**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**




**FORM
      10-K/A**


**AMENDMENT
      NO. 1**




ý ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE


SECURITIES
      EXCHANGE ACT OF 1934





For
      the
      fiscal year ended December 31, 2006





OR





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


SECURITIES
      EXCHANGE ACT OF 1934





For
      the
      transition period from ____________ to ____________




Commission
      file number: **1-32362**




**OTELCO
      INC.**


(Exact
      name of registrant as specified in 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, 2006, the aggregate market value of the registrant’s Income Deposit
      Securities (IDSs) held by non-affiliates of the registrant was $173.2 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 9, 2007, 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 2007 annual meeting of
      stockholders.





**TABLE
      OF CONTENTS**




**Page**PART
                I
            
            
            
            2Item
                1.
            
            Business
            
            2Item
                1A.
            
            Risk
                Factors
            
            8Item
                1B.
            
            Unresolved
                Staff Comments
            
            14Item
                2.
            
            Properties
            
            14Item
                3.
            
            Legal
                Proceedings
            
            14Item
                4.
            
            Submission
                of Matters to a Vote of Security Holders
            
            14Item
                X.
            
            Executive
                Officers of the Registrant
            
            15PART
                II
            
            
            
            16Item
                5.
            
            Market
                for Registrant’s Common Equity, Related Stockholder Matters and Issuer
                Purchases of Equity Securities
            
            16Item
                6.
            
            Selected
                Financial Data
            
            19Item
                7.
            
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations
            
            20Item
                7A.
            
            Quantitative
                and Qualitative Disclosures about Market Risk
            
            34Item
                8.
            
            Financial
                Statements and Supplementary Data
            
            35Item
                9.
            
            Changes
                in and Disagreements with Accountants on Accounting and Financial
                Disclosure
            
            65Item
                9A.
            
            Controls
                and Procedures
            
            65Item
                9B.
            
            Other
                Information
            
            66PART
                III
            
            
            
            66Item
                10.
            
            Directors
                and Executive Officers of the Registrant
            
            66Item
                11.
            
            Executive
                Compensation
            
            66Item
                12.
            
            Security
                Ownership of Certain Beneficial Owners and Management and Related
                Stockholder Matters
            
            66Item
                13.
            
            Certain
                Relationships and Related Transactions
            
            66Item
                14.
            
            Principal
                Accounting Fees and Services
            
            67PART
                IV
            
            
            
            68Item
                15.
            
            Exhibits,
                Financial Statement Schedules
            
            68





i


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




**EXPLANATORY
      NOTE**


This
        Annual Report on Form 10-K/A is being filed to amend and restate Note 8 to
        our
        consolidated financial statements contained in “Item 8. Financial Statements and
        Supplementary Data” of our Annual Report on Form 10-K for the fiscal year ended
        December 31, 2006 to provide additional information pursuant to Rule 3-10
        of
        Regulation S-X. In addition, Exhibit 21.1 is being refiled to correct certain
        clerical errors. Except as discussed above, we have not modified or updated
        disclosure presented in the original Annual Report on Form 10-K. Accordingly,
        this Form 10-K/A does not reflect events occurred after the filing of the
        original Annual Report on Form 10-K or modify or update those disclosures
        affected by subsequent events. Accordingly, this Form 10-K/A should be read
        in
        conjunction with our periodic filings made with the SEC subsequent to the
        date
        of the filing of the original Annual Report on Form 10-K, including any
        amendments to those filings, as well as any Current Reports filed on Form
        8-K
        subsequent to the date of the filing of the original Annual Report on Form
        10-K.
  In
        addition, in accordance with applicable SEC rules, this Form 10-K/A includes
        updated certifications from our Chief Executive Officer and Chief Financial
        Officer.
  **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
      1




**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 six RLEC
      businesses, four of which serve contiguous territories in north central Alabama,
      one which serves territory adjacent to Bangor, Maine and one which serves a
      portion of central Missouri. In addition, we provide facilities based
      competitive local exchange carrier (CLEC) services along the Interstate 95
      corridor in Maine. 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, 2006:




Access
                line equivalents
            
            
            63,954Long
                distance
            
            
            21,370Cable
                television customers
            
            
            4,188Dial-up
                Internet customers
            
            
            19,587





The
      six
      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, in some areas, 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. In Maine, we also serve
      business and residence customers outside of our RLEC territory, utilizing our
      188 mile fiber backbone network along the Interstate 95 corridor.




*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 a portion of Blount
      county in Alabama. In connection with the transaction, we acquired 4,080 access
      line equivalents.




-2-




*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.
      In addition, we provide Internet services in areas surrounding our territory.




*Mid-Maine* .
      On July
      3, 2006, we acquired Mid-Maine Communications, Inc., or Mid-Maine, a rural
      local
      exchange carrier that serves portions of Penobscot, Somerset and Piscataquis
      counties adjacent to Bangor, Maine and a competitive exchange carrier, serving
      customers adjacent to a 188 mile fiber network along the I-95 corridor in Maine.
      In connection with the transaction, we acquired approximately 22,413 access
      line
      equivalents. In addition, we provide dial-up Internet services throughout
      Maine.




**Service
      Offerings**




The
      following table reflects the percentage of total revenues derived from each
      of
      our service offerings for the year ended December 31, 2006:




**Revenue** **Mix**




**Source
                of Revenue**Local
                services
            
            
            37.3
            %Network
                access
            
            
            40.8Cable
                television
            
            
            3.8Internet
            
            
            14.8Transport
                services
            
            
            3.3Total
            
            
            100.0
            %





*Local
      Services*




We
      are
      the sole provider of wireline telephone services in the territories served
      by
      our six rural local exchange carriers. Local services enable customers to
      originate and receive telephone calls. The maximum amount that we can charge
      a
      customer for basic service in Alabama, Maine and Missouri is regulated by the
      Alabama Public Service Commission, or APSC, the Maine Public Utilities
      Commission, or MPUC, 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 also receive revenue for
      providing long distance services to our customers, billing and collection
      services for other carriers under contract, and directory advertising. We
      provide local services on a retail basis to residential and business customers.
      With the high level of acceptance of local service bundles, a growing percentage
      of our customers receive a broad range of services, including long distance,
      for
      a single, fixed monthly price.




We
      also
      offer long distance telephone services to our local telephone customers who
      do
      not purchase a local service bundle. We resell long distance services purchased
      from various long distance providers. At December 31, 2006, approximately
      51.0% of our regulated access lines subscribed to our long distance services.
      We
      intend to continue to expand our long distance business within our rural local
      exchange carrier territories, principally through marketing to our local
      telephone customers.




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




-3-


*Network
      Access*




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




Federal
      Universal Service Fund High Cost Revenue.     Blountsville,
      Hopper, Mid-Maine 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.




*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.




-4-




*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, cable modems
      or
      wireless broadband, depending upon the location in which the service is offered
      and via dedicated trunks to larger business customers. We charge our Internet
      customers a flat rate for unlimited Internet usage and a premium for higher
      speed Internet services. We are able to provide 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.
      In Maine, we offer dial-up Internet services throughout the state.




*Transport
      Services*




We
      receive monthly recurring revenues for the rental of fiber to transport data
      and
      other telecommunications services in Maine from business and telecommunications
      carriers along a 188 mile fiber route.




**Network
      Assets**




Our
      telephone networks include carrier grade advanced switching capabilities
      provided by six digital switches, fiber rings and routes, 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, and dedicated
      circuits. As of December 31, 2006, our networks included the following
      elements, all of which are owned by us:




·
            Three
                Lucent 5ESS digital switches, one Siemens EWSD switch, and three
                Nortel
                DMS-10 switches;




·
            More
                than 898 route miles of high-quality, high-speed fiber optic cable;
                and




·
            DSL,
                cable modem and wireless broadband
                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 307 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, credit card or automatic withdrawal from
      their bank account, many elect to pay their monthly bill in person at the local
      office. This provides us with an opportunity to directly market our services
      to
      our existing customers. These offices typically are staffed by local residents
      and provide sales and customer support services in the community. Local offices
      facilitate a direct connection to the community, which we believe improves
      customer satisfaction and enhances our reputation with local residents. We
      also
      build upon our strong reputation by participating in local activities, such
      as
      local fund raising and charitable events for schools and community organizations
      and by airing local interest programs on our local access community cable
      channels.




-5-




In
      order
      to capitalize on the strong branding of each of our rural local exchange
      carriers, while simultaneously establishing and reinforcing the “Otelco” brand
      name across our 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.




In
      Maine,
      we have retained the Mid-Maine name as it is well known in the areas we serve
      and will introduce the Otelco name where it does not detract from existing
      brand
      recognition. Our competitive local exchange carrier competes with the incumbent
      carrier in metropolitan areas from Portland to Bangor, utilizing both an
      employee and agent sales force. It provides increased service monitoring for
      its
      business customers through a state of the art network operations
      center.




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 bundles and the continued marketing of existing
      services and products.




**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, MPUC 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. 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 calling offers from wireless carriers, we have also experienced
      an
      increase in network access revenue associated with terminating wireless calls
      on
      our telephone network. In Alabama, the introduction of residential bundled
      offerings including unlimited calling appears to have shifted additional minutes
      back from wireless. 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.




-6-


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, 2006, customers representing approximately 51.0% of our
      regulated access lines subscribed to our long distance services. The majority
      of
      our competitive local exchange customers have also selected us for their long
      distance services as part of their overall package of services.




In
      addition, under the Communications Act, a competitor can obtain USF 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
      Maine,
      we also operate as a facilities based competitive local exchange carrier in
      a
      number of the larger metropolitan areas primarily served by Verizon as the
      incumbent local exchange carrier. There are other competitors who serve these
      markets today as both facilities based and resale carriers. Our focus has been
      on the small to medium business customer, where we offer a combination of
      service consulting to determine their telecommunications requirements, quality
      service to meet these needs, and market competitive pricing.




*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.




*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, 2006, we provided Internet
      services to approximately 30.3% of our rural access lines. In Maine and
      Missouri, we also provide Internet services to approximately 18,000 subscribers
      outside of our telephone services territory, as well as the majority of our
      competitive exchange carrier customers.




*Transport
      Services*




Other
      local telephone companies, long distance carriers, cable providers, utilities,
      governments, and industry associations deploy and sell fiber capacity to users.
      Existing and newly deployed capacity could be made available, impacting market
      pricing. Multi-year contracts generally protect existing relationships and
      provide reveneue stability. The cost of and time required for deploying new
      fiber can be a deterrent to adding capacity.




**Information
      Technology and Support Systems**




We
      have
      integrated software systems that function as an operational support and customer
      care/billing system. One system serves our Alabama and Missouri local exchange
      subscribers, one serves our additional Internet subscribers, and one serves
      our
      Maine subscribers. The systems include 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
      integrated software systems, we are able to reduce individual company costs
      and
      standardize functions resulting in greater efficiencies and
      profitability.




-7-


Each
      system allows us to provide a single, unified bill for all our services which
      we
      believe is a significant competitive advantage. Additionally, the systems
      provide us an extensive database that enables us to gather detailed marketing
      information in our service territory. This capability allows us to market new
      services as they become available to particular customers.




**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, 2006, we employed a total of approximately 220 full-time and 4
      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* .




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, Maine 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.




-8-


**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 wireless carriers. Our unlimited
      calling bundles provide our customers with an alternative to using cell phones.
      As wireless carriers continue to build-out their networks, 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.




In
      Maine,
      our competitive local exchange carrier operations may encounter a change in
      the
      competitive landscape that would impact their ability to grow and/or retain
      customers, sustain current pricing plans, and control the cost of access to
      incumbent carrier customers. We do not know what impact the announced merger
      of
      Verizon’s holdings in Maine with Fairpoint Communications, Inc. will have on our
      competitive business.




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
      and bundling long distance with other local services. Our existing long distance
      competitors can be expected to respond to such initiatives, including those
      with
      significantly greater resources than us. New competitors continue to enter
      the
      market with attractive offerings. There can be no assurance that our local
      services revenue, including long distance services, will not decrease in the
      future as competition and/or the cost of providing services
      increase.




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.




**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.




-9-


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




We
      have
      grown rapidly by acquiring other similar businesses. Since 1999, we have
      acquired and operate six rural local exchange carriers and a competitive local
      exchange carrier. 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, may 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/or incur expenses, and thereby
      adversely affect our business, revenue and cash flow. In addition, the ASPC,
      MPUC 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. 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 rural access line count declined by approximately
      2.6% during 2006. We may continue to experience net access line loss in our
      rural markets. Continued access line losses could adversely affect our business
      and results of operations.




**Our
      performance is subject to a number of other economic and non-economic factors,
      which we may not be able to predict accurately.**




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




-10-


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, Maine 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
      17.7% of our revenue for the year ended December 31, 2006 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, the MPUC 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,
      MPUC
      or MPSC may adopt. Such regulatory developments could adversely affect our
      business, revenue and cash flow.




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




Mid-Missouri
      Telephone and Mid-Maine Telecom charge rates for local services and intrastate
      access service based in part upon a rate-of-return authorized by the MPSC and
      the MPUC, respectively. These authorized rates are subject to audit at any
      time
      and may be reduced if the MPSC or MPUC finds them excessive. If either company
      is ordered to reduce its rates or if its applications to increase rates are
      denied or delayed, our business, revenue and cash flow may be negatively
      impacted.




-11-


In
      January 2007, the National Exchange Carrier Association or NECA notified all
      average schedule companies of a proposed reduction in compensation rates which
      will reduce the related compensation to these companies in a range from 5%
      to
      15% of the affected revenues beginning in July 2007. Two of our companies
      participate in average schedule rates. NECA also proposed a transition process
      which would feather the reduction in over 24 months. The level of funding;
      final
      rate; amount and timing of any transition fund payments; and future changes
      in
      the rate are not currently known with certainty and could be higher or
      lower.




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




Blountsville,
      Hopper, Mid-Maine and Mid-Missouri receive federal USF HC revenue to support
      their high cost of operations. Such support payments represented approximately
      9.3% of our revenue for the year ended December 31, 2006, 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.




In
      the
      last several 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 were 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. On May 16, 2006, the FCC released an
      order extending the current high-cost universal support rules until the FCC
      adopts changes, if any, to these rules. In addition, legislation was introduced
      in both the U. S. House of Representatives and Senate which, if approved, could
      affect USF 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. In the past, some disbursements to another
      class
      of universal service fund recipients, schools and libraries, were suspended
      to
      comply with the Anti-Deficiency Act (31 U.S.C. § 1341) (2000)). Legislation
      was passed that exempts USF funds from the Anti-Deficiency Act temporarily,
      with
      permanent legislation pending. We cannot predict the outcome of these
      actions.




Universal
      Services Administrative Co., or USAC, serves as the administrative agent to
      collect data and distribute funds for USF. In 2006, it began conducting High
      Cost Beneficiary audits, designed to ensure compliance with FCC rules and
      program requirements and to assist in program compliance. Carriers are chosen
      from a random sample of each type of ETC, including average schedule and cost
      companies, incumbents and competitors, rural and non-rural, from various states.
      Audits are designed to ensure proper designation of a carrier as ETC, accuracy
      of data submissions, documentation of accounting procedures, physical inventory
      of assets, true-up of projected data, and samples of detailed documentation
      (e.g., invoices, continuing property records). We were notified by USAC in
      December 2006 that two of our companies, Blountsville and Hopper, were selected
      for audit. Both audits are currently in process.




-12-


**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, MPUC 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, including statewide franchising
      proposals in a number of states. 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
      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. Our Class B common stock will convert to income deposit
      securities not later than the end of 2009, increasing the number of Class A
      shares with a resultant increase in dividend cost within the current policy.
      As
      a result, we may not have a sufficient amount of cash to fund our operations
      in
      the event of a significant business downturn, finance growth of our network
      or
      unanticipated capital expenditure needs. We may have to forego growth
      opportunities or capital expenditures that would otherwise be necessary or
      desirable if we do not find alternative sources of financing or if we do not
      modify our dividend policy. If we do not have sufficient cash for these
      purposes, our financial condition and our business will suffer or our board
      of
      directors may change our dividend policy.




-13-




**We
      are subject to restrictive debt covenants that limit our business flexibility
      by
      imposing operating and financial restrictions on our
      operations.**




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




·
            the
                incurrence of additional indebtedness and the issuance of preferred
                stock
                and certain redeemable capital
                stock;




·
            the
                making of certain types of restricted payments, including investments
                and
                acquisitions;




·
            specified
                sales of assets;




·
            specified
                transactions with affiliates;




·
            the
                creation of a number of liens;




·
            consolidations,
                mergers and transfers of all or substantially all of our assets;
                and




·
            our
                ability to change the nature of our
                business.




Item
        1B.Unresolved
        Staff Comments


None.




**Item
        2.**  **Properties**


Our
      property consists primarily of land and buildings, central office 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 in Alabama and Missouri, including our corporate office. We lease
      property in Maine, including our two primary office locations in Bangor and
      Portland. We also lease certain other real property, including land in Oneonta,
      Alabama, pursuant to a long-term, renewable lease. Substantially all our Alabama
      cable television service equipment is located on this leased property. Our
      real
      property is all located in Alabama, Maine and Missouri. As of December 31,
      2006, our property and equipment consisted of the following:




**(in
                thousands)**Land
            
            $
            850Buildings
                and improvements
            
            
            8,480Telephone
                equipment
            
            
            133,572Cable
                television equipment
            
            
            5,706Furniture
                and equipment
            
            
            1,997Vehicles
            
            
            3,895Computer
                hardware and software
            
            
            8,630Internet
                equipment
            
            
            2,585Total
                property and equipment
            
            
            165,715Accumulated
                depreciation
            
            
            (105,221
            )Net
                property and equipment
            
            $
            60,494




**Item
        3.**  **Legal
        Proceedings**


From
      time
      to time, we may be involved in various claims, legal actions and regulatory
      proceedings incidental to and in the ordinary course of business, including
      administrative hearings of the APSC, MPUC 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 2006, no matter was submitted to a vote of our
      security holders.




-14-


**Item
          X. Executive Officers of the Registrant**


The
      following table sets forth the names and positions of our executive officers
      and
      certain other officers, and their ages as of December 31,
      2006.




**Name**
            
            **Age**
            
            **Position**Michael
                D. Weaver
            
            54
            
            President,
                Chief Executive Officer and DirectorCurtis
                L. Garner, Jr.
            
            59
            
            Chief
                Financial OfficerDennis
                Andrews
            
            50
            
            Senior
                Vice President and General Manager, AlabamaJerry
                C. Boles
            
            54
            
            Vice
                President and ControllerGary
                B. Romig
            
            56
            
            Vice
                President and General Manager, MissouriNicholas
                A. Winchester
            
            36
            
            Senior
                Vice President and General Manager,
                Maine





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




*Jerry
      C. Boles* has
      served as our Vice President and Controller since he joined the company in
      January 1999. Prior to joining Otelco, he was controller for McPherson Oil
      Company for 14 years. He also worked in public accounting for
      10 years, is 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 our Missouri division 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. **




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




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




-15-




**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
      indicated are as follows:




High
                ($US)
            
            Low
                ($US)2006Fourth
                Quarter
            
            $
            23.12
            
            $
            18.59Third
                Quarter
            
            $
            20.10
            
            $
            17.95Second
                Quarter
            
            $
            18.05
            
            $
            15.42First
                Quarter
            
            $
            18.40
            
            $
            15.752005
              Fourth
                Quarter
            
            $
            16.90
            
            $
            15.19Third
                Quarter
            
            $
            16.48
            
            $
            14.95Second
                Quarter
            
            $
            15.43
            
            $
            14.55First
                Quarter
            
            $
            16.00
            
            $
            15.05





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




**Holders**




As
      of
      March 1, 2007, there were approximately 12,000 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, 2007, 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 and 2006 for a total of $0.705
      per share for each year. The dividend in the fourth quarter of 2006 was paid
      on
      January 2, 2007.




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.




-16-




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




-17-




·
            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:




·
            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 1.14x; 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
                3.8x.




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, 2006, 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. The
      Adjusted EBITDA financial test at December 31, 2006 did not allow for an early
      exchange of our Class B common stock for IDS units.




**Performance
      Graph**




The
      following graph compares the cumulative total stockholder return (stock price
      appreciation plus reinvested dividends) for our Class A shares (represented
      by
      IDSs) with the cumulative total return (including reinvested dividends) of
      the
      Russell 2000 Index (“R2000”) and the Standard & Poor’s - Telecommunications
      Services Index (“S&P-TS”), assuming a $100 investment on December 16, 2004
      (the date our IDSs began trading on the American Stock Exchange) through
      December 31, 2006:




-18-


**COMPARISON
        OF 2 YEAR CUMULATIVE TOTAL RETURN***
 Among
        Otelco Inc., The Russell 2000 Index
 And
        The S
& P Telecommunication Services Index







*
        $100
        invested on 12/16/04 in stock or on 11/30/04 in index-including reinvestment
        of
        dividends. Fiscal year ending December 31.




**Cumulative
                Stockholder Returns on $100 Invested:****12/16/04**
            
            **12/04**
            
            **12/05**
            
            **12/06****Otelco
                Inc.**
            
            
            **100.00**
            
            
            **104.20**
            
            
            **115.23**
            
            
            **167.15****Russell
                2000**
            
            
            **100.00**
            
            
            **102.96**
            
            
            **107.65**
            
            
            **127.42****S
                & P Telecommunication Services**
            
            
            **100.00**
            
            
            **102.57**
            
            
            **96.79**
            
            
            **132.42**




**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,
      2004, 2005, and 2006 and for each of the three years in the period ended
      December 31, 2006 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, 2002 and 2003 and for each of the two years in the period
      ended December 31, 2003 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.




-19-




**At
                  and For The Year Ended December31,****2002**
              
              **2003(1)**
              
              **2004(1)**
              
              **2005**
              
              **2006(1)****(in
                  thousands except per share amounts)****Income
                  Statement Data**Revenues:Local
                  services
              
              $
              15,079
              
              $
              15,661
              
              $
              16,657
              
              $
              17,445
              
              $
              21,523Network
                  access
              
              
              12,003
              
              
              14,701
              
              
              16,602
              
              
              21,873
              
              
              23,482Cable
                  television
              
              
              1,586
              
              
              1,748
              
              
              1,818
              
              
              2,087
              
              
              2,191Internet
              
              
              1,202
              
              
              1,645
              
              
              2,189
              
              
              5,567
              
              
              8,516Transport
                  Services
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,877Total
              
              $
              29,870
              
              $
              33,755
              
              $
              37,266
              
              $
              46,972
              
              $
              57,589Income
                  from operations
              
              $
              14,941
              
              $
              14,837
              
              $
              14,658
              
              $
              19,439
              
              $
              19,803Income
                  before income tax and accretion expense
              
              $
              11,017
              
              $
              11,600
              
              $
              10,074
              
              $
              3,246
              
              $
              2,802Net
                  income
              
              $
              7,199
              
              $
              7,493
              
              $
              6,114
              
              $
              1,792
              
              $
              1,161Net
                  income per share(2)Basic
              
              $
              0.89
              
              $
              0.93
              
              $
              0.75
              
              $
              0.19
              
              $
              0.12.Diluted
              
              $
              0.84
              
              $
              0.88
              
              $
              0.71
              
              $
              0.12
              
              $
              0.18.**Balance
                  Sheet Data**Cash
                  and cash equivalents
              
              $
              2,322
              
              $
              1,650
              
              $
              5,407
              
              $
              5,569
              
              $
              14,402Property
                  and equipment, net
              
              
              32,672
              
              
              37,919
              
              
              48,196
              
              
              44,556
              
              
              60,494Total
                  assets
              
              
              135,138
              
              
              150,721
              
              
              196,227
              
              
              192,126
              
              
              243,852Long-term
                  notes payable (including current portion)
              
              
              81,493
              
              
              83,073
              
              
              161,075
              
              
              161,075
              
              
              201,075




(1)
            During
                fiscal 2003, 2004 and 2006, we acquired Blountsville, Mid-Missouri
                and
                Mid-Maine respectively, all rural local telephone companies, with
                Mid-Maine also being a competitive local exchange company. More
                information about each acquisition can be found in Item 1 of this
                report.




(2)
            On
                December 21, 2004, the company completed its initial public offering
                of IDSs. Net income 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 operate six rural local exchange carriers serving
      subscribers in approximately 2,390 square miles of north central Alabama,
      central Maine and central Missouri. We are the sole wireline telephone services
      provider in the rural communities we serve. We also operate a competitive local
      exchange carrier serving subscribers from Portland to Bangor, Maine. Our
      services include local and long distance telephone services, network access,
      other telephone related services, cable television (in some markets) and
      Internet access. We view, manage and evaluate the results of operations from
      the
      various 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, 2006, we operated approximately 63,954 access line
      equivalents.




Our
      core
      businesses are local and long distance services 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 78.1% of our total revenues in 2006. We also provide cable
      television service in some markets and dial-up and digital high-speed Internet
      access in all of our markets.




The
      following discussion and analysis should be read in conjunction with our
      financial statements and the related notes and other financial information
      appearing elsewhere in this report, 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 Mid-Missouri as of
      December 21, 2004 and Mid-Maine as of July 3, 2006.




-20-




*Impact
      of Indebtedness Levels on our Results of Operations and
      Liquidity*




As
      a
      result of the significant amount of debt we have outstanding through our senior
      credit facility, the senior subordinated note portion of the outstanding IDSs,
      and the senior subordinated notes sold separately (not in the form of IDSs),
      our
      interest expense remains at a significantly high level. The interest on that
      portion of our senior credit facility not covered by an interest rate cap will
      fluctuate with market conditions and could increase until maturity. We will
      be
      required to refinance our credit facility upon its maturity in July 2011 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 our high levels of indebtedness
      and
      related debt service requirements discussed above. We expect the cash
      requirements to be funded through cash flow generated from the operations of
      our
      business. We also have access to a $15.0 million revolving credit facility
      to supplement our liquidity position as needed.




There
      can
      be no assurance that we will have sufficient cash in the future to pay dividends
      on our Class A common stock at the historical rate or at all. If we do not
      generate sufficient cash from our operating activities in the future to pay
      dividends, we may have to reduce or eliminate dividends or rely on cash provided
      by financing activities in order to fund dividend payments, if such financing
      is
      available. However, if we use working capital or borrowings under our credit
      facility to fund dividends, we would have less cash available for future
      dividends and we may not have sufficient cash to pursue growth opportunities
      such as the 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, our high indebtedness levels and related debt service
      requirements and our capital expenditure requirements will significantly limit
      any cash available from operations for other uses for the foreseeable
      future.




*Revenue
      Sources*




We
      derive
      our revenues from five sources:




·
            *Local
                services.*We
                receive revenues from providing local exchange 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. 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. A growing portion of our subscribers
                take bundled service plans which include multiple services, including
                unlimited domestic calling.




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




-21-




·
            *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.




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




·
            *Transport
                Services.*We
                receive monthly recurring revenues for the rental of fiber to transport
                data and other telecommunications services in
                Maine.




*Access
      Line and Customer Trends*




The
      number of access lines served is a fundamental factor in determining revenue
      stability for a telecommunications provider. Reflecting a general trend in
      the
      rural local exchange carrier industry, the number of rural 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 competitive
      carrier access lines have grown as we continue to further penetrate our chosen
      markets. Our ability to continue this growth and our response to the rural
      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 rural customer base and
      providing better service and support levels than the incumbent carrier to our
      competitive customer base.




**Year
                    Ended December 31,****2004**
                
                **2005**
                
                **2006**Access
                    line equivalents(1):Residential
                    access lines
                
                
                25,237
                
                
                24,541
                
                
                29,832Business
                    access lines
                
                
                8,414
                
                
                8,036
                
                
                22,171Access
                    lines
                
                
                33,651
                
                
                32,577
                
                
                52,003Digital
                    high-speed lines
                
                
                3,488
                
                
                6,314
                
                
                11,951Total
                    access line equivalents
                
                
                37,139
                
                
                38,891
                
                
                63,954Long
                  distance customers
                
                
                13,641
                
                
                14,438
                
                
                21,370Cable
                  television customers
                
                
                3,959
                
                
                4,220
                
                
                4,188Dial-up
                  Internet customers
                
                
                15,348
                
                
                12,149
                
                
                19,780


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




The
      primary reason for the increase in access lines, access line equivalents, long
      distance customers and Internet customers was the acquisition of Mid-Maine.
      Excluding Mid-Maine, access line equivalents increased 5.0%, access line
      declined 2.7% and long distance subscribers increased 18.4% over 2005. Cable
      customers declined 0.8% from 2005.




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 and growing our penetration of the competitive
      market in Maine. Our digital high-speed Internet customers continue to grow
      rapidly, with 11,951 customers at December 31, 2006. This includes
      wholesale DSL customers in one of our rural local exchange carrier territories.
      We expect continued digital high-speed Internet revenue growth which has a
      negative effect on our dial-up Internet customers as some customers migrate
      to
      high-speed Internet access. In addition, the growth in our digital high-speed
      Internet access customers has a negative effect on our access lines as some
      customers no longer have a need for second lines for purposes of dial-up
      Internet access.




-22-




Mid-Maine
      provides dial-up Internet on a statewide basis. The acquisition of Mid-Maine
      more than doubled the number of dial-up Internet customers we served outside
      our
      telephone serving area. Our dial-up Internet customers will continue to reflect
      the expected impact of the shift to digital high-speed Internet
      services.




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 and 2006, the improved
      performance of the Alabama and Missouri local economies was partially offset
      by
      the impact of higher energy prices.




*Competition.* There
      are currently no wireline telephone competitors operating within our rural
      territories. There has been a negative impact on our local toll and long
      distance minutes of use due to flat rate offers from wireless carriers. While
      originating minutes have declined, terminating minutes have increased. We have
      experienced limited access line losses to wireless carriers. In addition, we
      have responded to wireless competition by offering bundled service packages
      which include unlimited domestic calling for our Alabama and Missouri residence
      customer. These service bundles are designed to meet the broader communications
      needs of our customers at industry competitive prices. Over 30% of our Alabama
      market and 12% of our Missouri market have accepted one of these service
      bundles.




*Acquisitions.* In December 2004, we purchased Mid-Missouri Telephone, a rural local
      exchange carrier in central Missouri. In July 2006, we purchased Mid-Maine
      Communications, Inc., a rural local exchange carrier in central Maine and a
      competitive local exchange carrier serving urban markets from Portland to
      Bangor.




*Ancillary
      Effects of our Internet Services.* As
      we increase penetration of our digital 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. In addition, we are offering special
      pricing to bundle customers who also install a second line.




*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. Four of our operating subsidiaries
      continue to receive compensation from the TSF. We received total compensation
      of
      $2.8 million, representing 4.9% of our total revenue, from the TSF for the
      year ended December 31, 2006. We do not expect material changes in the
      amount of revenue we receive from the TSF.




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. As of February 1, 2007, the APSC has no jurisdiction over
      bundled services. 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.




-23-




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. On September
      1, 2006, our Alabama RLECs filed to be regulated under the Reform Act. This
      filing was effective on October 31, 2006.




In
      Maine,
      Incumbent Local Exchange Carriers (ILECs) are regulated either through
      traditional rate-of-return regulation or through a statutorily defined Alternate
      Form of Regulation (AFOR).  Verizon-Maine is the only company operating
      under an AFOR. All other ILECs in Maine operate under traditional rate-of-return
      regulation.  The Country Road Communications subsidiaries in Maine, Saco
      River Telegraph & Telephone, and Pine Tree Telephone & Telegraph
      (collectively “Pine Tree Networks”), have obtained authority to engage in
      Pricing Flexibility while remaining under rate-of-return regulation. 
Pricing Flexibility includes a price cap provision whereby rates may be lowered
      below the price cap, but may not be raised above the price cap, upon notice
      to
      the Commission.  In addition, Pine Tree Networks may enter into special
      contracts with customers without the need for direct Commission approval for
      individual contracts.  The Pricing Flexibility plan does not include any
      form of stay-out or other provision which would constitute an AFOR and the
      conditions of the plan may be changed at any time by the Commission simply
      by
      virtue of the Commission opening a proceeding to examine the Pricing Flexibility
      plan.  As a result of a legislative initiative by Pine Tree Networks, the
      MPUC and members of the Telephone Association of Maine (TAM), which is composed
      of all of the Independent Telephone Companies (ITCs) in the State, are engaging
      in regular meetings to examine the possibility of instituting a Pricing
      Flexibility template that other companies could use, as well as examining the
      overall regulatory burdens on ILECs as compared to intermodal competitors,
      such
      as wireless and VOIP providers.  TAM and MPUC are meeting once a month
      until Fall 2007 to work on these issues, with a report to be submitted to the
      Legislature at the conclusion of the discussions.




The
      MPUC,
      as a result of a State statute, required companies to reduce their intrastate
      access rates to levels comparable to interstate access rates.  To address
      the revenue impacts of this process, the Commission required companies to raise
      their local service rates.  Where a company’s basic service rates would
      exceed a cap equal to the Verizon-Maine’s residential rates of approximately
      $19.29 per month, a Maine Universal Service Fund (MUSF) was established to
      address the difference. Companies, including Mid-Maine Communications, began
      to
      receive support through the MUSF.  This support continues today, although
      it may be impacted by any intercarrier compensation decision on the part of
      the
      FCC.  Maine’s Commission has been aggressively promoting an Early Adopter
      Fund within the Missoula Plan for intercarrier compensation at the FCC. 
The Early Adopter Fund would provide a mechanism to replace the need for a
      State
      specific USF for those States which had already adopted intercarrier
      compensation reforms at the State level.  It is not clear at this time what
      will be the results of the Missoula Plan discussions, including the question
      of
      whether the FCC will authorize an Early Adopter Fund.




In
      Missouri, local exchange and Intrastate 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 in 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 eligible to convert to price cap regulation but has not
      elected to convert at this time.




-24-




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.




*Categories
      of Operating Expenses*




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




*Cost
      of services.* This
      includes 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.




*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. 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 and 2006.




*Depreciation
      and amortization.* This
      includes depreciation of our telecommunications, cable and Internet networks
      and
      equipment, and amortization of intangible assets. Certain of these amortization
      expenses continue to be deductible for tax purposes.




*Our
      Ability to Control Operating Expenses*




We
      strive
      to control expenses in order to maintain our strong operating margins. As our
      revenue shifts to non-regulated services and competitive customers, operating
      margins decrease reflecting the lower margins associated with these services.
      As
      an example, the cost of services as a percentage of revenue has increased each
      year from 2004 to 2006, but the absolute dollars available to cover all other
      expenses after these service costs has also increased. We expect to control
      expenses while we continue to grow our business.




-25-




*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,****2004**
            
            **2005**
            
            **2006**RevenuesLocal
                services
            
            
            44.7
            %
            
            37.1
            %
            
            37.3
            %Network
                access
            
            
            44.5
            
            
            46.6
            
            
            40.8Cable
                television
            
            
            4.9
            
            
            4.4
            
            
            3.8Internet
            
            
            5.9
            
            
            11.9
            
            
            14.8Transport
                services
            
            
            –
            
            
            –
            
            
            3.3Total
                revenues
            
            
            100.0
            %
            
            100.0
            %
            
            100.0
            %Operating
                expensesCost
                of services and products
            
            
            23.7
            %
            
            26.8
            %
            
            32.5
            %Selling,
                general and administrative expenses
            
            
            20.6
            
            
            14.3
            
            
            14.4Depreciation
                and amortization
            
            
            16.4
            
            
            17.5
            
            
            18.7Total
                operating expenses
            
            
            60.7
            
            
            58.6
            
            
            65.6Income
                from operations
            
            
            39.3
            
            
            41.4
            
            
            34.4Other
                income (expense)Interest
                expense
            
            
            (12.9
            )
            
            (37.7
            )
            
            (34.8
            )Change
                in fair value of derivative
            
            
            –
            
            
            2.0
            
            
            (0.5
            )Other
                income
            
            
            0.6
            
            
            1.2
            
            
            5.8Total
                other expense
            
            
            (12.3
            )
            
            (34.5
            )
            
            (29.5
            )Income
                before income tax and accretion expense
            
            
            27.0
            
            
            6.9
            
            
            4.9Income
                tax expense
            
            
            (10.6
            )
            
            (2.2
            )
            
            (2.1
            )Income
                before accretion expense
            
            
            16.4
            
            
            4.7
            
            
            2.8Accretion
                of Class B common convertible to senior subordinated notes
            
            
            –
            
            
            (0.9
            )
            
            (0.8
            )Net
                income available to common stockholders
            
            
            16.4
            %
            
            3.8
            %
            
            2.0
            %




*Year
      ended December 31, 2006 compared to year ended December 31,
      2005*




*Total
      Revenues.* Total
      revenues grew 22.6% in 2006 to $57.6 million from $47.0 million in
      2005. The table below provides the components of our revenues for 2006 compared
      to 2005.


**Year
                    Ended December 31,**
                
                **Change****2005**
                
                **2006**
                
                **Amount**
                
                **Percent****(dollars
                    in thousands)**Local
                    services
                
                $
                17,445
                
                $
                21,523
                
                $
                4,078
                
                
                23.4
                %Network
                    access
                
                
                21,873
                
                
                23,482
                
                
                1,609
                
                
                7.4Cable
                    television
                
                
                2,087
                
                
                2,191
                
                
                104
                
                
                5.0Internet
                
                
                5,567
                
                
                8,516
                
                
                2,949
                
                
                53.0Transport
                    services
                
                
                -
                
                
                1,877
                
                
                1,877
                
                
                -Total
                
                $
                46,972
                
                $
                57,589
                
                $
                10,617
                
                
                22.6




Local
      services.    Local service revenue in 2006 grew 23.4% to
      $21.5 million from $17.4 million in 2005. This increase was
      attributable to an increase of $4.3 million from the acquisition of
      Mid-Maine on July 3, 2006, an increase of $0.1 million in directory advertising,
      offset by a reduction of $0.2 million from access line loss by our other
      rural local exchange carriers and lower billing and collection fees from long
      distance carriers and $0.1 million in building rental income. Loss of 2.6%
      of
      our access lines was 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. The acceptance of unlimited calling
      plans
      continues to grow the percentage of our customers with service bundles.




Network
      access.    Network access revenue in 2006 grew 7.4% to
      $23.5 million from $21.9 million in 2005. This increase was
      attributable to an increase of $2.3 million from the acquisition of
      Mid-Maine, offset by a decrease of $0.2 million from end user associated
      fees and $0.5 million associated with access trunks, interexchange carrier
      traffic, and USF HC reimbursement.




-26-




Cable
      television.    Cable television revenue in 2006 increased
      5.0% to $2.2 million from $2.1 million in 2005. The increase was
      primarily due to an increase in local channel advertising revenue and increased
      basic cable prices.




Internet.    Internet
      revenue in 2006 increased 53.0% to $8.5 million from $5.6 million in
      2005. This increase was attributable to an increase of $2.4 million from the
      acquisition of Mid-Maine and $1.3 million from the addition of over 2,400 new
      high-speed Internet customers in Alabama and Missouri, partially offset by
      $0.7
      million associated with the loss of approximately 2,600 dial-up Internet
      customers in Alabama and Missouri, including those we serve outside of our
      territory in Missouri.




Transport
      services.    The addition of $1.9 million in transport
      services revenue is attributable to the acquisition of Mid-Maine on July 3,
      2006.




*Operating
      expenses.* Operating
      expenses in 2006 increased 37.2% to $37.8 million from $27.5 million
      in 2005. The increase was primarily attributable to the purchase of Mid-Maine
      on
      July 3, 2006, and increased costs associated with higher Internet
      revenues.


**Year
                  Ended December 31,**
              
              **Change****2005**
              
              **2006**
              
              **Amount**
              
              **Percent****(dollars
                  in thousands)**Cost
                  of services
              
              $
              12,611
              
              $
              18,728
              
              $
              6,117
              
              
              48.5
              %Selling,
                  general and administrative expenses
              
              
              6,711
              
              
              8,278
              
              
              1,567
              
              
              23.3Depreciation
                  and amortization
              
              
              8,212
              
              
              10,781
              
              
              2,569
              
              
              31.3Total
              
              $
              27,534
              
              $
              37,787
              
              $
              10,253
              
              
              37.2




Cost
      of
      services.    The cost of services increased 48.5% to
      $18.7 million in 2006 from $12.6 million in 2005. The acquisition of
      Mid-Maine accounted for a $6.1 million increase. For the balance of the
      company, increases in energy costs, long distance charges, cable programming
      charges, and Internet expense were offset by operational
      efficiencies.




Selling,
      general and administrative expenses.    Selling, general and
      administrative expenses increased 23.3% to $8.3 million in 2006 from
      $6.7 million in 2005. The acquisition of Mid-Maine accounted for an
      increase of $1.9 million, offset by reductions of $0.3 million in legal,
      insurance and external relations expenses in the remainder of the
      company.




Depreciation
      and amortization.    Depreciation and amortization increased
      31.3% to $10.8 million in 2006 from $8.2 million in 2005. The
      acquisition of Mid-Maine accounted for an increase of $2.7 million, including
      amortization of non-compete, plant acquisition, and other intangibles, partially
      offset by a decrease of $0.1 million in the remainder of the
      company.




*Interest
      expense.* Interest
      expense increased 13.3% to $20.1 million in 2006 from $17.7 million in
      2005. The addition of $40 million in long-term notes payable associated with
      the
      purchase of Mid-Maine and the non-cash amortization of the related loan costs
      together accounted for $2.1 million of the increase. The balance of the increase
      was associated with the increase in the non-cash caplet costs associated with
      our five year $80 million rate cap at 3% LIBOR through December 21, 2009.




*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 increased the value of the derivative by $0.3 million when
      compared with the end of 2005.




-27-




*Other
      income.* Other
      income increased 481.3% to $3.4 million in 2006 from $0.6 million in
      2005. The Rural Telephone Bank (RTB) redeemed its stock, leading to a one time
      gain of $2.7 million. Interest income increased $0.2 million as interest rates
      associated with invested cash increased. These increases were offset by a
      decline in the patronage dividends associated with the RTB
      redemption.




*Income
      taxes.* Income
      taxes in 2006 increased 19.7% to $1.2 million from $1.0 million in
      2005. Our 2006 effective income tax rate increased primarily due to the impact
      of acquiring Mid-Maine where the state has a unitary income tax which yields
      higher state income taxes and the 2006 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 was accreted over two years
      which is the length of time up to the earliest date the Class B common
      stock could be exchanged for IDSs. The accretion has been
      completed.




*Net
      income.* As
      a result of the foregoing, net income in 2006 decreased 35.2% to
      $1.2 million from $1.8 million in 2005.




*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
                services
            
            $
            16,657
            
            $
            17,445
            
            $
            788
            
            
            4.7
            %Network
                access
            
            
            16,602
            
            
            21,873
            
            
            5,271
            
            
            31.7Cable
                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 4.7% to
      $17.4 million from $16.7 million in 2004. This increase was
      attributable to an increase of $1.2 million from the acquisition of
      Mid-Missouri, $0.1 million increase in local cellular termination revenue and
      $0.1 million increase in directory and other telephone services. These were
      partially offset by a decrease of $0.2 million from an access line loss of
      2.9%, or 855 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.




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 $27.5 million from $22.6 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.




-28-




**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
            
            
            6,100
            
            
            8,212
            
            
            2,112
            
            
            34.6Total
            
            $
            22,609
            
            $
            27,534
            
            $
            4,925
            
            
            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
      34.6% to $8.2 million in 2005 from $6.0 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 268.8% to $17.7 million from $4.8 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 and the increase
      in non-cash amortization of loan costs.




*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 our former equity holders coincident
      with our initial public offering on December 21, 2004. The payment of
      dividends on the Class B common stock is prohibited by our certificate of
      incorporation. Shares of Class B common stock will be exchanged for IDSs no
      later than December 21, 2009. The discount 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.




-29-




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




**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 2006 amounted to $16.5 million compared
      to $10.9 million for 2005. The increase was primarily due to the
      acquisition of Mid-Maine.




Cash
      used
      in investing activities for 2006 amounted to $18.4 million compared to
      $3.6 million for 2005. The redemption of the RTB stock provided a one time
      increase of $3.1 million. The acquisition of Mid-Maine used $16.0 million.
      The
      acquisition and construction of property and equipment including Mid-Maine
      increased cash used in investing activities by $1.5 million over
      2005.




Cash
      from
      financing activities for 2006 amounted to $10.8 million compared to cash used
      of
      $7.1 million in 2005. In 2006, the company declared dividends amounting to
      $6.8
      million to the holders of its Class A common stock, $1.7 million of which were
      paid on January 2, 2007. The company repaid $24.3 million in long-term
      notes payable as part of the transaction to purchase Mid-Maine for which it
      borrowed $40.0 million in long-term notes payable.




Total
      capital expenditures in 2006 were $5.6 million, up $1.5 million from
      $4.1 million in 2005, reflecting the acquisition of Mid-Maine and the
      purchase of a soft switch in our Alabama territory.




We
      currently have outstanding $120.0 million under the term loan portion of
      our amended and restated credit facility that matures in 2011. Borrowings under
      the term loan bear interest at three-month LIBOR plus 3.25% (8.62% as of
      December 31, 2006). On December 21, 2004 the company purchased a five year
      rate cap on $80 million as an effective hedge against any increase in interest
      rates on that portion of our term loan, capping the three month LIBOR rate
      at
      3.00% per year for the five years. 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,
      2006 or at any time since its inception. We are charged a 0.5% 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.




-30-


**Obligations
      and Commitments**




The
      following table discloses aggregate information about our contractual
      obligations as of December 31, 2006, 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**Amended
                and restated credit facilityTerm
            
            $
            120.0
            
            $
            —
            
            $
            —
            
            $
            120.0
            
            $
            —Revolver(1)
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Senior
                subordinated notes(2)
            
            
            85.2
            
            
            —
            
            
            —
            
            
            —
            
            
            85.2Expected
                interest expense(3)
            
            
            183.9
            
            
            19.1
            
            
            38.3
            
            
            37.9
            
            
            88.6Total
                contractual cash obligations
            
            $
            389.1
            
            $
            19.1
            
            $
            38.3
            
            $
            157.9
            
            $
            173.8




(1)
            We
                have a $15.0 million revolving credit facility with a July 2011
                maturity available. No amounts were drawn on this facility on
                December 31, 2006 or during 2006. The company pays a commitment fee
                of 0.50% per annum, payable quarterly in arrears, on the unused portion
                of
                the revolver loan.




(2)
            Includes
                $4.1 million liquidation value of Class B common stock
                convertible into senior subordinated notes and interest on those
                notes
                beginning December 21, 2009, the date they can be exchanged for IDSs
                on a one-for-one basis without passing a financial test. If Class
                B common
                were to convert prior to this date, the annual interest on the senior
                subordinated debt would be $0.5
                million.




(3)
            Expected
                interest payments to be made in future periods reflect anticipated
                interest payments related to our $120.0 million senior credit
                facility and our $85.2 million senior subordinated notes at 13.0%,
                including those associated with our IDSs and those sold separately.
                Interest on the senior credit facility reflects current LIBOR three
                month
                rate of 5.32% plus a margin of 3.25%, partially offset by a 3% cap
                on
                three month LIBOR for $80.0 million through December 21, 2009. We
                have
                assumed in the presentation above that we will hold the senior credit
                facility until maturity in 2011 and the senior subordinated notes
                until
                maturity in 2019. No interest payment is included for the revolving
                credit
                facility because of the variability and timing of advances and repayments
                thereunder.




**Off-Balance
      Sheet Arrangements**




The
      Company has no off-balance sheet arrangements.




**Critical
      Accounting Policies and Accounting Estimates**




The
      process of preparing financial statements requires the use of estimates on
      the
      part of management. These estimates are based on our historical experience
      combined with management’s understanding of current facts and circumstances.
      Certain of our accounting policies are considered critical as they are both
      important to the portrayal of our financial statements and require significant
      or complex judgment on the part of management. The following is a summary of
      certain policies considered critical by management.




*Regulatory
      Accounting.* We
      follow the accounting for regulated enterprises prescribed by SFAS No. 71, *Accounting
      for the Effects of Certain Types of Regulations* ,
      or SFAS
      71, for our rural local exchange carriers. 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 for our rural
      local
      exchange carriers.




-31-


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 and
      non-compete agreements. Goodwill represents the excess of total acquisition
      cost
      over the assigned value of net identifiable tangible and intangible assets
      acquired through various business combinations. Due to the regulatory accounting
      required by SFAS 71, we did not record acquired regulated telecommunications
      property and equipment at fair value as required by SFAS No. 141, *Business
      Combinations,* or
      SFAS 141. In accordance with 47 CFR 32.2000, the federal regulation
      governing acquired telecommunications property and equipment, such property
      and
      equipment is accounted for at original cost and depreciation and amortization
      of
      property and equipment acquired is credited to accumulated depreciation. For
      the
      acquisition of Mid-Maine, property has been marked to fair value in accordance
      with SFAS 141, resulting in a plant acquisition adjustment in Mid-Maine Telecom.
      We have acquired identifiable intangible assets associated with the territories
      we serve through our acquisitions of various companies, including a non-compete
      agreement with the former CEO of Mid-Maine. Any excess of the total purchase
      price over the amounts assigned to net tangible and intangible assets is
      recorded as goodwill.




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




Network
      access revenue is derived from several sources. 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, Maine and
      Missouri, compensation for intrastate access services is received through
      tariffed access charges filed with the APSC, MPUC 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.




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, 2006, we
      do not have an option plan.




-32-




*Accounting
      Treatment for Class B Common Stock.* In
      connection with our initial public offering, we issued shares of Class B
      common stock. In general, subject to a financial test which, as of December
      31,
      2006, had not been met, and other conditions, our Class B common stock is
      exchangeable at the holder’s option for IDSs registered under the Securities Act
      of 1933. Each share of Class B common stock will be exchangeable for one
      IDS, subject to certain adjustments. All Class B common stock will be
      exchanged for IDSs not later than December 21, 2009.




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 was accreted up to the par
      amount of the senior subordinated notes which could be issued on or after
      December 21, 2006. This equals our maximum potential cash obligation at the
      maturity of the senior subordinated notes assuming the senior subordinated
      notes
      are originally issued in an aggregate principal amount of $7.50, with a charge
      for the accretion recorded as a reduction to income available to
      shareholders.




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


-33-


*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 3.0% per annum plus the relevant margin for the five year term
      of
      our credit facility. The relevant margin was 4.0% from December 21, 2004 to
      July
      3, 2006, when the amended and restated credit facility lowered the margin to
      3.25%. 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.




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**




On
      June
      13, 2006, the FASB issued FIN 48, “Accounting for Uncertainty in Income Taxes -
      an interpretation of FASB Statement No. 109, Accounting for Income Taxes”, FIN
      48, which clarifies the accounting for uncertainty in income taxes. FIN 48
      prescribes a recognition threshold and measurement attribute for the financial
      statement recognition and measurement of a tax position taken or expected to
      be
      taken in a tax return. FIN 48 also provides guidance on derecognition,
      classification, interest and penalties, accounting in interim periods and
      disclosure. This pronouncement is effective for years beginning after December
      15, 2006. We have not completed our evaluation of the impact of this
      pronouncement and do not anticipate that it will have a material impact on
      the
      Company.




On
      September 15, 2006, the FASB adopted SFAS No. 157, “Fair Value Measures”, SFAS
      157. It provides clarification on the definition and use of the fair value
      of
      assets and liabilities. We have evaluated the impact of this pronouncement
      and
      will apply it when accounting for future acquisitions beginning in
      2008.




On
      February 15, 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
      Financial Assets and Financial Liabilities,” or SFAS 159. It permits all
      entities to choose to elect, at specified election dates, to measure eligible
      financial instruments at fair value. An entity shall report gains and losses
      on
      items for which the fair value options has been elected in earnings at each
      subsequent reporting date, and recognize upfront costs and fees related to
      those
      items in earnings as incurred and not deferred. SFAS 159 applies to fiscal
      years
      beginning after November 15, 2007, with early adoption permitted for an entity
      that has also elected to apply the provisions of SFAS 157. An entity is
      prohibited from retroactively applying SFAS 159 unless it chooses early
      adoption. SFAS 159 also applies to eligible items existing at November 15,
      2007.
      We are evaluating the impact of this pronouncement and do not anticipate that
      it
      will have a material impact on the Company.




**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.




-34-




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




**Report
      of Independent Registered Public Accounting Firm**




To
      the
      Board of Directors and Stockholders


of
      Otelco
      Inc.


Oneonta,
      Alabama




We
      have
      audited management’s assessment, included in the accompanying Management’s
      Report on Internal Control over Financial Reporting in Item 9A of Form
      10-K, that Otelco Inc. (the “Company”) maintained effective internal control
      over financial reporting as of December 31, 2006, based on criteria established
      in *Internal
      Control - Integrated Framework* issued
      by
      the Committee of Sponsoring Organizations of the Treadway Commission (the COSO
      criteria)”. 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; (2)
      provide reasonable assurance that transactions are recorded as necessary to
      permit preparation of financial statements in accordance with generally accepted
      accounting principles, and that receipts and expenditures of the company are
      made only in accordance with authorizations of management and directors of
      the
      company; and (3) provide reasonable assurance regarding prevention or timely
      detection of unauthorized acquisition, use, or disposition of the company’s
      assets that could have a material effect on the financial
      statements.




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




In
      our
      opinion, management’s assessment that Otelco Inc. maintained effective internal
      control over financial reporting as of December 31, 2006, is fairly stated,
      in
      all material respects, based on the COSO criteria. Also in our opinion, Otelco
      Inc. maintained, in all material respects, effective internal control over
      financial reporting as of December 31, 2006, based on the COSO
      criteria.




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, 2006 and 2005, and the related consolidated statements of
      income, stockholders’ equity, and cash flows for each of the three years in the
      period ended December 31, 2006 and our report dated February 28, 2007
      expressed an unqualified opinion thereon.





/s/
      BDO
      Seidman, LLP


Atlanta,
      Georgia


February
      28, 2007





-35-




**Consolidated
      Financial Statements:**


**Page**Report
                  of Independent Registered Public Accounting Firm
              
              37Consolidated
                  Balance Sheets
              
              38Consolidated
                  Statements of Income
              
              39Consolidated
                  Statements of Changes in Stockholders’ Equity
              
              40Consolidated
                  Statements of Cash Flow
              
              41Notes
                  to Consolidated Financial Statements
              
              43





-36-





**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, 2006 and 2005 and the related consolidated statements of income,
      stockholders’ equity, and cash flows for each of the three years in the period
      ended December 31, 2006. 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,
      2006 and 2005, and the results of its operations and its cash flows for each
      of
      the three years in the period ended December 31, 2006 **,** 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, 2006, 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 28, 2007 expressed an unqualified opinion
      thereon.






/s/
      BDO
      Seidman, LLP


Atlanta,
      Georgia


February
      28, 2007, except for Note 8 which is as of June 14, 2007





-37-





**OTELCO
      INC.**




**CONSOLIDATED
      BALANCE SHEETS**




**December
                31,****2005**
            
            **2006****Assets**Current
                assetsCash
                and cash equivalents
            
            $
            5,569,233
            
            $
            14,401,849Accounts
                receivable:Due
                from subscribers, net of allowance for doubtful accounts of $160,270
                and
                $207,359 respectively
            
            
            1,212,909
            
            
            3,105,636Unbilled
                receivables
            
            
            1,828,104
            
            
            2,324,213Other
            
            
            1,482,171
            
            
            1,680,144Materials
                and supplies
            
            
            932,861
            
            
            1,962,938Prepaid
                expenses
            
            
            504,256
            
            
            1,062,947Income
                tax receivables
            
            
            749,591
            
            
            —Deferred
                income taxes
            
            
            872,675
            
            
            766,225Total
                current assets
            
            
            13,151,800
            
            
            25,303,952Property
                and equipment, net
            
            
            44,555,611
            
            
            60,493,789Goodwill
            
            
            119,431,993
            
            
            134,182,309Intangible
                assets, net
            
            
            1,588,079
            
            
            11,340,806Investments
            
            
            1,108,249
            
            
            1,240,250Deferred
                financing costs
            
            
            6,971,610
            
            
            6,652,393Interest
                rate cap
            
            
            5,318,728
            
            
            4,542,160Deferred
                charges
            
            
            —
            
            
            96,628Total
                assets
            
            $
            192,126,070
            
            $
            243,852,287**Liabilities
                and Stockholders’ Equity**Current
                liabilitiesAccounts
                payable
            
            $
            1,106,114
            
            $
            1,658,911Dividends
                payable
            
            
            —
            
            
            1,705,524Accrued
                expenses
            
            
            1,692,841
            
            
            5,875,863Advance
                billings and payments
            
            
            1,204,680
            
            
            2,119,701Customer
                deposits
            
            
            213,524
            
            
            197,496Total
                Current Liabilities
            
            
            4,217,159
            
            
            11,557,495Deferred
                income taxes
            
            
            15,345,890
            
            
            24,712,213Other
                liabilities
            
            
            192,769
            
            
            187,037Total
                deferred tax and other liabilities
            
            
            15,538,659
            
            
            24,899,250Long-term
                notes payable
            
            
            161,075,498
            
            
            201,075,498Derivative
                liability
            
            
            1,830,095
            
            
            2,107,877Class
                B common convertible to senior subordinated notes
            
            
            3,655,454
            
            
            4,085,033Stockholders’
                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
            
            
            5,613,703
            
            
            284,041Retained
                deficit
            
            
            (805,731
            )
            
            (1,137,166
            )Accumulated
                other comprehensive income
            
            
            899,019
            
            
            878,045Total
                stockholders’ equity
            
            
            5,809,205
            
            
            127,134Total
                liabilities and stockholders’ equity
            
            $
            192,126,070
            
            $
            243,852,287




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





-38-





**OTELCO
      INC.**




**CONSOLIDATED
      STATEMENTS OF INCOME**




**Years
                Ended December 31,****2004**
            
            **2005**
            
            **2006**RevenuesLocal
                services
            
            $
            16,657,356
            
            $
            17,445,233
            
            $
            21,523,406Network
                access
            
            
            16,602,572
            
            
            21,873,485
            
            
            23,481,490Cable
                television
            
            
            1,817,711
            
            
            2,086,854
            
            
            2,191,210Internet
            
            
            2,188,703
            
            
            5,566,650
            
            
            8,515,899Transport
                services
            
            
            —
            
            
            —
            
            
            1,877,387Total
                revenues
            
            
            37,266,342
            
            
            46,972,222
            
            
            57,589,392Operating
                expensesCost
                of services and products
            
            
            8,831,951
            
            
            12,611,499
            
            
            18,727,806Selling,
                general and administrative expenses
            
            
            7,676,496
            
            
            6,710,542
            
            
            8,277,449Depreciation
                and amortization
            
            
            6,100,376
            
            
            8,211,552
            
            
            10,781,333Total
                operating expenses
            
            
            22,608,823
            
            
            27,533,593
            
            
            37,786,588Income
                from operations
            
            
            14,657,519
            
            
            19,438,629
            
            
            19,802,804Other
                income (expense)Interest
                expense
            
            
            (4,806,787
            )
            
            (17,728,834
            )
            
            (20,082,037
            )Change
                in fair value of derivative
            
            
            —
            
            
            958,621
            
            
            (277,782
            )Other
                income
            
            
            223,104
            
            
            577,769
            
            
            3,358,860Total
                other expense
            
            
            (4,583,683
            )
            
            (16,192,444
            )
            
            (17,000,959
            )Income
                before income tax and accretion expense
            
            
            10,073,836
            
            
            3,246,185
            
            
            2,801,845Income
                tax expense
            
            
            (3,946,625
            )
            
            (1,011,675
            )
            
            (1,211,269
            )Income
                before accretion expense
            
            
            6,127,211
            
            
            2,234,510
            
            
            1,590,576Accretion
                of Class B common convertible to senior subordinated notes
            
            
            (13,348
            )
            
            (442,926
            )
            
            (429,579
            )Net
                income available to common stockholders
            
            $
            6,113,863
            
            $
            1,791,584
            
            $
            1,160,997Weighted
                average shares outstanding:Basic
            
            
            8,103,720
            
            
            9,676,733
            
            
            9,676,733Diluted
            
            
            8,607,455
            
            
            10,221,404
            
            
            10,221,404Basic
                net income per share
            
            $
            0.75
            
            $
            0.19
            
            $
            0.12Diluted
                net income per share
            
            $
            0.71
            
            $
            0.12
            
            $
            0.18Dividends
                declared per share
            
            $
            —
            
            $
            0.71
            
            $
            0.71





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





-39-





**OTELCO
      INC.**




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




**Members’**
            
            **Class
                A**
              **Common
                Stock**
            
            **Class
                B**
              **Common
                Stock**
            
            **Additional
                Paid**
            
            **Retained**
              **Earnings**
            
            **Accumulated
                Other**
              **Comprehensive**
            
            **Total
                Stockholders’****Equity**
            
            **Shares**
            
            **Amount**
            
            **Shares**
            
            **Amount**
            
            **In
                Capital**
            
            **(Deficit)**
            
            **Income**
            
            **Equity**Balance,
                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
            
            $
            5,809,205Comprehensive
                income:Net
                Income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,160,997
            
            
            
            
            
            1,160,997Interest
                rate cap
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (20,974
            )
            
            (20,974
            )Total
                comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,140,023Dividends
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (5,329,662
            )
            
            (1,492,432
            )
            
            
            
            
            (6,822,094
            )Balance,
                December 31, 2006
            
            $
            —
            
            
            9,676,733
            
            $
            96,767
            
            
            544,671
            
            $
            5,447
            
            $
            284,041
            
            $
            (1,137,166
            )
            $
            878,045
            
            $
            127,134




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





-40-





**OTELCO
      INC.**




**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**





**2004**
            
            **2005**
            
            **2006**Cash
                flows from operating activities:Net
                income
            
            $
            6,113,863
            
            $
            1,791,584
            
            $
            1,160,997Adjustments

                to reconcile net income to cash flows from operating
                activities:Depreciation
            
            
            5,837,033
            
            
            7,748,687
            
            
            9,527,319Amortization
            
            
            263,343
            
            
            462,865
            
            
            1,254,014Interest
                rate caplet
            
            
            —
            
            
            258,291
            
            
            755,594Amortization
                of loan costs
            
            
            1,128,095
            
            
            1,373,747
            
            
            1,627,960Stock
                based compensation expense
            
            
            1,493,985
            
            
            —
            
            
            —Accretion
                expense
            
            
            13,348
            
            
            442,924
            
            
            429,579Change
                in fair value of derivative
            
            
            —
            
            
            (958,621
            )
            
            277,782Gain
                on disposition of other assets
            
            
            —
            
            
            —
            
            
            (2,686,745
            )Provision
                for deferred income taxes
            
            
            3,042,751
            
            
            2,072,614
            
            
            983,786Provision
                for uncollectible revenue
            
            
            107,224
            
            
            124,367
            
            
            193,561Changes
                in assets and liabilities; net of assets and liabilities
                acquired:Accounts
                receivables
            
            
            214,940
            
            
            (61,126
            )
            
            (327,129
            )Material
                and supplies
            
            
            200,232
            
            
            107,049
            
            
            3,385Prepaid
                expenses and other assets
            
            
            (16,716
            )
            
            33,531
            
            
            (365,795
            )Income
                tax receivables
            
            
            —
            
            
            (749,591
            )
            
            1,037,395Accounts
                payable and accrued liabilities
            
            
            (28,271
            )
            
            (1,754,002
            )
            
            2,757,784Advance
                billings and payments
            
            
            (2,583
            )
            
            63,667
            
            
            (110,253
            )Other
                liabilities
            
            
            (23,014
            )
            
            (10,561
            )
            
            (22,029
            )Net
                cash from operating activities
            
            
            18,344,230
            
            
            10,945,425
            
            
            16,497,205Cash
                flows from investing activities:Purchase
                of interest rate cap
            
            
            (4,678,000
            )
            
            —
            
            
            —Deferred
                charges / acquisition
            
            
            —
            
            
            —
            
            
            (44,296
            )Acquisition
                and construction of property and equipment
            
            
            (3,261,177
            )
            
            (4,083,222
            )
            
            (5,618,295
            )Cash
                received from acquisition
            
            
            50,633
            
            
            —
            
            
            —Proceeds
                from retirement of investment
            
            
            116,334
            
            
            165,094
            
            
            3,224,913Cash
                paid for the purchase of Mid-Maine, net of cash acquired
            
            
            —
            
            
            —
            
            
            (16,000,040
            )Payments
                for the purchase of Mid-Missouri Holding Corp., net of cash
                acquired
            
            
            —
            
            
            29,683
            
            
            —Payment
                for the purchase of Page & Kiser Communications, Inc., net of cash
                acquired
            
            
            47,858
            
            
            252,418
            
            
            —Net
                cash from investing activities
            
            
            (7,724,352
            )
            
            (3,636,027
            )
            
            (18,437,718
            )Cash
                flows from financing activities:Cash
                dividends paid
            
            
            —
            
            
            (6,822,097
            )
            
            (5,116,572
            )Proceeds
                from long-term notes payable
            
            
            88,500,000
            
            
            —
            
            
            40,000,000Loan
                origination costs and transaction costs
            
            
            (8,060,735
            )
            
            (324,613
            )
            
            237,000Repayment
                of long-term notes payable
            
            
            (99,787,468
            )
            
            —
            
            
            (24,347,299
            )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
            
            
            (6,863,640
            )
            
            (7,146,710
            )
            
            10,773,129Net
                increase in cash and cash equivalents
            
            
            3,756,238
            
            
            162,688
            
            
            8,832,616Cash
                and cash equivalents, beginning of period
            
            
            1,650,307
            
            
            5,406,545
            
            
            5,569,233Cash
                and cash equivalents, end of period
            
            $
            5,406,545
            
            $
            5,569,233
            
            $
            14,401,849Supplemental
                disclosures of cash flow information:Interest
                paid
            
            $
            3,114,381
            
            $
            16,343,237
            
            $
            14,284,165Income
                taxes paid (received)
            
            $
            1,581,026
            
            $
            (651,536
            )
            $
            (698,336
            )Dividends
                declared but not paid
            
            $
            —
            
            $
            —
            
            $
            1,705,524Supplemental
                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
            
            $
            —
            
            $
            —





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




-41-





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




***Nature
      of Business***




Otelco’s
      principal line of business is providing local telephone service, network access,
      transport, digital high-speed and dial-up Internet access, cable television
      and
      other telephone related services. 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, Maine and Missouri and along
      the
      Interstate 95 corridor in Maine. 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”), Page & Kiser Communications, Inc. (“PKC”), and
      Mid-Missouri Holding Corporation (“MMH”), and Mid-Maine Communications, Inc.
      (“MMeT”). HHC’s wholly owned subsidiary is Hopper Telecommunications Company,
      Inc. (“HTC”). BH’s wholly owned subsidiary is Brindlee Mountain Telephone
      Company, Inc. (“BMTC”). PKC’s wholly owned subsidiary is Blountsville Telephone
      company, Inc. (“BTC”). MMH’s wholly owned subsidiary is Mid-Missouri Telephone
      Company (“MMT”). MMT is the sole stockholder of Imagination, Inc. MMeT’s wholly
      owned subsidiaries are Mid-Maine Telecom, Inc. (“MMTI”) and Mid-Maine TelPlus
      (“MMTP”). The accompanying consolidated financial statements include the
      accounts of the Company and all of the aforesaid subsidiaries after elimination
      of all material intercompany balances and transactions.




***Use
      of Estimates***




The
      Company prepares its consolidated financial statements in accordance with
      accounting principles generally accepted in the United States of America, which
      require management to make estimates and assumptions that affect the reported
      amounts of assets, liabilities, revenues and expenses and disclosure of
      contingent assets and liabilities. The estimates and assumptions used in the
      accompanying consolidated financial statements are based upon management’s
      evaluation of the relevant facts and circumstances as of the date of the
      financial statements. Actual results may differ from the estimates and
      assumptions used in preparing the accompanying consolidated financial
      statements.




Significant
      accounting estimates include the recoverability of goodwill and long-term
      assets.




***Regulatory
      Accounting***




The
      Company follows the accounting for regulated enterprises prescribed by Statement
      of Financial Accounting Standards (SFAS) No. 71, *Accounting
      for the Effects of Certain Types of Regulations* or SFAS
      71. This accounting practice recognizes the economic effects of rate regulation
      by recording costs and a return on investment as such amounts are recovered
      through rates authorized by regulatory authorities. Accordingly, SFAS 71
      requires the Company to depreciate telecommunications property and equipment
      over the useful lives approved by regulators, which could be different than
      the
      useful lives that would otherwise be determined by management. SFAS 71 also
      requires deferral of certain costs and obligations based upon approvals received
      from regulators to permit recovery of such amounts in future years. Criteria
      that would give rise to the discontinuance of accounting in accordance with
      SFAS
      71 include (1) increasing competition restricting the ability of the Company
      to
      establish prices that allow it to recover specific costs and (2) significant
      changes in the manner in which rates are set by regulators from cost-based
      regulation to another form of regulation. The Company periodically reviews
      the
      criteria to determine whether the continuing application of SFAS 71 is
      appropriate.




-42-




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 and
      non-compete agreements. Goodwill represents the excess of total acquisition
      cost
      over the assigned value of net identifiable tangible and intangible assets
      acquired through various business combinations. Due to the regulatory accounting
      required by SFAS 71, the Company did not record acquired regulated
      telecommunications property and equipment at fair value as required by SFAS
      No.141, *Business
      Combinations* .
      In
      accordance with 47 CFR 32.2000, the federal regulation governing acquired
      telecommunications property and equipment, such property and equipment is
      accounted for at original cost, and depreciation and amortization of property
      and equipment acquired is credited to accumulated depreciation. For the
      acquisition of MMeT, property has been marked to fair value in accordance with
      SFAS No. 141, resulting in a plant acquisition adjustment for MMTI in 2006.
      The
      Company has acquired identifiable intangible assets associated with the
      territories it serves through its acquisitions of various companies, including
      a
      non-compete agreement with the former CEO of an acquired business. 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 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. Long distance service is billed to
      customers in arrears based on actual usage except when it is included in service
      bundles. The Company records unbilled long distance revenue as unbilled revenue
      when services are rendered. In bundles, unlimited usage is billed in arrears
      at
      a flat rate.




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”),
      the Missouri Public Service Commission (“MPSC”) and the Maine Public Utilities
      Commission (“MPUC”) and are retained by the Company. Revenue for the
      intrastate/interLATA access service is received through tariffed access charges
      as filed with the APSC, MPSC and MPUC. 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.




-43-




Cable
      television, Internet and transport services. Cable television, Internet and
      transport 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 an average cost basis.




***Property
      and Equipment***




Regulated
      property and equipment is stated at original cost. Unregulated property and
      equipment purchased through acquisitions is stated at its fair value at the
      date
      of acquisition. Expenditures for improvements that significantly add to
      productive capacity or extend the useful life of an asset are capitalized.
      Expenditures for maintenance and repairs are expensed when incurred.
      Depreciation is computed principally using the straight-line method over useful
      lives determined by the APSC, MPSC and MPUC 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 and loan costs consist of debt issuance costs incurred in obtaining
      long-term financing, which are amortized over the life of the related debt.
      Amortization of deferred financing and loan costs is classified as “Interest
      expense”.




-44-




***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 was 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 8.




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 6.25% on
      $80
      million of our senior debt through the cap’s maturity. The interest rate cap is
      an effective hedge in offsetting the potential variability of interest rates
      and
      all critical terms of the interest rate cap are identical to the debt it hedges.
      Changes in the fair value of the interest rate cap are not included in earnings
      but are reported as a component of accumulated other comprehensive income.
      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. Under our amended and restated credit agreement we are required
      to
      have interest rate protection on half of our $120 million in senior debt through
      July 3, 2008. This rate cap meets that requirement.




***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, 2005 and 2006.




***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.




-45-




***Income
      per Common Share***




The
      Company computes net income per Class A common share in accordance with the
      provision of SFAS No. 128, *“Earnings
      per Share”* or SFAS
      128. Under the provision of SFAS 128, basic and diluted income per share is
      computed by dividing net income available to stockholders by the weighted
      average number of common shares and common share equivalents outstanding during
      the period. Basic income per common share excludes the effect of potentially
      dilutive securities, while diluted income per common share reflects the
      potential dilution that would occur if securities or other contracts to issue
      common shares were exercised for, converted into or otherwise resulted in the
      issuance of common shares. Net income is adjusted for accretion and derivative
      liability in calculating diluted earnings.




***Recent
      Accounting Pronouncements***




On
      June
      13, 2006, the FASB issued FIN 48, “Accounting for Uncertainty in Income Taxes -
      an interpretation of FASB Statement No. 109, Accounting for Income Taxes”, FIN
      48, which clarifies the accounting for uncertainty in income taxes. FIN 48
      prescribes a recognition threshold and measurement attribute for the financial
      statement recognition and measurement of a tax position taken or expected to
      be
      taken in a tax return. FIN 48 also provides guidance on derecognition,
      classification, interest and penalties, accounting in interim periods and
      disclosure. This pronouncement is effective for years beginning after December
      15, 2006. We have not completed our evaluation of the impact of this
      pronouncement and do not anticipate that it will have a material impact on
      the
      Company.




On
      September 15, 2006, the FASB adopted SFAS No. 157, “Fair Value Measures”, SFAS
      157. It provides clarification on the definition and use of the fair value
      of
      assets and liabilities. We have evaluated the impact of this pronouncement
      and
      will apply it when accounting for future acquisitions beginning in
      2008.




On
      February 15, 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
      Financial Assets and Financial Liabilities,” SFAS 159. It permits all entities
      to choose to elect, at specified election dates, to measure eligible financial
      instruments at fair value. An entity shall report gains and losses on items
      for
      which the fair value options has been elected in earnings at each subsequent
      reporting date, and recognize upfront costs and fees related to those items
      in
      earnings as incurred and not deferred. SFAS 159 applies to fiscal years
      beginning after November 15, 2007, with early adoption permitted for an entity
      that has also elected to apply the provisions of SFAS 157. An entity is
      prohibited from retroactively applying SFAS 159 unless it chooses early
      adoption. SFAS 159 also applies to eligible items existing at November 15,
      2007.
      We are evaluating the impact of this pronouncement and do not anticipate that
      it
      will have a material impact on the Company.




***Reclassifications***




Certain
      items in prior year’s consolidated financial statements have been reclassified
      to conform with 2006 presentation. Amortization of loan cost has been
      reclassified to “Interest expense” from “Depreciation and amortization” in
      the
      amount of $1,128,095 and $1,373,747 for 2004 and 2005
      respectively.




**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




-46-




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




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





·
            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 exisiting 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.





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 December 21, 2009, 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.




-47-




At
      issuance, the Company discounted to present value the potential debt issuance
      on
      conversion of Class B common stock to IDSs for two years at a discount rate
      equal to the interest rate on the senior subordinated notes. We recorded
      $3,212,528 to reflect the initial allocation of Class B common stock to the
      potential debt issuance upon conversion to IDSs. At December 31, 2006 the senior
      subordinated notes payable associated with the Class B common stock is recorded
      at full value in the mezzanine section of the consolidated balance
      sheets.





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,
      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 adjusts 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. All options were valued at fair market when issued, no
      options were backdated, and all options were converted on December 21,
      2004.


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 APIC
              
              
              143,232Total
                  costs
              
              $
              9,730,105




-48-




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.




**3.** **Acquisitions**




On
      July
      3, 2006, the Company acquired 100% of the outstanding common stock of MMeT
      through a merger of MMeT with MM Merger Corp, with MMeT as the surviving
      wholly-owned subsidiary. MMeT owns 100% of two subsidiaries, MMTI and MMTP.
      MMeT
      provides telecommunications solutions, including voice, data and Internet
      services, to residential and business customers in portions of Maine and extends
      Otelco into the New England market.




The
      acquisition agreement of MMeT was $37,750,000 plus transaction costs. The
      purchase price was $40,555,738, including transaction costs and the assumed
      notes payable of $24,347,299 which were paid off at closing. The excess of
      the
      purchase price over the market value of assets and liabilities is reflected
      as
      goodwill of $14,889,559. The goodwill related to the acquisition is not
      deductible for tax purposes. The aggregate consideration paid for the
      acquisition was as follows:


Cash
                  paid
              
              $
              16,208,439Notes
                  payable assumed
              
              
              24,347,299Purchase
                  price
              
              $
              40,555,738




The
      allocation of the net purchase price for the MMeT acquisition was as
      follows:


July
                  3, 2006Cash
              
              $
              208,399Other
                  current assets
              
              
              3,867,982Property
                  and equipment
              
              
              20,180,158Intangible
                  assets
              
              
              10,700,606Goodwill
              
              
              14,750,314Other
                  assets
              
              
              2,367,842Current
                  liabilities
              
              
              (3,030,576
              )Other
                  liabilities
              
              
              (8,488,987
              )Purchase
                  price
              
              $
              40,555,738




Property
      and equipment have depreciation lives consistent with those shown in Note 5.
      The
      intangible assets at time of acquisition included regulated and unregulated
      customer based assets fair value at $8.8 million which had remaining lives
      of 25
      years and a non-competition agreement fair valued at $1.8 million which had
      a
      remaining life of 2 years.




-49-




Concurrent
      with the closing of the acquisition, the Company entered into an amended and
      restated credit agreement, dated as of July 3, 2006, to amend and restate the
      credit agreement, dated as of December 21, 2004, by and among Otelco and the
      other credit parties to the agreement and General Electric Capital Corporation
      as a lender and agent for the lenders. The credit facilities under the amended
      and restated credit agreement are comprised of:




·
            Term
                loans of $120 million due July 3, 2011, consisting of an original
                term
                loan of $80 million, and an additional term loan of $40 million,
                used to
                finance the acquisition and related transaction costs and to provide
                working capital for the Company and its subsidiaries and for other
                corporate purposes: and




·
            A
                revolving loan commitment of up to $15
                million.




The
      term
      loan facility was fully drawn concurrent with closing. Interest rates applicable
      to the term loan and any revolving loans are an index rate plus 2.25% or LIBOR
      plus 3.25%. In addition, there are fees associated with undrawn revolver
      balances and certain annual fees. The Company has an $80 million interest rate
      cap through December 16, 2009 which caps LIBOR plus 3.25% margin at
      6.25%.




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




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




**Unaudited**2005
              
              2006Revenues
              
              $
              69,053,427
              
              $
              69,118,553Income
                  from operations
              
              
              20,286,654
              
              
              19,090,260Net
                  income
              
              
              769,869
              
              
              290,936Basic
                  net income per share
              
              $
              0.08
              
              $
              0.03Diluted
                  net income per share
              
              $
              0.08
              
              $
              0.03




**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, 2005 or 2006, respectively.




Intangible
      assets are summarized as follows:




December
                  31, 2005
              
              December
                  31, 2006Carrying
                  Value
              
              AccumulatedAmortization
              
              NetValue
              
              Carrying
                  Value
              
              AccumulatedAmortization
              
              NetValueCustomer
                  relationships
              
              $
              1,800,000
              
              $
              (211,916
              )
              $
              1,588,084
              
              $
              10,553,440
              
              $
              (592,701
              )
              $
              9,960,739Non
                  competition
              
              
              -
              
              
              -
              
              
              -
              
              $
              1,840,090
              
              $
              (460,022
              )
              $
              1,380,068Total
              
              $
              1,800,000
              
              $
              (211,916
              )
              $
              1,588,084
              
              $
              12,393,530
              
              $
              (1,052,723
              )
              $
              11,340,807




-50-




These
      intangible assets have a range of 2 to 25 years of useful lives. The following
      table presents current and expected amortization expense of the existing
      intangible assets as of December 31, 2006 for each of the following
      periods:




Aggregate
                amortization expense:For
                the year ended December 31, 2004
            
            $
            263,343For
                the year ended December 31, 2005
            
            
            462,865For
                the year ended December 31, 2006
            
            $
            1,254,014


Expected
        amortization expense for the years ending December 31,




2007
              
              $
              1,475,8972008
              
              
              1,015,8742009
              
              
              555,8522010
              
              
              555,8522011
              
              
              553,268Thereafter
              
              
              7,184,064Total
              
              $
              11,340,807




The
      Company utilized the Emerging Issues Task Force Issue No.95-3 (EITF 95-3) in
      2005 in accounting for a change in pension liability associated with its
      purchase of BTC. At the time of acquisition, a liability was established for
      the
      transition of BTC employees from a multi-employer pension plan to the Company’s
      401k plan. The exit cost was revalued by an outside actuary during 2005, leading
      to the business decision that it was not economically feasible to transfer
      the
      employees as originally planned. The liability was reversed and the offset
      was a
      reduction to goodwill associated with the BTC purchase since the amount actually
      incurred was less than the original liability.




-51-




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




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


Estimated
              
              December
                  31,Life
              
              2005
              
              2006Land
              
              
              
              
              $
              772,399
              
              $
              850,257Building
                  and improvements
              
              
              20-40
              
              
              6,961,203
              
              
              8,480,551Telephone
                  equipment
              
              
              6-20
              
              
              92,122,002
              
              
              133,572,157Cable
                  television equipment
              
              
              7
              
              
              5,571,788
              
              
              5,706,003Furniture
                  and equipment
              
              
              8-14
              
              
              1,379,306
              
              
              1,996,877Vehicles
              
              
              7-9
              
              
              3,133,743
              
              
              3,895,058Computer
                  software equipment
              
              
              5-7
              
              
              2,950,946
              
              
              8,629,616Internet
                  equipment
              
              
              5
              
              
              2,146,725
              
              
              2,584,652Total
                  property, plant and equipment
              
              
              
              
              
              115,038,112
              
              
              165,715,171Accumulated
                  depreciation
              
              
              
              
              
              (70,482,501
              )
              
              (105,221,382
              )Net
                  property, plant and equipment
              
              
              
              
              $
              44,555,611
              
              $
              60,493,789




The
      Company’s composite depreciation rate for property and equipment was 12.1%,
      17.4% and 19.0% in 2004, 2005 and 2006, respectively. Depreciation expense
      from
      operations for the years ended December 31, 2004, 2005 and 2006 was $5,837,033,
      $7,748,687 and $9,527,319, respectively.




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




Other
      accounts receivable consist of the following:


December
                  31,2005
              
              2006Carrier
                  access bills receivable
              
              $
              980,294
              
              $
              1,015,850Receivables
                  from Alabama Service Fund
              
              
              461,729
              
              
              462,338Other
                  miscellaneous
              
              
              40,148
              
              
              201,956$
              1,482,171
              
              $
              1,680,144





-52-





**7.** **Investments**




Investments
      consist of the following:


December
                  31,2005
              
              2006Investment
                  in CoBank stock
              
              $
              106,049
              
              $
              659,978Investment
                  in Rural Telephone Bank (Class C stock)
              
              
              435,858
              
              
              -Rental
                  property
              
              
              550,700
              
              
              525,191Other
                  miscellaneous
              
              
              15,642
              
              
              55,081$
              1,108,249
              
              $
              1,240,250




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. In
      connection with the acquisition of MMeT, the purchase price allocation included
      investment in CoBank stock. Rural Telephone Bank stock was redeemed by the
      U.S.
      Department of Agriculture in 2006 as part of dissolving the bank leading to
      a
      one-time gain of $2.7 million recorded in other income in the consolidated
      statements of income.




**8.** **Long-Term
      Debt**




The
      Company amended and restated its term credit facility of December 21, 2004
      on
      July 3, 2006, increasing the balance due from $80,000,000 to $120,000,000 and
      changing its maturity for December 21, 2009 to July 3, 2011.




-53-


Long-term
      notes payable consists of the following:


December
                  31,2005
              
              2006Term
                  credit facility, General Electric Captial Corporation;variable
                  interest rate of 6.53% and 8.62% at Decemberer 31, 2005
                  and2006,
                  respectively. There are no principal payments. Interestpayments
                  are due on the last day of each LIBOR period or at threemonth
                  intervals, whichever date comes first. Interest rate is
                  theindex
                  rate plus the applicable term loan index margin of 2.25%or
                  the applicable LIBOR rate plus the applicable term loan
                  LIBORmargin
                  of 3.5%. The unpaid balance will be due onJuly
                  3, 2011.
              
              $
              80,000,000
              
              $
              120,000,00013%
                  Senior subordinated notes, due 2019; interest paymentsare
                  due quarterly
              
              
              72,575,498
              
              
              72,575,49813%
                  Senior subordinated notes, held seperately, due 2019;interest
                  payments are due quarterly
              
              
              8,500,000
              
              
              8,500,000Total
                  long-term notes payable
              
              $
              161,075,498
              
              $
              201,075,498Less:
                  current portion
              
              
              -
              
              
              -Long-term
                  notes payable
              
              $
              161,075,498
              
              $
              201,075,498




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
      on December 21, 2004 and capitalized $8.1 million in deferred financing costs
      associated with the new credit facility and the 13% senior subordinated notes.
      On July 3, 2006 an additional $1,545,743 in deferred financing costs was
      capitalized. 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 was no balance as of December 31, 2005 and 2006. The interest
      rate is the index rate plus a 2.25% margin or LIBOR rate, plus a 3.25% margin,
      whichever is applicable. The Company pays a commitment fee of 0.50% per annum,
      payable quarterly in arrears, on the unused portion of the revolver loan. The
      commitment fee expense was $117,500, and $95,104 for the years ended December
      31, 2005 and 2006, respectively.




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


2007
              
              $
              -2008
              
              
              -2009
              
              
              -2010
              
              
              -2011
              
              
              120,000,000Thereafter
              
              
              81,075,498Total
              
              $
              201,075,498




The
      above
      schedule of maturities of long-term debt excludes the $4.1 million liquidation
      value of Class B common shares convertible into senior subordinated notes in
      the
      mezzanine section of consolidated balance sheet.




-54-




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, 2005 and 2006,
      respectively, 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 five of its
      seven operating subsidiaries are full and unconditional, joint and several.
      The
      operating subsidiaries have no independent long-term notes payable. There are
      no
      significant restrictions on the ability of the Company to obtain funds from
      its
      operating subsidiaries by dividend or loan. In 2004, the impact of the
      non-guarantor subsidiaries of the parent was minor. The following condensed
      consolidated financial information is provided for the guarantor entities for
      the years ended December 31, 2005 and 2006:




**Otelco
                  Inc.****Notes
                  To Consolidated Financial Statements****Condensed
                  Consolidating Balance Sheet****December
                  31, 2006**Guarantor
              
              Non-GuarantorParent
              
              Subsidiaries
              
              Subsidiaries
              
              Eliminations
              
              ConsolidatedASSETSCurrent
                  assetsCash
                  and cash equivalents
              
              $
              —
              
              $
              14,376,843
              
              $
              25,006
              
              $
              —
              
              $
              14,401,849Accounts
                  receivable, net
              
              
              21,028
              
              
              6,050,195
              
              
              1,038,770
              
              
              —
              
              
              7,109,993Materials
                  and supplies
              
              
              —
              
              
              847,045
              
              
              1,115,893
              
              
              —
              
              
              1,962,938Prepaid
                  and other current assets
              
              
              3,487
              
              
              1,006,316
              
              
              53,144
              
              
              —
              
              
              1,062,947Deferred
                  income taxes
              
              
              766,225
              
              
              —
              
              
              —
              
              
              —
              
              
              766,225Intercompany
                  receivables (payables)
              
              
              (7,613,619
              )
              
              26,350,164
              
              
              (18,736,545
              )
              
              —
              
              
              —Total
                  current assets
              
              
              (6,822,879
              )
              
              48,630,563
              
              
              (16,503,732
              )
              
              —
              
              
              25,303,952Property
                  and equipment, net
              
              
              —
              
              
              42,745,710
              
              
              17,748,079
              
              
              —
              
              
              60,493,789Goodwill
              
              
              —
              
              
              136,118,949
              
              
              (1,936,640
              )
              
              —
              
              
              134,182,309Intangibles
                  assets, net
              
              
              5,454,799
              
              
              2,235,052
              
              
              3,650,955
              
              
              —
              
              
              11,340,806Investments
              
              
              1,000
              
              
              914,093
              
              
              325,157
              
              
              —
              
              
              1,240,250Other
                  long-term assets
              
              
              5,135,118
              
              
              6,156,063
              
              
              —
              
              
              —
              
              
              11,291,181Total
                  assets
              
              $
              3,768,038
              
              $
              236,800,430
              
              $
              3,283,819
              
              $
              —
              
              $
              243,852,287LIABILITIES
                  AND STOCKHOLDERS' EQUITYCurrent
                  liabilitiesAccounts
                  payables and accrued expenses
              
              $
              4,924,962
              
              $
              3,081,839
              
              $
              1,233,497
              
              $
              —
              
              $
              9,240,298Other
                  current liabilities
              
              
              —
              
              
              2,238,188
              
              
              79,009
              
              
              —
              
              
              2,317,197Total
                  current liabilities
              
              
              4,924,962
              
              
              5,320,027
              
              
              1,312,506
              
              
              —
              
              
              11,557,495Deferred
                  income taxes
              
              
              4,661,690
              
              
              17,544,383
              
              
              2,506,140
              
              
              —
              
              
              24,712,213Other
                  liabilities
              
              
              —
              
              
              187,037
              
              
              —
              
              
              —
              
              
              187,037Long-term
                  notes payables
              
              
              105,458,990
              
              
              95,616,508
              
              
              —
              
              
              —
              
              
              201,075,498Derivative
                  liability
              
              
              2,107,877
              
              
              —
              
              
              —
              
              
              —
              
              
              2,107,877Class
                  B common convertible to senior subordinated notes
              
              
              4,085,033
              
              
              —
              
              
              —
              
              
              —
              
              
              4,085,033Stockholders'
                  equity (deficit)
              
              
              (117,470,514
              )
              
              118,132,445
              
              
              (534,797
              )
              
              —
              
              
              127,134Total
                  liabilities and stockholders' equity (deficit)
              
              $
              3,768,038
              
              $
              236,800,400
              
              $
              3,283,849
              
              $
              —
              
              $
              243,852,287




-55-




**Otelco
                  Inc.****Notes
                  to Consoldiated Financial Statements****Condensed
                  Consolidated Statement of Operations****For
                  the Year End December 31, 2006**Guarantor
              
              Non-GuarantorParent
              
              Subsidiaries
              
              Subsidiaries
              
              Eliminations
              
              ConsolidatedRevenue
              
              $
              2,614,748
              
              $
              52,518,931
              
              $
              9,245,580
              
              $
              (6,789,867
              )
              $
              57,589,392Operating
                  expenses
              
              
              (2,614,747
              )
              
              (35,161,253
              )
              
              (6,800,455
              )
              
              6,789,867
              
              
              (37,786,588
              )Income
                  from operations
              
              
              1
              
              
              17,357,678
              
              
              2,445,125
              
              
              —
              
              
              19,802,804Other
                  income (expense)
              
              
              (13,993,334
              )
              
              (3,074,764
              )
              
              67,139
              
              
              —
              
              
              (17,000,959
              )Income
                  before income tax and accretion expense
              
              
              (13,993,333
              )
              
              14,282,914
              
              
              2,512,264
              
              
              —
              
              
              2,801,845Income
                  tax expense
              
              
              6,073,066
              
              
              (6,198,285
              )
              
              (1,086,050
              )
              
              —
              
              
              (1,211,269
              )Accretion
                  of class B common convertibleto
                  senior subordinated notes
              
              
              (429,579
              )
              
              —
              
              
              —
              
              
              —
              
              
              (429,579
              )Net
                  income (loss) to common stockholders
              
              $
              (8,349,846
              )
              $
              8,084,629
              
              $
              1,426,214
              
              $
              —
              
              $
              1,160,997




-56-




**Otelco
                  Inc.****Notes
                  to Consolidated Financial Statements****Condensed
                  Consolidating Statement of Cash Flows****For
                  the Twelve Months Ended December 31, 2006**Guarantor
              
              Non-GuarantorParent
              
              Subsidiaries
              
              Subsidiaries
              
              Eliminations
              
              ConsolidatedCash
                  flows from operating activities:Net
                  income (loss)
              
              $
              (8,349,846
              )
              $
              8,084,629
              
              $
              1,426,214
              
              $
              —
              
              $
              1,160,997Adjustment
                  to reconcile net income (loss)to
                  cash flows from operating activities
              
              
              3,491,185
              
              
              6,401,396
              
              
              2,470,269
              
              
              —
              
              
              12,362,850Changes
                  in assets and liabilities, net ofassets
                  and liabilities acquired
              
              
              10,331,192
              
              
              (13,389,268
              )
              
              6,031,434
              
              
              —
              
              
              2,973,358Cash
                  flows from investing activities
              
              
              (592,958
              )
              
              (7,884,555
              )
              
              (9,960,205
              )
              
              —
              
              
              (18,437,718
              )Cash
                  flows from financing activities
              
              
              (4,879,573
              )
              
              15,652,702
              
              
              —
              
              
              —
              
              
              10,773,129Net
                  increase (decrease) in cash and cash equivalents
              
              
              —
              
              
              8,864,904
              
              
              (32,288
              )
              
              —
              
              
              8,832,616Cash
                  and cash equivalents, beginning of period
              
              
              —
              
              
              5,511,939
              
              
              57,294
              
              
              —
              
              
              5,569,233Cash
                  and cash equivalents, end of period
              
              $
              —
              
              $
              14,376,843
              
              $
              25,006
              
              $
              —
              
              $
              14,401,849




-57-




**Otelco
                  Inc.****Notes
                  To Consolidated Financial Statements****Condensed
                  Consolidating Balance Sheet****December
                  31, 2005**Guarantor
              
              Non-GuarantorParent
              
              Subsidiaries
              
              Subsidiaries
              
              Eliminations
              
              ConsolidatedASSETSCurrent
                  assetsCash
                  and cash equivalents
              
              $
              —
              
              $
              5,511,939
              
              $
              57,294
              
              $
              —
              
              $
              5,569,233Accounts
                  receivable, net
              
              
              13,506
              
              
              4,062,305
              
              
              447,373
              
              
              —
              
              
              4,523,184Materials
                  and supplies
              
              
              —
              
              
              908,556
              
              
              24,305
              
              
              —
              
              
              932,861Prepaid
                  and other current assets
              
              
              799,499
              
              
              424,587
              
              
              29,761
              
              
              —
              
              
              1,253,847Deferred
                  income taxes
              
              
              872,675
              
              
              —
              
              
              —
              
              
              —
              
              
              872,675Intercompany
                  receivables (payables)
              
              
              (1,118,958
              )
              
              17,624,883
              
              
              (16,505,925
              )
              
              —
              
              
              —Total
                  current assets
              
              
              566,722
              
              
              28,532,270
              
              
              (15,947,192
              )
              
              
              
              
              13,151,800Property
                  and equipment, net
              
              
              -
              
              
              33,023,888
              
              
              11,531,723
              
              
              —
              
              
              44,555,611Goodwill
              
              
              -
              
              
              116,355,199
              
              
              3,076,794
              
              
              —
              
              
              119,431,993Intangibles
                  assets, net
              
              
              6,971,610
              
              
              (6,971,615
              )
              
              1,588,084
              
              
              —
              
              
              1,588,079Investments
              
              
              1,000
              
              
              1,090,719
              
              
              16,530
              
              
              —
              
              
              1,108,249Other
                  long-term assets
              
              
              5,318,728
              
              
              6,971,610
              
              
              —
              
              
              —
              
              
              12,290,338Total
                  assets
              
              $
              12,858,060
              
              $
              179,002,071
              
              $
              265,939
              
              $
              —
              
              $
              192,126,070LIABILITIES
                  AND STOCKHOLDERS' EQUITYCurrent
                  liabilitiesAccounts
                  payables and accrued expenses
              
              $
              171,396
              
              $
              2,556,960
              
              $
              70,599
              
              $
              —
              
              $
              2,798,955Other
                  current liabilities
              
              
              —
              
              
              1,414,547
              
              
              3,657
              
              
              —
              
              
              1,418,204Total
                  current liabilities
              
              
              171,396
              
              
              3,971,507
              
              
              74,256
              
              
              —
              
              
              4,217,159Deferred
                  income taxes
              
              
              4,019,721
              
              
              9,173,477
              
              
              2,152,692
              
              
              —
              
              
              15,345,890Other
                  liabilities
              
              
              —
              
              
              192,768
              
              
              —
              
              
              —
              
              
              192,768Long-term
                  notes payables
              
              
              105,458,990
              
              
              55,616,508
              
              
              —
              
              
              —
              
              
              161,075,498Derivative
                  liability
              
              
              1,830,095
              
              
              —
              
              
              —
              
              
              —
              
              
              1,830,095Class
                  B common convertible to senior subordinated notes
              
              
              3,655,454
              
              
              —
              
              
              —
              
              
              —
              
              
              3,655,454Stockholders'
                  equity (deficit)
              
              
              (102,277,596
              )
              
              110,047,811
              
              
              (1,961,009
              )
              
              —
              
              
              5,809,206Total
                  liabilities and stockholders' equity (deficit)
              
              $
              12,858,060
              
              $
              179,002,071
              
              $
              265,939
              
              $
              —
              
              $
              192,126,070




-58-




**Otelco
                  Inc.****Notes
                  to Consoldiated Financial Statements****Condensed
                  Consolidated Statement of Operations****For
                  the Year End December 31, 2005**Guarantor
              
              Non-GuarantorParent
              
              Subsidiaries
              
              Subsidiaries
              
              Eliminations
              
              ConsolidatedRevenue
              
              $
              2,563,989
              
              $
              43,270,099
              
              $
              6,884,179
              
              $
              (5,746,045
              )
              $
              46,972,222Operating
                  expenses
              
              
              (2,808,682
              )
              
              (26,460,876
              )
              
              (4,010,080
              )
              
              5,746,045
              
              
              (27,533,593
              )Income
                  from operations
              
              
              (244,693
              )
              
              16,809,223
              
              
              2,874,099
              
              
              —
              
              
              19,438,629Other
                  income (expense)
              
              
              (12,722,108
              )
              
              (3,473,876
              )
              
              3,540
              
              
              —
              
              
              (16,192,444
              )Income
                  before income tax and accretion expense
              
              
              (12,966,801
              )
              
              13,335,347
              
              
              2,877,639
              
              
              —
              
              
              3,246,185Income
                  tax expense
              
              
              4,810,285
              
              
              (4,694,211
              )
              
              (1,127,749
              )
              
              —
              
              
              (1,011,675
              )Accretion
                  of class B common convertibleto
                  senior subordinated notes
              
              
              (442,926
              )
              
              —
              
              
              —
              
              
              —
              
              
              (442,926
              )Net
                  income (loss) to common stockholders
              
              $
              (8,599,442
              )
              $
              8,641,136
              
              $
              1,749,890
              
              $
              —
              
              $
              1,791,584




-59-




**Otelco
                  Inc.****Notes
                  to Consolidated Financial Statements****Condensed
                  Consolidating Statement of Cash Flows****For
                  the Twelve Months Ended December 31,
                  2005**Guarantor
              
              Non-GuarantorParent
              
              Subsidiaries
              
              Subsidiaries
              
              Eliminations
              
              ConsolidatedCash
                  flows from operating activities:Net
                  income (loss)
              
              $
              (8,599,442
              )
              $
              8,641,136
              
              $
              1,749,890
              
              $
              —
              
              $
              1,791,584Adjustment
                  to reconcile net income (loss)to
                  cash flows from operating activities
              
              
              3,049,429
              
              
              7,158,418
              
              
              1,317,027
              
              
              —
              
              
              11,524,874Changes
                  in assets and liabilities, net ofassets
                  and liabilities acquired
              
              
              12,696,724
              
              
              (12,492,317
              )
              
              (2,575,440
              )
              
              —
              
              
              (2,371,033
              )Cash
                  flows from investing activities
              
              
              —
              
              
              (2,973,404
              )
              
              (662,623
              )
              
              —
              
              
              (3,636,027
              )Cash
                  flows from financing activities
              
              
              (7,146,711
              )
              
              1
              
              
              —
              
              
              —
              
              
              (7,146,710
              )Net
                  increase (decrease) in cash and cash equivalents
              
              
              —
              
              
              333,834
              
              
              (171,146
              )
              
              —
              
              
              162,688Cash
                  and cash equivalents, beginning of period
              
              
              —
              
              
              5,178,105
              
              
              228,440
              
              
              —
              
              
              5,406,545Cash
                  and cash equivalents, end of period
              
              $
              —
              
              $
              5,511,939
              
              $
              57,294
              
              $
              —
              
              $
              5,569,233




-60-




**9.** **Income
      Taxes**




Deferred
      income taxes are provided for certain temporary differences principally due to
      the use of accelerated depreciation 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, 2004, 2005 and 2006 is summarized
      below.


For
                  the years ended2004
              
              2005
              
              2006Federal
                  incomeCurrent
              
              $
              777,594
              
              $
              (940,443
              )
              $
              134,177Deferred
              
              
              2,657,080
              
              
              1,789,674
              
              
              819,045Total
                  federal tax expense
              
              
              3,434,674
              
              
              849,231
              
              
              953,222State
                  incomeCurrent
              
              
              126,280
              
              
              27,085
              
              
              13,559Deferred
              
              
              385,671
              
              
              135,359
              
              
              244,488Total
                  state tax expense
              
              
              511,951
              
              
              162,444
              
              
              258,047Total
                  tax expense
              
              $
              3,946,625
              
              $
              1,011,675
              
              $
              1,211,269




Total
      income tax expense from operations was different than that computed by applying
      U.S. federal income tax rates to income from operations before income taxes
      for
      the years ended December 31, 2004, 2005 and 2006. The reasons for the
      differences are presented below.


For
                  the years ended December2004
              
              2005
              
              2006Federal
                  income tax at statutory rate
              
              
              34
              %
              
              
              34
              %
              
              
              34
              %Federal
                  income tax (provision) at statutory rate
              
              $
              3,425,104
              
              
              $
              1,103,704
              
              
              $
              952,626New
                  deductible IPO cost
              
              
              518,887
              
              
              
              -
              
              
              
              -Change
                  in fair value of derivative
              
              
              -
              
              
              
              (325,931
              )
              
              
              97,900State
                  income tax (provision), net offederal
                  income tax effects
              
              
              337,888
              
              
              
              79,568
              
              
              
              170,311Other
              
              
              (335,254
              )
              
              
              154,334
              
              
              
              (9,568
              )Provision
                  for income taxes
              
              $
              3,946,625
              
              
              $
              1,011,675
              
              
              $
              1,211,269Effective
                  income tax rate
              
              
              39.2
              %
              
              
              31.1
              %
              
              
              43.2
              %




The
      Company purchased MMHC as described in Note 2, which resulted in incremental
      net
      deferred tax liabilities of approximately $2.2 million that are included in
      the
      consolidated balance sheet at December 31, 2004.




As
      of
      December 31, 2006, the Company has state net operating loss carry-forwards
      of
      approximately $1.9 million for tax purposes, which will be available to offset
      future taxable income. If not used, these carry-forwards will expire between
      2020 and 2026.




In
      connection with the acquisition of MMeT, the purchase price allocation included
      deferred tax liabilities of $8,488,987.




-61-




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, 2005 and
      2006 are presented below:


December
                  31,2005
              
              2006Deferred
                  tax liabilities:Amortization
              
              $
              (9,297,930
              )
              $
              (12,457,601
              )Depreciation
              
              $
              (6,047,960
              )
              $
              (8,876,879
              )Amortized
                  intangibles
              
              
              -
              
              
              (3,377,733
              )Total
                  deferred tax liabilities
              
              $
              (15,345,890
              )
              $
              (24,712,213
              )Deferred
                  tax assets:Deferred
                  Compensation
              
              $
              160,724
              
              $
              228,348Amortized
                  intangibles
              
              
              353,249
              
              
              -State
                  net operating loss carryforwards
              
              
              92,093
              
              
              97,274Advance
                  payments
              
              
              199,133
              
              
              260,514Other
              
              
              67,476
              
              
              180,089Total
                  deferred tax assets
              
              $
              872,675
              
              $
              766,225Net
                  deferred tax liability
              
              $
              (14,473,215
              )
              $
              (23,945,988
              )




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.




**10.** **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 not to exceed $13,000, $14,000
      and $15,000 for 2004, 2005, and 2006, 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 or 2006. For the years ended December 31, 2004,
      2005 and 2006, the total expense associated with this plan was $265,366,
      $391,418 and $385,718, respectively.




The
      employees of BTC participate in a multi-employer Retirement and Security Program
      (“RSP”) as a defined benefit plan 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, 2004, 2005 and 2006 the total
      expense associated with these plans was $95,721, $108,007 and $102,641,
      respectively.




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




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




Basic
      income per common share is computed by dividing net income by the
      weighted-average number of shares outstanding for the period. Diluted income
      per
      common share reflects the potential dilution that could occur if the Class
      B
      common stock were exercised into IDSs. Class B common stock is convertible
      on a
      one-for-one basis into IDSs, each of which includes a Class A common share.
      For
      periods prior to our conversion, membership units were treated on an as if
      converted basis into Class A and Class B common shares.




-62-




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 December2004
              
              2005
              
              2006Weighted
                  average common shares at conversion
              
              
              8,103,720
              
              
              9,676,733
              
              
              9,676,733Effect
                  of dilutive securities
              
              
              503,735
              
              
              544,671
              
              
              544,671Weighted-average
                  common sharesand
                  potential common shares-diluted
              
              
              8,607,455
              
              
              10,221,404
              
              
              10,221,404Net
                  income available to commonshareholders
              
              $
              6,113,863
              
              $
              1,791,584
              
              $
              1,160,997Net
                  income per basic share
              
              $
              0.75
              
              $
              0.19
              
              $
              0.12Net
                  income available to commonstockholders
              
              $
              6,113,863
              
              $
              1,791,584
              
              $
              1,160,997Accretion
                  expense of Class B commonconvertible
                  to senior subordinated notes
              
              
              13,348
              
              
              442,926
              
              
              429,579Change
                  in fair value of derivative
              
              
              -
              
              
              (958,621
              )
              
              277,782Net
                  income available for diluted shares
              
              $
              6,127,211
              
              $
              1,275,889
              
              $
              1,868,358Net
                  income per diluted share
              
              $
              0.71
              
              $
              0.12
              
              $
              0.18




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


**First**
              
              **Second**
              
              **Third**
              
              **Fourth****Quarter**
              
              **Quarter**
              
              **Quarter**
              
              **Quarter**Fiscal
                  2005:Revenue
              
              $
              12,027,093
              
              $
              11,442,526
              
              $
              11,659,317
              
              $
              11,843,287Operating
                  income
              
              
              5,122,128
              
              
              4,871,447
              
              
              4,747,123
              
              
              4,697,931Net
                  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
              )Fiscal
                  2006:Revenue
              
              $
              11,513,397
              
              $
              11,557,813
              
              $
              17,136,972
              
              $
              17,381,212Operating
                  income
              
              
              4,699,029
              
              
              4,880,216
              
              
              5,139,472
              
              
              5,084,087Net
                  income
              
              
              244,592
              
              
              2,053,571
              
              
              (364,761
              )
              
              (772,405
              )Net
                  income per share, basic
              
              
              0.03
              
              
              0.21
              
              
              (0.04
              )
              
              (0.08
              )Net
                  income per share, diluted
              
              
              0.02
              
              
              0.18
              
              
              (0.03
              )
              
              (0.01
              )




**13.** **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.




-63-




Number
                  of
              
              Weighted
                  Average Exerciseunits
              
              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 $908,343 for the period ended 2004 based on the estimated
      fair market value of a membership unit at each period.




The
      estimated fair market value of a membership unit for the year ended December
      31,
      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.




**14.** **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
      year ended December 31, 2004, Otelco Holdings paid Seaport $973,118 in advisory
      fees.




**15.** **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 20.2%, 20.9%, and 17.7%
      of the Company’s total revenues from operations for the years ended December 31,
      2004, 2005 and 2006, respectively.




-64-




**16.** **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, MPSC and MPUC relating primarily to rate
      making. Currently, none of the legal proceedings are expected to have a material
      adverse effect on our business.




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




None.




**Item
      9A.**  **Controls
      and Procedures**




**Disclosure
      Controls and Procedures**




With
      the
      participation of the Chief Executive Officer and the Chief Financial Officer,
      management has evaluated the effectiveness of our disclosure controls and
      procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act
      of 1934). Based on that evaluation, the Chief Executive Officer and Chief
      Financial Officer concluded that our disclosure controls and procedures were
      effective as of December 31, 2006.




**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:




·
            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, 2006. 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, 2006, the
      company’s internal control over financial reporting is effective based upon
      those criteria.




-65-




Management’s
      assessment of the effectiveness of the company’s internal control over financial
      reporting as at December 31, 2006 has been audited by BDO Seidman, LLP, an
      independent registered public accounting firm, as stated in their report which
      appears in Item 8 of this report.




**Changes
      in Internal Control over Financial Reporting**




There
      were no changes in our internal control over financial reporting (as defined
      in
      Rule 13a-15(f) under the Securities Exchange Act of 1934) during the fourth
      quarter of fiscal 2006 that materially affected, or are reasonably likely to
      materially affect, our internal control over financial reporting.




**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 2007 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.” See Item X in Part I of this report regarding our executive
      officers.




**Item
      11.**  **Executive
      Compensation**




The
      information required by this Item is incorporated herein by reference to the
      applicable information in the proxy statement for our 2007 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
      2007 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 2007 annual meeting of
      stockholders, including the information set forth under the caption “Other
      Relationships and Transactions with Executives.”




-66-




**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 2007 annual meeting of
      stockholders, including the information set forth under the caption “Our
      Relationship with Our Independent Auditors.”




-67-




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**2.1
            
            Agreement
                and Plan of Merger between MM Merger Corp. and Mid-Maine Communications,
                Inc. dated April 10, 2006 (filed as Exhibit 2.1 to the company’s current
                report on Form 8-K filed on April 10, 2006 and incorporated herein
                by
                reference)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
            
            Supplemental
              Indenture,
              dated as of July 3, 2006, by and among Mid-Maine Communications, Inc.,
              Mid-Maine TelPlus, the Existing Guarantors listed on the signature
              pages
              thereto, and Wells Fargo Bank, NA, as trustee (filed as Exhibit 10.2
              to the company’s Current Report on Form 8-K filed on July 5,
              2006 and incorporated herein by reference)4.3
            
            Form
                of 13% Senior Subordinated Note due 2019 (included in Exhibit
                4.1)4.4
            
            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)4.5
            
            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)4.6
            
            Form
                of global Income Deposit Security (filed as Exhibit 4.5 to Amendment
                No. 4
                to Registration Statement on Form S−1 (file no. 333−115341) and
                incorporated herein by reference)10.1
            
            Amended
                and Restated Credit Agreement, dated July 3, 2006, 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 Current Report on Form 8-K filed on July 5, 2006 and
                incorporated herein by reference)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)*




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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)*10.5
            
            Employment
                Agreement, dated as of July 3, 2006, between Mid-Maine and Nicholas
                A.
                Winchester (filed as Exhibit 10.3 to the company’s Current Report on Form
                8-K filed on July 5, 2006 and incorporated herein by
                reference)*10.6
            
            Employment
              Agreement,
              dated as of August 24, 2006, between Otelco Inc. and Dennis Andrews
              (filed
              as Exhibit 10.1 to the company’s Current Report on Form 8-K filed
              on August 29, 2006 and incorporated herein by
              reference)*10.7
            
            Employment
              Agreement, dated as of November 15, 2006, between Otelco Inc. and Gary
              B.
              Romig (filed as Exhibit 10.1 to the company’s Current Report on Form 8-K
              filed on November 15, 2006 and incorporated herein by
              reference)*10.8
            
            Employment
              Agreement,
              dated as of November 15, 2006, between Otelco Inc. and Jerry C. Boles
              (filed as Exhibit 10.2 to the company’s Current Report on Form 8-K filed
              on November 15, 2006 and incorporated herein by
              reference)*12.1
            
            Computation
              of Ratio of Earnings to Fixed Charges (filed as Exhibit 12.1 to the
              Company's Annual Report on Form 10-K filed on March 15, 2007 and
              incorporated herein by reference)21.1
            
            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





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**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 14th day
      of
      June, 2007.


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




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