No. 109.* On
      July
      14, 2005, the FASB issued an exposure draft, “Accounting for Uncertain Tax
      Positions,” of the proposed interpretation of FASB No. 109, “Accounting for
      Income Taxes.” Companies would be required to recognize in the financial
      statements, the best estimate of the impact of a tax position only if it is
      probable that the position would be sustained on audit based solely on the
      technical merits of the position. The term probable is used in this proposed
      Interpretation as it is used in FASB Statement No. 5, “Accounting for
      Contingencies,” to mean “the future event or events are likely to occur.” This
      proposed Interpretation would require the presumption that the tax position
      will
      be evaluated during an audit by taxing authorities. A final Interpretation
      is
      expected to be released in first quarter of 2006. The company is in the process
      of evaluating the impact of this interpretation.




*FASB
      Statement No. 154, Accounting Changes and Error Corrections.* In
      May
      2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections.”
This Statement replaces APB Opinion No.20, “Accounting Changes” and FAS No.3,
“Reporting Accounting Changes in Interim Financial Statements,” and changes the
      accounting for and reporting of a change in accounting principle. This Statement
      applies to all voluntary changes in accounting principle and changes required
      by
      accounting pronouncement when specific transition provisions are not provided.
      Retrospective application to all prior periods’ financial statements is required
      for a change in accounting principle, unless it is impracticable to determine
      the prior period specific effects or cumulative effect of the change. This
      Statement carries forward without change the guidance from APB 20 regarding
      the
      correction of error in previously issued financial statements and the reporting
      of a change in accounting estimate. SFAS 154 is effective for the accounting
      changes and corrections of errors made in fiscal years beginning after December
      15, 2005.




***Reclassifications***




Certain
      items in prior year’s financial statements have been reclassified to conform
      with the presentation used in 2005.




**2.**  **Initial
      Public Offering**




On
      December 16, 2004, the SEC declared the Company’s Income Deposit Securities
      (IDSs) registration effective and public trading of the Company’s IDSs
      commenced. Prior to the closing of the offering, the Company converted from
      a
      Delaware limited liability company to a Delaware corporation and changed its
      name to Otelco Inc. Certain activities occurred simultaneously with the
      offering, including a recapitalization of debt, our equity conversion to a
      Delaware corporation, the acquisition of Mid-Missouri Telephone Company and
      offering IDSs to the public.




IDSs
      are
      securities consisting of Class A common stock and senior subordinated notes.
      Each IDS represents:




·
            one
                share of our Class A common stock;
                and




·
            a
                13% senior subordinated note with a $7.50 principal
                amount.




The
      initial public offering closed on December 21, 2004. The offering consisted
      of:




45




·
            9,331,513
                IDSs, representing 9,331,513 shares of Class A common stock and
                $69,986,348 aggregate principal amount of senior subordinated notes,
                at an
                initial public offering price of $15.20 per IDS (comprised of $7.70
                allocated per share of Class A common stock and $7.50 allocated per
                senior
                subordinated note); and




·
            $8,500,000
                aggregate principal amount of senior subordinated notes sold separately
                (not in the form of IDSs).




A
      summary
      of the Class A common stock associated with the IDSs included in the public
      offering follows:




Shares
                sold by existing equity investors
            
            
            7,828,224Shares
                sold in conjunction with overallotment by existing equity
                investors
            
            
            672,513Shares
                sold by the Company
            
            
            830,776Shares
                sold in initial public offering
            
            
            9,331,513Shares
                retained by existing equity investors and employees
            
            
            345,220Total
                Class A outstanding
            
            
            9,676,733




Net
      proceeds from the 830,776 shares sold by the Company of $12,627,795 were
      allocated to the senior subordinated notes portion of the IDSs and the Class
      A
      common stock portion in amounts of $6,230,820 and $6,338,667, respectively,
      based on the fair value of these instruments.




Included
      in the 9,331,513 IDSs were 8,054,841 shares of Class A common stock and 502,463
      shares of Class B common stock, which represented our conversion from a Delaware
      limited liability company to a Delaware corporation and the conversion of our
      2,512,699 outstanding membership interests and 97,365 outstanding options to
      acquire membership interests. We recorded $60,411,308 to reflect the senior
      subordinated notes portion of the IDSs at fair value.




In
      conjunction with the public offering, the Company acquired Mid-Missouri in
      a
      business combination accounted for based on the purchase method of accounting
      under SFAS 141. The Company issued 856,234 shares of Class A common stock and
      53,413 shares of Class B common stock and assumed $16,714,140 in notes payable
      for a total purchase price of $30,540,774. As part of the acquisition, the
      Company also issued 5,527 IDS for the vesting of Mid-Missouri’s option plan. See
      Note 3 for additional disclosure related to the acquisition of
      Mid-Missouri.




Class
      A
      and Class B common stock carry identical voting rights. In conjunction with
      our
      public offering, we amended our articles of incorporation to prohibit
      participation in dividends and other distributions to our Class B holders.
      Each
      outstanding share of our common stock will carry one vote per share and all
      classes of common stock will vote as a single class on all matters presented
      to
      the stockholders for a vote.




Class
      B
      common stock will be exchangeable on a one-for-one basis for IDSs at the
      holder’s option, upon our liquidation or during specified period beginning
      December 21, 2006 subject to certain conditions. The conditions to such exchange
      include a financial test related to Adjusted EBITDA (as such term is defined
      in
      the indenture governing the notes). After five years, the Adjusted EBITDA test
      will no longer apply and the Class B common stock will be exchangeable for
      IDSs
      at the option of the holder subject only to the satisfaction of the other
      conditions to such exchange.




The
      Class
      A and Class B common stock was recorded at the carryover basis of existing
      investor’s equity. We recorded a $21,056,979 reduction to retained earnings to
      eliminate deficiency in additional paid-in capital resulting from the
      conversion.




The
      Company discounted to present value the potential debt issuance on conversion
      of
      Class B common stock to IDSs at a discount rate equal to the interest rate
      on
      the senior subordinated notes. The fair value of the senior subordinated notes
      payable associated with the Class B common stock is recorded in the mezzanine
      section of the consolidated balance sheets.




46




As
      previously described, the holders of Class B common stock have the right to
      exchange their shares for IDSs. This exchange right is an embedded derivative
      feature that is required to be separately accounted for as a liability and
      measured at fair value. In connection with the issuance of Class B common stock
      and related partial repurchase, the Company has reflected the initial fair
      value
      of the exchange right as a long-term liability and reduction of retained
      earnings and additional paid in capital of $2,788,716. The derivative is not
      considered a hedge and thus does not qualify for hedge accounting under SFAS
      133. The Company will adjust on a quarterly basis the derivative liability
      to
      fair value with a corresponding gain or loss recorded in other income (expenses)
      in the consolidated statements of income.




A
      summary
      of shares issued by activity is provided. The impact of conversion of options
      is
      included in our conversion and the purchase of Mid-Missouri. The repurchase
      and
      retirement of IDSs and Class B common stock shown below was associated with
      the
      tax impact of the cashless exercise of management options as part of the
      existing option plan.




Class
                A
            
            Class
                BConversion
                to Delaware Corporation
            
            
            8,054,841
            
            
            502,463Acquisition
                of Mid-Missouri
            
            
            856,234
            
            
            53,413Company
                offered shares
            
            
            830,776
            
            
            -Repurchase
                of shares
            
            
            (65,118
            )
            
            (11,205
            )Shares
                outstanding
            
            
            9,676,733
            
            
            544,671




During
      2004, the Company incurred costs related to the offering. These costs were
      for
      the public offering, expenses of the selling shareholders and cost of obtaining
      the new credit facility and senior subordinated notes. In conjunction with
      the
      public offering, costs related to the debt were capitalized; costs related
      to
      the offering were charged to additional paid in capital; and the costs
      associated with the selling shareholders were expensed in the consolidated
      statements of income. The following table depicts all costs related to the
      public offering except the purchase of the interest rate cap which is accounted
      for separately:




Costs
                related to long term notes payable and capitalized
            
            $
            8,060,735Costs
                related to selling shareholders and expensed
            
            
            1,526,138Costs
                related to the Company and charged to additional paid-in
                capital
            
            
            143,232Total
                costs
            
            $
            9,730,105




After
      the
      underwriters’ discount of $1.0 million, net proceeds to the Company from the
      sale of IDSs and the senior subordinated notes sold separately were $20.1
      million. On December 21, 2004 the Company also obtained a new credit facility
      of
      $80.0 million. The net proceeds of the IPO, together with $6.4 million of cash
      on hand, and the new credit facility were used to:




Repay
                existing indebtedness
            
            $
            92.0
                millionPurchase
                interest rate cap
            
            $
            4.7
                millionFees
                and expenses
            
            $
            8.7
                millionRepurchase
                IDSs and Class B common stock
            
            $
            1.1
                million




Also
      as
      part of this offering, 8,500,737 IDSs were sold by certain selling shareholders
      of the Company, for which the Company received no proceeds.




We
      recorded $3,212,528 to reflect the initial allocation of Class B common stock
      to
      the potential debt issuance upon conversion to IDSs. This entry is net of
      $885,852 which reduced the potential debt issuance to its present value at
      the
      closing of the offering using a discount rate equal to the interest rate on
      the
      senior subordinated notes. The embedded exchange feature of the Class B common
      stock is accounted for separately as a derivative liability.




47




**3.**  **Acquisitions**




On
      June
      30, 2003, the Company acquired 100% of the outstanding common stock of PKC.
      PKC
      owns 100% of the common stock of BTC. BTC is a local exchange telephone company
      with a service area that borders those of OTP, HTC and BMTC. The excess of
      the
      total acquisition cost over the assigned value of the identifiable net assets
      acquired is reflected as goodwill in the amount of $8,867,736. The goodwill
      related to this acquisition is not deductible for tax purposes.




On
      December 21, 2004, the Company acquired 100% of the outstanding common stock
      of
      MMH. MMH owns 100% of MMT. MMT is a local exchange carrier in central Missouri.
      The purchase price of the acquisition was $30,540,774 including assumed notes
      payable. The excess of the total purchase price over the assigned value of
      the
      identifiable net assets is reflected as goodwill and other intangible assets
      in
      the amount of $17,858,806 and $1,800,000, respectively. The goodwill related
      to
      the acquisition is not deductible for tax purposes.




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




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




The
      Company issued 856,234 shares of Class A common stock ($8,562 par value)
      underlying the 856,234 IDSs and 53,413 shares of Class B common stock ($534
      par
      value) in connection with the acquisition of MMHC based on an exchange ratio
      of
      0.14126 IDSs and 0.00881 shares of Class B common stock for each share of MMHC.
      The issuance of Class A common stock represented by IDSs, Class B common stock
      and Class A common Stock associated with the conversion of options resulted
      in
      an increase in paid-in capital of $7,222,120. Each IDS represents one share
      of
      Class A common stock and a 13.0% senior subordinated note with a $7.50 principal
      amount. The number of IDSs and shares of Class B common stock to be received
      upon exchange of each outstanding option to acquire shares of Mid-Missouri
      Holding were equal to the number of IDSs and shares of Class B common stock
      that
      a holder would have received in the exchange had the holder exercised the option
      on a “cashless basis”. The embedded exchange feature of the Class B common stock
      is accounted for separately as a derivative liability. We recorded $273,475
      for
      the value of the exchange feature to the derivative liability with an offsetting
      entry to additional paid-in capital.




The
      following unaudited pro forma information presents the combined results of
      operations of the Company as though the acquisition MMH completed in 2004
      occurred at the beginning of the preceding year. The results include certain
      adjustments, including increased interest expense on notes payable related
      to
      the acquisition. The pro forma financial information does not necessarily
      reflect the results of operations had the acquisition been completed at the
      beginning of 2003 or those which may be obtained in the future.




48




Unaudited2004Revenues
            
            $
            48,162,092Income
                from continuing operations
            
            
            16,284,236Net
                income
            
            
            6,861,029Basic
                net income per share
            
            $
            0.85Diluted
                net income per share
            
            $
            0.80




Each
      acquisition was accounted for using the purchase method of
      accounting.




**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, 2004 or 2005, respectively.




Intangible
      assets are summarized as follows:




December
                31, 2004
            
            December
                31, 2005Carrying
            
            Accumulated
            
            Net
            
            Carrying
            
            Accumulated
            
            NetValue
            
            Amortization
            
            Value
            
            Value
            
            Amortization
            
            ValueCustomer
                relationships
            
            $
            3,600,000
            
            $
            (1,549,057
            )
            $
            2,050,943
            
            $
            3,600,000
            
            $
            (2,011,916
            )
            $
            1,588,084




These
      intangible assets have either seven or ten year useful lives. The following
      table presents current and expected amortization expense of the existing
      intangible assets as of December 31, 2005 for each of the following
      periods:




Aggregate
                amortization expense:For
                the year ended December 31, 2003
            
            $
            257,143For
                the year ended December 31, 2004
            
            
            263,342For
                the year ended December 31, 2005
            
            
            462,858Expected
                amortization expense for the years endingDecember
                31,2006
            
            $
            205,7142007
            
            
            205,7142008
            
            
            205,7142009
            
            
            205,7142010
            
            
            205,714




**5.**  **Property
      and Equipment**




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




49




Estimated
            
            December
                31,Life
            
            2004
            
            2005Land
            
            
            
            
            $
            757,897
            
            $
            772,399Building
                and improvements
            
            
            20-40
            
            
            6,826,776
            
            
            6,961,203Telephone
                equipment
            
            
            6-20
            
            
            89,233,193
            
            
            92,122,002Cable
                television equipment
            
            
            7
            
            
            5,232,479
            
            
            5,571,788Furniture
                and equipment
            
            
            8-14
            
            
            1,342,387
            
            
            1,379,306Vehicles
            
            
            7-9
            
            
            3,184,904
            
            
            3,133,743Computer
                software equipment
            
            
            5-7
            
            
            2,886,775
            
            
            2,950,946Internet
                equipment
            
            
            5
            
            
            1,923,497
            
            
            2,146,725Total
                property and equipment
            
            
            
            
            
            111,387,908
            
            
            115,038,112Accumulated
                depreciation
            
            
            
            
            
            (63,192,340
            )
            
            (70,482,501
            )Net
                property and equipment
            
            
            
            
            $
            48,195,568
            
            $
            44,555,611





The
      Company’s composite depreciation rate for property and equipment was 13.5%,
      12.1% and 17.4% in 2003, 2004 and 2005, respectively. Depreciation expense
      from
      continuing operations for the years ended December 31, 2003, 2004 and 2005
      was
      $5,107,110, $5,837,033 and $7,748,687, respectively.




**6.**  **Other
      Accounts Receivable**




Other
      accounts receivable consist of the following:




December
                31,2004
            
            
            2005Carrier
                access bills receivable
            
            $
            1,021,969
            
            $
            980,294Receivables
                from Alabama Service Fund
            
            
            461,729
            
            
            461,729Other
                Miscellaneous
            
            
            39,247
            
            
            40,148$
            1,522,945
            
            $
            1,482,171




**7.**  **Investments**




Investments
      consist of the following:




December
                31,2004
            
            
            2005Investment
                in CoBank stock
            
            $
            271,031
            
            $
            106,049Investment
                in Rural Telephone Bank (Class C stock)
            
            
            435,858
            
            
            435,858Rental
                property
            
            
            576,210
            
            
            550,700Other
                miscellaneous
            
            
            15,753
            
            
            15,642$
            1,298,852
            
            $
            1,108,249




The
      investments in CoBank stock and Rural Telephone Bank Class C stock are carried
      at historical cost due to no readily determinable fair value for those
      instruments being available. These investments are patronage certificates that
      represent ownership in the financial institutions (CoBank and Rural Telephone
      Bank) where the Company has, or 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 by the respective financial
      institution.




50




**8.**  **Accrued
      Expenses**




Our
      initial public offering and related notes payable transactions which closed
      on
      December 21, 2004 created a number of accrued expenses at December 31, 2004.
      We
      accrued $688,762 for Merrill Corp., our printer for the initial public offering
      in 2004. No vendor’s accrued expenses exceeded 5% of total current liabilities
      in 2005.




**9.**  **Long-Term
      Debt**




Long-term
      notes payable consists of the following:


December
                  31,2004
              
              2005Term
                  credit facility, General Electric Capital Corporation;variable
                  interest rate of 6.53% and 8.50% at December 31, 2004 and2005,
                  respectively. There are no principal payments. Interestpayments
                  are due on the last day of the LIBOR period or at threemonth
                  intervals, whichever date comes first. Interest rate is
                  theindex
                  rate plus the applicable term loan index margin of 3.0%or
                  the applicable LIBOR rate plus the applicable term loan
                  LIBORmargin
                  of 4.0%. The unpaid balance will be due onDecember
                  21, 2009.
              
              $
              80,000,000
              
              $
              80,000,00013%
                  Senior subordinated notes, due 2019; interest paymentsare
                  due quarterly
              
              
              72,575,498
              
              
              72,575,49813%
                  Senior subordinated notes, held separately, due 2019;interest
                  payments are due quarterly
              
              
              8,500,000
              
              
              8,500,000Total
                  long-term notes payable
              
              $
              161,075,498
              
              $
              161,075,498Less:
                  current portion
              
              
              -
              
              
              -Long-term
                  notes payable
              
              $
              161,075,498
              
              $
              161,075,498




Associated
      with these long-term notes payable, the Company wrote off $1.0 million in
      deferred financing costs associated with the payoff of the CoBank notes payable
      and capitalized $8.1 million in deferred financing costs associated with the
      new
      credit facility and the 13% senior subordinated notes. The credit facility
      is
      secured by the total assets of the Company.




The
      Company has a revolving credit facility of $15,000,000 available as of December
      21, 2004. There were no amounts outstanding as of December 31, 2004 and 2005.
      The interest rate is the index rate plus a 3.00% margin or LIBOR rate, whichever
      is applicable. The Company pays a commitment fee of 0.75% per annum, payable
      quarterly in arrears, on the unused portion of the revolver loan. The commitment
      fee expense was $117,500 for the year ended December 31, 2005.




The
      Company had an available working line of credit of $5,000,000 through December
      21, 2004. The Company had a commitment fee of .50% per annum, payable quarterly
      in arrears, on the unused portion of the revolver loan. Commitment fee expense
      was not material for the years ended December 31, 2003 and 2004. No borrowings
      were outstanding under this facility at December 31, 2004 and 2005.




51




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




2006
            
            $
            -2007
            
            
            -2008
            
            
            -2009
            
            
            80,000,0002010
            
            
            -Thereafter
            
            
            81,075,498Total
            
            $
            161,075,498




The
      above
      schedule of maturities of long-term debt does not include the $4.1 million
      liquidation value of Class B common shares convertible into senior subordinated
      notes.




The
      Company’s various long-term notes payable agreements contain certain financial
      covenants that require the maintenance of certain levels and ratios of working
      capital and equity to total assets as well as certain coverage ratios associated
      with debt service and fixed charges. As of December 31, 2004 and 2005, the
      Company was in compliance with all financial covenants.




The
      Company has no independent assets or operations separate from its operating
      subsidiaries. The guarantees of its senior subordinated notes by four of its
      five 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. Prior to 2005, the impact of the
      non-guarantor subsidiary of the parent was minor. The following condensed
      consolidated financial information is provided for the guarantor entities for
      the year ended December 31, 2005:




For
                the year ended December 31, 2005Otelco
            
            NonInc.
            
            Guarantor
            
            Guarantor(Consolidated)
            
            Subsidiaries
            
            SubsidiariesTotal
                revenues
            
            $
            46,972,222
            
            $
            9,763,863
            
            $
            37,208,359Total
                operating expenses
            
            $
            28,907,340
            
            $
            6,731,065
            
            $
            22,176,275Income
                from operations
            
            $
            18,064,882
            
            $
            3,032,798
            
            $
            15,032,084Net
                Income available to common stockholders
            
            $
            1,791,584
            
            $
            (482,587
            )
            $
            2,274,171Total
                current assets
            
            $
            13,151,800
            
            $
            709,148
            
            $
            12,442,652Property
                and equipment, net
            
            $
            44,555,611
            
            $
            11,896,141
            
            $
            32,659,470Total
                current liabilities
            
            $
            4,217,159
            
            $
            851,300
            
            $
            3,365,859





**10.**  **Income
      Taxes**




Deferred
      income taxes are provided for certain temporary differences principally due
      to
      the use of accelerated depreciation and amortization for income tax purposes.
      Such deferred taxes are credited to income as the related temporary differences
      reverse.




Income
      tax expense for the years ended December 31, 2003, 2004 and 2005 is summarized
      below.




52




For
                the years ended December 31,2003
            
            2004
            
            2005Federal
                income taxesCurrent
            
            $
            835,013
            
            $
            777,594
            
            $
            (940,443
            )Deferred
            
            
            2,769,740
            
            
            2,657,080
            
            
            1,789,674Total
                federal tax expense
            
            
            3,604,753
            
            
            3,434,674
            
            
            849,231State
                income taxesCurrent
            
            
            119,282
            
            
            126,280
            
            
            27,085Deferred
            
            
            383,240
            
            
            385,671
            
            
            135,359Total
                state tax expense
            
            
            502,522
            
            
            511,951
            
            
            162,444Total
                tax expense
            
            $
            4,107,275
            
            $
            3,946,625
            
            $
            1,011,675




Total
      income tax expense 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, 2003, 2004 and 2005. The
      reasons for the differences are presented below.




For
                the years ended December 31,2003
            
            2004
            
            2005Federal
                income tax at statutory rate
            
            
            34
            %
            
            34
            %
            
            34
            %Federal
                income tax (provision) at statutory rate
            
            $
            3,944,065
            
            $
            3,425,104
            
            $
            1,103,704Non
                deductible IPO cost
            
            
            -
            
            
            518,887
            
            
            -Change
                in fair value of derivative
            
            
            -
            
            
            -
            
            
            (325,931
            )State
                income tax (provision), net of federalincome
                tax effects
            
            
            331,665
            
            
            337,888
            
            
            79,568Other
            
            
            (168,455
            )
            
            (335,254
            )
            
            154,334Provision
                for income taxes
            
            $
            4,107,275
            
            $
            3,946,625
            
            $
            1,011,675Effective
                income tax rate
            
            
            35.4
            %
            
            39.2
            %
            
            31.1
            %





As
      of
      December 31, 2005, the Company has state net operating loss carry-forwards
      of
      approximately $2.1 million for tax purposes, which will be available to offset
      future taxable income. If not used, these carry-forwards will expire between
      2020 and 2025.




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, 2004 and
      2005 are presented below:




December
                31,2004
            
            2005Deferred
                tax liabilities:Amortization
            
            $
            (6,637,399
            )
            $
            (9,297,930
            )Depreciation
            
            
            (6,415,827
            )
            
            (6,047,960
            )Total
                deferred tax liabilities
            
            $
            (13,053,226
            )
            $
            (15,345,890
            )Deferred
                tax assets:Deferred
                Compensation
            
            $
            283,948
            
            $
            160,724Amortized
                intangibles
            
            
            -
            
            
            353,249State
                net operating loss carryforwards
            
            
            -
            
            
            92,093Advance
                payments
            
            
            186,482
            
            
            199,133Other
            
            
            182,195
            
            
            67,476Total
                deferred tax assets
            
            $
            652,625
            
            $
            872,675Net
                deferred tax liability
            
            $
            (12,400,601
            )
            $
            (14,473,215
            )




53




The
      income tax receivable of $749,591 at December 31, 2005 results primarily from
      the carryback of the Company’s projected 2005 federal net operating loss of $2.1
      million to 2003 and 2004.




**11.**  **Employee
      Benefit Program**




Employees
      of OTC, HTC, BMTC and MMHC 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 up to 15% of their annual compensation through September 30, 2002
      and
      100% beginning October 1, 2002, not to exceed $12,000, $13,000 and $14,000
      for
      2003, 2004, and 2005, respectively. The Company matches the employee’s
      contribution up to 6% of the employee’s annual compensation. In addition, the
      Company made a discretionary contribution for each employee equal to 1.7 %
      of
      their annual compensation for 2003 and 2004. No discretionary contribution
      was
      made in 2005. For the years ended December 31, 2003, 2004 and 2005, the total
      expense associated with this plan was $244,625, $265,366 and $391,418,
      respectively.




The
      employees of BTC participate in a Retirement and Security Program (“RSP”) and a
      Savings Plan (“SP”) provided through the National Telecommunications Cooperative
      Association. Participation in the RSP requires a minimum contribution of 1%
      from
      the employees. The Company contributes 15.1% 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% of pre-tax employee earnings
      and the employee can make additional voluntary contributions as desired with
      no
      additional Company contribution. For the years ended December 31, 2003, 2004
      and
      2005 the total expense associated with these plans was $148,893, $95,721 and
      $108,007, respectively.




**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 with Class A common shares. Class B common
      stock is convertible on a one-for-one basis into IDSs, each of which includes
      a
      Class A common share. For periods prior to our conversion, membership units
      were
      treated on an as if converted basis into Class A and Class B common shares.
      For
      2004, the shares associated with the purchase on Mid-Missouri Holding Corp.,
      the
      sale of common shares by the Company, and the buy-back of common shares by
      the
      Company, were prorated from December 21, 2004 until the end of the
      year.




A
      reconciliation of the common shares for the Company’s basic and diluted income
      per common share calculation is as follows:




For
                the years ended December 31,2003
            
            2004
            
            2005Weighted
                average of common shares at conversion
            
            
            8,054,841
            
            
            8,054,841
            
            
            8,054,841Purchase
                of Mid Missouri Holding Corp., sale of common shares by Company,
                and
                buy-back of common shares by Company (12/21/04)
            
            
            -
            
            
            48,879
            
            
            1,621,892Weighted
                average common shares
            
            
            8,054,841
            
            
            8,103,720
            
            
            9,676,733Effect
                of Class B shares at conversion
            
            
            502,463
            
            
            502,463
            
            
            502,463Effect
                of Class B shares from purchase of Mid Missouri Holding Corp., sale
                of
                common shares by Company, and buy-back of common shares by Company
                (12/21/04)
            
            
            -
            
            
            1,272
            
            
            42,208Effect
                of dilutive securities
            
            
            502,463
            
            
            503,735
            
            
            544,671Weighted-average
                common shares and potential common shares
            
            
            8,557,304
            
            
            8,607,455
            
            
            10,221,404Net
                income available to common shareholders
            
            $
            7,492,916
            
            $
            6,113,863
            
            $
            1,791,584Net
                income per basic share
            
            $
            0.93
            
            $
            0.75
            
            $
            0.19Net
                income available to common shareholders
            
            $
            7,492,916
            
            $
            6,113,863
            
            $
            1,791,584Plus:
                Accretion expense of Class B common convertible to senior subordinated
                notes
            
            
            -
            
            
            13,348
            
            
            442,926Less:
                Change in fair value of derivative
            
            
            -
            
            
            -
            
            
            958,621Net
                income available for diluted shares
            
            $
            7,492,916
            
            $
            6,127,211
            
            $
            1,275,889Net
                income per diluted share
            
            $
            0.88
            
            $
            0.71
            
            $
            0.12




54




**13.**  **Selected
      Quarterly Financial Data (unaudited)**




**First**
            
            **Second**
            
            **Third**
            
            **Fourth****Quarter**
            
            **Quarter**
            
            **Quarter**
            
            **Quarter
                (1)**Fiscal
                2004:Revenue
            
            $
            9,127,238
            
            $
            9,029,003
            
            $
            9,319,806
            
            $
            9,790,295Operating
                income
            
            
            3,973,643
            
            
            3,955,372
            
            
            4,085,174
            
            
            1,515,234Net
                income
            
            
            2,056,516
            
            
            2,047,558
            
            
            2,142,503
            
            
            (132,714
            )Net
                income per share, basic
            
            
            0.26
            
            
            0.25
            
            
            0.27
            
            
            (0.02
            )Net
                income per share, diluted
            
            
            0.24
            
            
            0.24
            
            
            0.25
            
            
            (0.02
            )Fiscal
                2005:Revenue
            
            $
            12,027,093
            
            $
            11,442,526
            
            $
            11,659,317
            
            $
            11,843,287Operating
                income
            
            
            4,793,392
            
            
            4,539,441
            
            
            4,415,984
            
            
            4,316,065Net
                income
            
            
            829,212
            
            
            616,359
            
            
            496,256
            
            
            (150,243
            )Net
                income per share, basic
            
            
            0.09
            
            
            0.06
            
            
            0.05
            
            
            (0.02
            )Net
                income per share, diluted
            
            
            0.06
            
            
            0.04
            
            
            0.03
            
            
            (0.01
            )




(1)
            Fourth
                quarter 2004 results were impacted by a charge of $1.5 million in
                initial
                public offering costs related to the selling
                shareholders.




**14.**  **Option-based
      Compensation**




1999
      Option Plan




In
      1999
      the Company adopted an option plan that covers senior management and consultants
      of the Company. At the time our initial public offering on December 21, 2004,
      under the terms of the option plan, a change in ownership caused the options
      to
      fully vest. All options were converted to IDSs on a cashless exercise basis
      as
      allowed in the option plan and the plan was terminated. As of December 31,
      2004,
      there were no outstanding options.




55




Number
                of
              units
            
            Weighted
                Average Exercise PriceOutstanding
                at December 31, 2000
            
            
            54,865
            
            $
            10.00Granted
            
            
            13,500
            
            
            25.20Exercised
            
            
            -
            
            
            -Outstanding
                at December 31, 2001
            
            
            68,365
            
            
            13.00Granted
            
            
            14,500
            
            
            28.00Exercised
            
            
            -
            
            
            -Outstanding
                at December 31, 2002
            
            
            82,865
            
            
            15.63Granted
            
            
            14,500
            
            
            36.00Exercised
            
            
            -
            
            
            -Outstanding
                at December 31, 2003
            
            
            97,365
            
            $
            18.66Granted
            
            
            -
            
            
            -Exercised
                12/21/04
            
            
            (97,365
            )
            $
            18.66Outstanding
                at December 31, 2004
            
            
            -
            
            $
            -




The
      Company accounts for the option-based compensation plan based on variable
      accounting in accordance with APB 25. The option plan included a cashless
      exercise feature that allowed option holders to provide payment upon exercise
      of
      vested options in the form of cash, units or options for units. As a result
      of
      applying variable accounting, the Company recognized compensation expense net
      of
      tax in the amount of $662,753 and $908,343 for the periods ended 2003 and 2004
      respectively, based on the estimated fair market value of a membership unit
      at
      each period.




The
      estimated fair market value of a membership unit at each period for the years
      ended December 31, 2003 and 2004 was determined based on using market comparable
      valuations for public companies in the same industry as the Company. Based
      on
      these comparable companies and their enterprise value to EBITDA multiples at
      each period, the Company calculated its enterprise value based on a range of
      enterprise value to EBITDA multiples supported by the comparable company metrics
      after taking into account an illiquidity discount. From enterprise value, the
      Company calculated the resulting equity value and value per unit to come up
      with
      a range of values per unit. The Company chose an estimated fair market value
      per
      unit from with this range.




**15.**  **Related
      Party Transactions**




Two
      of
      the Company’s subsidiaries had advisory agreements with CEA Management Corp. and
      Seaport Capital, LLC (together “Seaport”). Prior to December 21, 2004 affiliates
      of Seaport owned approximately 68% of the Company. Under the agreements, Seaport
      furnished professional advisory services. This agreement was terminated on
      December 21, 2004 in conjunction with the initial public offering.




For
      the
      years ended December 31, 2003 and 2004, Otelco Holdings paid Seaport $850,000
      and $973,118 respectively, in advisory fees. Accounts payable at December 31,
      2004 included amounts payable to Seaport of $334,672.




**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 15.4%, 20.2%, and 20.9%
      of the Company’s total revenues from continuing operations for the years ended
      December 31, 2003, 2004 and 2005, respectively.




**17.**  **Commitments
      and Contingencies**




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




56




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




None.




**Item
                9A.**
            **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, 2005.




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 2005 that materially affected, or are reasonably likely to
      materially affect, our internal control over financial reporting.




Management’s
      report on internal control over financial reporting is included in Item 8 of
      this report.




**Item
                9B.**
            **Other
                Information**




None.




**PART
      III**




**Item
                10.**
            **Directors
                and Executive Officers of the
                Registrant**




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 at http://www.otelco.net under the Investor
      Relations section titled Corporate Governance.




The
      other
      information required by this Item is incorporated herein by reference to the
      applicable information in the proxy statement for our 2006 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—Audit Committee Financial
      Expert.”




**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 2006 annual meeting of
      stockholders, including the information set forth under the captions “Executive
      Compensation,” Compensation of Directors” 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
      2006 annual meeting of stockholders , including the information set forth under
      the caption “Beneficial Ownership of Otelco Inc. Common
      Stock.”




**Item
                13.**
            **Certain
                Relationships and Related
                Transactions**




The
      information required by this Item is incorporated herein by reference to the
      applicable information in the proxy statement for our 2006 annual meeting of
      stockholders, including the information set forth under the caption “Other
      Relationships and Transactions with Executives.”




57




**Item
                14.**
            **Principal
                Accounting Fees and
                Services**




The
      information required by this Item is incorporated herein by reference to the
      applicable information in the proxy statement for our 2006 annual meeting of
      stockholders, including the information set forth under the caption “Our
      Relationship with Our Independent Auditors.”




**PART
      IV**




**Item
                15.**
            **Exhibits,
                Financial Statement
                Schedules**




**(a)(1)** **Financial** **Statements**




Report
      of
      Independent Certified Public Accountants




Consolidated
      Balance Sheets




Consolidated
      Statements of Operations




Consolidated
      Statements of Changes in Stockholders’ Equity




Consolidated
      Statements of Cash Flow




Notes
      to
      Consolidated Financial Statements




**(a)(2)    Financial
      Statement Schedules**




None




**(a)(3)    Exhibits**






**Exhibit
                  No.**
              
              **Description**3.1
              
              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
              
              Form
                  of 13% Senior Subordinated Note due 2019 (included in Exhibit
                  4.1)4.3
              
              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)4.4
              
              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)4.5
              
              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
              
              Credit
                  Agreement, dated December 21, 2004, among Otelco Inc., as Borrower,
                  the
                  other credit parties signatory thereto, as Credit Parties, the
                  Lenders
                  signatory thereto from time to time, as Lenders and General Electric
                  Capital Corporation, as Administrative Agent and Lender and CoBank,
                  ACB,
                  as Syndication Agent and Lender (filed as Exhibit 10.1 to the company’s
                  Annual Report on Form 10-K for the year ended December 31, 2004
                  and
                  incorporated herein by reference)
  58
  10.2
              
              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)*10.3
              
              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)*10.4
              
              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)*12.1
              
              Computation
                  of Ratio of Earnings to Fixed Charges21.1
              
              List
                  of material 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 Officer32.1
              
              Certificate
                  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section
                  906 of
                  the Sarbanes-Oxley Act of 2002, of the Chief Executive
                  Officer32.2
              
              Certificate
                  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section
                  906 of
                  the Sarbanes-Oxley Act of 2002, of the Chief Financial
                  Officer




*
      Management contract or compensatory plan or arrangement




59




**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, in the City of Oneonta, State
      of
      Alabama, on the 15 th day of
      March, 2006.




OTELCO INC.





BY:
            /S/  MICHAEL
                D. WEAVERMichael
                D. Weaver
              President
                and Chief Executive Officer





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




**Signature**
            
            **Title**
            
            **Date**





/s/  MICHAEL
                D. WEAVER
              
              Michael
                D. Weaver
            
            President,
                Chief Executive Officer and Director
              (Principal
                Executive Officer)
            
            March
                15, 2006





/s/  CURTIS
                L. GARNER, JR.
              
              Curtis
                L. Garner, Jr.
            
            Chief
                Financial Officer (Principal Financial and Accounting
                Officer)
            
            March
                15, 2006





/s/  WILLIAM
                BAK
              
              William
                Bak
            
            Director
            
            March
                15, 2006





/s/  HOWARD
                HAUG
              
              Howard
                Haug
            
            Director
            
            March
                15, 2006





/s/  JOHN
                P. KUNZ
              
              John
                P. Kunz
            
            Director
            
            March
                15, 2006





/s/  STEPHEN
                P. MCCALL
              
              Stephen
                P. McCall
            
            Director
            
            March
                15, 2006





/s/  ANDREW
                MEYERS
              
              Andrew
                Meyers
            
            Director
            
            March
                15, 2006





/s/  WILLIAM
                F. REDDERSEN
              
              William
                F. Reddersen
            
            Director
            
            March
                15, 2006





60