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Executives

Michael D. Weaver - President, Chief Executive Officer, Director

Curtis L. Garner Jr. - Chief Financial Officer

Dennis K. Andrews - Senior Vice President and General Manager

Analysts

Tim Horan - Oppenheimer & Co. Inc.

Dave Coleman - RBC Capital Markets

Frank Louthan - Raymond James

Otelco Inc. (OTT) Q4 2008 Earnings Call Transcript February 18, 2009 11:00 AM ET

Operator

Good day everyone and welcome to the Otelco Inc. Fourth Conference Call.

Today’s call is being recorded and at this time for opening remarks and introduction I would like to turn the call over to Mr. Kevin Enda. Please go ahead Sir.

Kevin Enda

Thank you Roby and welcome to the Otelco conference call to review the Company’s result for the fourth quarter and year-ended, December 31st, 2008 which are released yesterday afternoon. Conducting the call today will be Michael D. Weaver, President, Chief Executive and Curtis Garner, Chief Financial Officer.

Before we start let me offer the cautionary note. The statements made on this conference call that are not statements of the historical or current effect. Constitute forward looking statements. Such forward looking statements involved known and unknown risks, uncertainties, other unknown factors that can cause the actual results of the Company to be maturely different from the historical result or from any future results expressed or implied buy such forward looking statements.

In addition, to statements which explicitly describes such risks or uncertainties, listeners are urged to consider statements labeled with terms believes, belief, expects, intends, anticipate, plans or similar terms to be uncertain and forward looking.

The forward looking statements contained herein are also subject generally to other risks and uncertainties that are described from time to time in the Companies filing of the SEC with that stated I would turn the call over to Mike Weaver.

Michael Weaver

Good morning. Thanks for joining us on the call. Despite an increasingly difficult business environment our 2008 results was our strongest ever. In 2008, we experienced growth in both our revenue and EBITDA over 2007 with revenue increasing by 10.6% and EBTIDA increasing about 7.9% respectively.

This growth was achieved by both in internal sources and the recently completed acquisition of the Country Road entities. Internal grow was primary late attributable to these continued success of our CLEC operations as it grew access line equivalents by almost 3 000 lines or 15% over 2007 but the fourth quarter CLEC voice line increased by break point 4% and this growth was enhanced by the addition of two significant customers in December.

On the RLEC side, our legacy operations experienced our decline in access line equivalents of 274 or 2.5% on annualized basis. The CRC CLEC operations experienced a decline in access line equivalents of 644 or 16% on an annualized basis. Two of the four RLECS we acquired is part of the CRC acquisition have competition in their service area from a cable provider.

This service by the cable provider was introduced in the third quarter of 2008. We are presently reviewing our product offerings in these areas and our developing new bundled services and more competitive pricing that we believe will improved our market position. For the year, we generated $37.4 million in EBITDA which is an increase of $2.7 million over 2007.

Legacy operations increased the EBITDA about 500,000 and the newly acquired operations added $2.2 million of the total. The improvement in our legacy operations actually has two components. An operational improvement of $1 million offset by a decrease of 500, 000 in interest income is interest rates declined substantially.

On October 31st we completed the acquisition of the Country Road entities which added approximately 29, 000 access line equivalents for their operations in New England and West Virginia. As previously mentioned these newly acquired properties generated $2.2 million in EBITDA for the final 2 months of 2008 in are inline with our expectations.

We made significant progress on the integration process and we remain focused on these processes throughout 2009. We expect these processes to be substantially complete by the end of the second or early third quarter and anticipate total synergies realized to be approximately $3 million.

The acquisition of Country Road increased our senior secured debt by $109 million. Our lenders maintained their commitment to Otelco both in the amount of the funding and the committed margin for this amended facility. Given the current interest rate market conditions we entered in two-swap agreements which effectively locked a significant portion of our debt in the low fixed rights through February 2012.As a reminder the senior debt has a maturity date of 2013.

In our capital expenditures for 2008 we completed the initial deployment of IPTB for Alabama properties expanding the range of television as an additional revenue generating unit in next stage. These new product was initially offer to a small portion of our customers in late December and we plan to expand this offering throughout selected markets in 2009. The product works well and currently provides three video streams to customers within 5500 feet circumference of our service nodes.

Another significant CapEx project for 2008 was the addition of 42 miles to our existing fiber network in Maine which extended our network reach to include the Bar Harbor in West Infield area. This network’s extension is significant because it provides additional marking opportunities as well as rebases our cost due to decreasing our dependence on third party network providers. Our Broadband products continued to shows a significant growth in 2008 as we had over 5300 subscribers with 30% of these growths generated from legacy operations. Currently our Broadband services are available to 90 plus percent of our customers.

While recently in acted stimulus plan we may provide additional opportunities for expansion of our coverage. There are simply are not enough details available at this time to estimate the impact if any, it will have on our abilities to expand the service. Finally, we paid our 16th consecutive RDS distribution in December and we remained committed to return in cash to our shareholders.

This time I want to ask Curtis to discuss the financial results.

Curtis Garner

Thank you Michael and thanks to everyone on the call for joining us today. We had certainly done an exciting quarter. Let me do a quick overview of our financial performance for the quarter and for the year. As a reminder our fourth quarter and 2008 result includes the three entities acquired from Country Road Communications on October 31 on a GAAP basis.

In general that means that most of the explanations are changed related primarily to the acquisition. Total revenues grew 30.7% in the three months ended December 31, 2008 compared to as it grew to $ 23.3 million from $17.9 million in the three months ended December 31, 2007.

The growth in revenue included $5.7 million from the acquisition partially offset by a decline of $.3 million from the existing Otelco units. Total revenue for the year 2008, where 10.6% to $77.1 million from $69.7 million in 2007. Breaking those categories of total revenue down a little bit, local services group 48% in the fourth quarter to $9.9 million from $6.7 million in the quarter-ended December 31, 2007.

The acquisition generated almost $3.5 million while the existing businesses declined a little les than 300,000. For 2008, local services revenue grew 15.3% to $30 million from $26 million in 2007. 2008 access revenue increased 23.4% in the fourth quarter to $8 million from $6.5 million in the same quarter in 2007. The increase was associated with the acquisition.

For 2008, network access revenue grew 6% to $27.3 million from $25.7 million in 2007. Cable Television revenue for the existing subsidiaries in three months ended December 31, 2008 increased 24.8% to just $0.7 million from just over $0.5 million in the same three month period in 2007. For 2008, Cable Television revenue grew 9.4%, to $2.2 million in 2007. As Mike mentioned the IPTB initial investment in Alabama was completed in December and the first customer is added in our Blountsville community.

Internet revenue for the fourth quarter 2008 increased 14% to $3.4 million from $3 million in the quarter ended December 31, 2007, primarily associated with the acquisition. For 2008 internet revenue grew 8.1% to $12.4 million from $11.5 million in 2007.

Transport services revenue from the existing subsidiaries grew 16.7% to over $1.3 million in the three months ended December 31, 2008 from just under to $1.2 million in the same period of 2007. For 2008 transport services revenue grew 16.5% to $5 million from $4.3 million in 2007 and Mike have already mentioned the fiber expansion this year in Maine which supports the segments of our business.

Operating expenses in the three months ended December 31, 2008 increased 40.4% to $18.1 million from $12.9 million in the three months ended December 31, 2007.Operating expenses increased 11% to $56 million from $0.5 million in 2007. The quarter we increased primarily reflects the acquisition of the Country Road Communications entities about the year over year increase also reflects the higher cost associated with the growth in CLEC operations and digital high-speed internet.

The results also reflect the continued cost management throughout our business. Breaking that down a little bit across, the services increased 38.8% for the fourth quarter 2008 to $9.1 million from $6.6 million in fourth quarter 2007. The acquisition provided an increase of $2.7 million which was partially offset by reduction of $0.2 million from the existing entity. Cost to services for the full year 2008 increased 13.5% to $29.2 million from $25.7 million in 2007.

Selling, General and Administrative expense increased 14.5% to $3.2 million in the quarter-ended December 31, 2008 from $2.8 million in the quarter ended December 31, 2007. This included $600,000 from the acquisition again partially offset by a reduction of $200,000 from the existing units. SG&A expenses increased 7.8% to $11.2 in the year ended December 31, 2008 from $10.4 million in 2007.

Amortization have the largest percentage change for the fourth quarter increasing 64.5% to 5.7 from 3.5 million. This reflects $2.5 million in the acquisition which includes the amortization of intangible assets associated with the acquisition and adjustments which reflects the higher market value of the real assets that were acquired.

Existing units saw a reduction of $0.3 million in the recorder which continued to trend in the balance of 2008. Interest expense increased 59.7% to $7.6 million in the quarter ended December 31, 2008 from $4.7 million in the same period a year ago. The results reflect a $1.4 million in one time amortization of lowering cost as GAAP requires that our amended loan facility will be treated as if we extinguished the old loan and put in placed a new loan. The balance reflects the increased senior debt associated with the acquisition, the higher margin for two months and below our interest rates compared to last year.

Provision for income taxes was $700,000 compared to $300,000 a year ago, as a kind of an aside we currently anticipate that the Company’s 2009 dividends will continue to be treated as a return of capital for tax purposes as they where in 2008. As a result of these factors I just mentioned internet loss for the quarter of $1.4 million compared to net income of $1.1 million for the fourth quarter of 2007. Basic and diluted net income or net loss per share was 0.11 and $0.13 for the fourth quarter of 2008 compared to net income of $0.8 and $0.4 for a year ago quarter.

For 2007 and 2008 full year we had a net income of $200,000 for both years basic and diluted net income per share was $0.2 on basic and a loss of $0.3 on diluted for 2008 when compared to net income of $0.2 in net loss of $0.10 good for 2007.Cash flows from operating activity were $18.7 million for 2008 compared to $14.8 million a year ago the cash for investing and financing activities obviously reflects the acquisition. Cash used in investing activities for 2008 amounted to $170.8 million compared to $6.7 million a year ago. These included the $108.7 million to require the Country Road entities including transaction cost and $9.2 million in capital expenditure invested in our business.

For financing activities for the year our cash flow amount is $99.9 million up from a reduction of $9.7 million in the same period last year. In terms of the balance sheet we ended the year with $13.5 million in cash equivalents of $700, 000 from last year while income debt of $278.8 million reflects the acquisition of the Country Road entities.

Mike mentioned interest rate management in swaps going forward to become two interest rates swaps in place for the three month LIBOR rate which we generally used for our loan. There’s a $90 million [notational/notional] amount swap runs for three years from February 9, 2009 at 1.855 and $16 million [notational/notional] amount swap that runs for two years beginning February 9 of next year and that is at 2.0475% both counterparties are lenders to the credit agreement and this protects the Company from interest rate swings through that period but it also allows us for some room to reduced debt without unwinding the swaps.

Robin, how about if you provide the directions and we will take questions at this time.

Presentation

Operator

(Operator instructions) Your next question comes from the line of Tim Horan - Oppenheimer

Tim Horan – Oppenheimer & Co. Inc.

Mike, can you provide maybe a little bit of color on what you are expecting the economy? How it is going to hit you guys? Then maybe I know you have not provided guidance for 2009 or beyond kind of what your target ratio is for free cash flow pay out going forward?

Michael Weaver

As you can tell by the ALEC increase in access line loss in the fourth quarter, the economy really hit our rural markets. This is the first time in 2008 we felt that increase in those access lines and we feel that that was driven by the increase in unemployment rate in our legacy markets in all three states. The unemployment rate increased in the fourth quarter and we feel that is what it was attributable to.

I think typically at least in my mind there is always about 10 to 16 month lag from the general more metro areas for the economy effects to be felt in rural markets that certainly fit this timetable. We have taken several steps to kind of offset that. We have looked not just in the Country Road properties I mentioned. We are reviewing all of our existing packages but we are doing that in all our legacy operations as well. We believe that Broadband, having Broadband in the homes is an important part of our service offering.

We have tweaked our packages to include Broadband. Many of those packages are already done. We have increased the speeds that are available to our customers because there is a great of demand for more bandwidth in the rural markets as well as in metropolitan markets. So our response to the economy is to review all of our packages, created additional bundles, check our pricing. We certainly are not giving service away but we understand that these are tough times and we want to be competitively priced for that. So, that is our response to the economy. You are right, Tim, we typically do not provide guidance for the coming year.

On our cash, you saw the improvement in our payout ratio in the fourth quarter and that was one of the primary reasons the Country Road Act that we were so active in pursuing the Country Road probably is the additional free cash flow that will generate from that. We should continue to see moderation downwards in the payout ratio based on where we anticipate will finish 2009; we think that it will be in the mid to upper 80% for our payout ratio. Does that give you the guidance you are looking for?

Tim Horan – Oppenheimer & Co. Inc.

Yes that would be great and good luck with that and thanks to the update.

Operator

Your next question comes from the line of Dave Coleman - RBC Capital Markets.

Dave Coleman - RBC Capital Markets

Just a couple of question on the Country Road, just I am trying to find out what the historical rate of access line loss was before the cable competitor enter that market?

Michael Weaver

It was pretty comparable to what we are seeing in our other rural markets as well across the industry anywhere from 2.5% to 3.5%. I am glad you asked the question because we want to provide just a little bit of the color on that.

As part of the Country Road acquisition, we acquired four RLEC properties. There are two that are in the Portland area, two separate RLECs in the Portland area. There is one in West Virginia and one in Massachusetts. The West Virginia and Massachusetts, West Virginia actually got an increase in access lines. It is in the very rural part of the state and there is no competition in that area.

The Massachusetts property which was Granby Telephone actually had less than 2% access line loss for the quarter. The two properties in the Portland area which are New Gloucester, in the cities of New Gloucester and Gray, the cable provider introduced telephony and I think it was either August or September of last year.

So what we saw then or what Country Road at that time saw was there was a new guy on the block and there was more, and the actually run some pretty aggressive promotions when they introduced that service. So, the access line loss certainly increased as the result of them entering the market. Now, that is higher than we want to it be but we continue to see and we will continue to see access line loss. The good news is it is declining as the months have gone by, the access line; the rate of the decline has actually improved.

The other issue that we have is prior to Otelco taking ownership, the bundled offerings and the packages that Country Road was marketing in that area were not as competitive as they can be from my price standpoint and from my service standpoint. So when I said, we are reviewing, our Vice President in Sales is very skilled and very experienced and he is currently undergoing a review of all of those packages and those particularly with the emphasis on the two, New Gloucester and Gray to come out with a new packages and new pricing.

We do not accept that the right of loss that we had in the fourth quarter I mean we can do better than that. At the end it was a combination of a new entrant into the market in the first six months that they came in with aggressive promotions coupled with our less than competitive offerings and we certainly will be making great progress on getting those new packages and processing out in the market and again we think that will help improve our market position in those particular markets.

Dave Coleman - RBC Capital Markets

And just to follow that, 2.5% to 3.5% rate, is that an annualized or quarterly?

Michael Weaver

Yearly.

Dave Coleman RBC Capital Markets

That is annualized. And then as far as the IPTV business, I do not see a specific line item as the number of IPTV subs. Is that included in cable or RLEC data access lines?

Michael Weaver

No, it is not included in cable and the reason you did not see that was we only rolled that product out in, I guess, it was already the mid December and the first test market that we did, we chose that market because I wanted to be sure and we have done a lot of testing but I wanted to be sure that when you go live with the product that we had no technical issues with delivery of the video streams to the homes.

So, the first market that we chose, we chose because it was close to our CO. It was an area where if we had any kind of service issues, we could really resolve those issues quickly. It was not chosen for and it was really small. It was a really small market so that is the reason. The ads that we had for the less than one month that we had to service were insignificant in December and we did not, that is why you do not see that as a separate number.

Our plans for 2009 call for continued expansion of that service of the IPTV service in more populous nodes, service areas if you will and so we will in 2009 be providing additional information about our success with that product. We are very pleased with the technical, with the product itself. We have had little to no issues, technical issues as far as getting the signal to the customers, having the guide and the programs, the clarity is incredible. To separate video streams, we have had no issues with that. So, we were pleased with the product, the product is in its infancy with Otelco and we will continue to provide strong marketing support for that product and are expecting great things.

Again, the most significant parts of this rollout will not take place until May of 2009 and we will not finish this project in 2009. I think to date, we spent somewhere around $1.9 million on the IPTV project. We anticipate for 2009 included in our CapEx numbers is another $500,000 or so for these new products.

The $1.9 million essentially got all of the backbone and the equipment that we made to provide the signal in our COs and in our heading and so the bulk of it, the big money if you will, and the big cash is capital expenditure has been spent.

Dave Coleman - RBC Capital Markets

I believed a lot of the customers that your signing up are existing cable subscribers so will they, the net number of cable subscribers really be unchanged since you are just sort of swapping out cable for IPTV?

Michael Weaver

Well, we certainly hope for some growth but you are exactly right that this is to some degree it is an improved product and it is opening. And then our initial test market which passed the, I think 600 customers; they did not have our cable service. So you should see some increase in the number of subscribers. It will be a mix of Greenfield opportunities and then a replacement service for our cable in some areas.

Dave Coleman RBC Capital Markets

And just final question, just reported I guess the Country Road wholesale network connections, I am just trying to get a little more detail as far as who the customers are? What the economics associated with that wholesale business?

Michael Weaver

That is a contractual arrangement and fairly limited in the amount of information I can provide on that. The good news, that service is one where Otelco is providing certain back office functions and long distance to a major cable provider in New England who is offering telephony. That services offered is currently throughout the state of Maine and we will shortly be offered in other parts of New England as well.

The good news on that service is that is a contract that I believe runs through to the end of 2012. That service we had it over 4000 subscribers in two months that we own these entities and we expect that growth will continue. Generally, that is a very good relationship for Otelco and we chose to characterize those as wholesale connections because we are not providing dial tone for those customers.

Curtis Garner

And Mike as an addition, we also served by a half a dozen other customers beside the large MSL.

Operator

(Operator instructions) Your next question comes from the line of Frank Louthan - Raymond James

Frank Louthan - Raymond James

Mike, can you give as an idea, you said you are lowering prices to be a little bit more competitive. Give us an idea of sort of the magnitude there. How far off the mark were you or was it just a matter of bundling some products that you were not bundling before? Can you give us an idea on what you expect to spend an IPTV in total and then maybe how much of that is left to spend in 2009? I understand there is some success based CapEx in there but what amount for the fixed networks investments and so forth?

Michael Weaver

On the IPTV as I have mentioned there is about $500, 000 that is in the CapEx budget for 2009 but again that will be spent and then the reminder, the biggest CapEx that we remain Frank, is going to be a success based and it is frankly the converter boxes in the home. So those will be added as we add customers so it will be an incremental CapEx depending on the volume of customers that we received. With the 1.9 and the 5, we will have about $2.4 million to $2.5 million in the backbone and the network and the delivery system for IPTV and again, the only over significant expense will be the converter boxes which are solely dependent on our success and the number of customers that we are able to sign on that service.

Back to the first part of your question, again in the New Gloucester and the Gray markets that was about on $11 price differential for a comparable service with the new aggressive offering that the cable provider had in that area. That is too large and the other thing is it does not have to be that large. There are some different products that we could put in the bundled.

There are some higher speeds that we can provide on the broadband and certainly the margin; we can reduce that price to be competitive and still obtaining a great margin in that product. That is, as I mentioned, our VP of Sales is working hard on that project and there is room in the margin without being severe penalty to Otelco. In other words, we are not marking that down below cost or being more close to that margin. Margins will still be in line with what our process are on similar products in other states.

So we feel Otelco was just, that we can be more competitive is probably the best way to say that with pricing. And yes, you are also right that there is some by offering additional bandwidth for their broadband park and packaging some popular services for our retail customers in that area we do feel like we can certainly slow the greater decline in those two markets.

Frank Louthan Raymond James

Two other quick questions. When can you, can you give us an idea of how you expect the synergies for Country Road to begin to hit. Is that going, for run rate relatively soon, is that going to kind of build during the year and then can you give us an idea, looking at your whole network and across all three states, what percentage of your lines do you think you can, you will be able to roll IPTV out that you have the right distant from the COs and so forth to get the metrics. What percentage of your customers you think you could eventually offer that too?

Michael Weaver

On the synergies Frank, you are right. Those, essentially, will be hitting the P&A along through the year as we take advantage of the integration plans and finish the work. We saw a little effect in the two months that we reported on today. The executive team at Country Road is not part of the new Otelco organization so you saw no cost for them in November and December P&L.

We have gone through a fairly substantial reduction in the duplicative employees and that has tool place right at the end of the year. So you really have not seen the effect to that and if you will recall, there was essentially two parts to the synergies that we now estimate to be around $3 million with the operational part which is to stop the duplicative employees and duplicative functions as well and an improvement in operational synergies and the operational synergies are things where we both had sales offices in Portland. We only need one so the lease on our sales office safe will expires at the end of this month that will be as substantial savings to us.

There is also, were in both companies where in the same co-locations that we have leased from FairPoint -- Verizon, now FairPoint. So there is some cost savings there. As you know those things take a little bit more time to work through so it will rollout and it will come in, it would not necessary be an equal amounts. It will be fairly lumpy for like of a better work as we are able to complete the different parts and segments of our very detailed integrations plan.

The IPTV, initially plan is that would be in Alabama only. Head-ends in Alabama, it is the right place to start in Alabama. So, all our plans now are the rollout of IPTV for Alabama only. We are considering, there is a possibilities at some point in time we want to do that in Maine.

There are certain technical issues about the transport of those signals that might add an expensive proposition to undertake at this time and also I want, again, there is just so many advantages. The Alabama properties are continuous, you can literally drive from the Southern end and Northern end in about an hour so it is very, certainly not congested but they are all within easy driving distance which also makes the transport of that signal in Alabama, it will be all own fiber network so that is internal cost. So Alabama is a right place to be there.

Now, we estimate today that signal, you are right. It is limited to about 5000 to 6000 feet from a service note and that is in the circle. It is not a linear, about 5500 feet. So it is actually gets some more coverage than you first might imagine but eventually we think we will be able to offer that service to about 35% to 40% of our Alabama RLEC lines.

Operator

And with that we have no further questions. I would like to turn the program back over today’s presenters for any additional or closing comments.

Michael Weaver

Again it has been it is great quarter for us and a great year. We appreciate, you guys, taking time to join us this morning, welcomed your questions and hope that you will join us again in three months for our next regular scheduled call. Thank you.

Operator

That has concluded today’s conference. You may disconnect your lines at this time.

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