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Executives

Michael Weaver - Chairman, President & Chief Executive Officer

Curtis Garner - Chief Financial Officer & Board Secretary

Kevin Enda - Investor Relations

Analysts

Frank Louthan - Raymond James

Dave Coleman - RBC Capital Markets

Tim Horan - Oppenheimer

Otelco Inc. (OTT) Q3 2009 Earnings Call November 5, 2009 11:00 AM ET

Operator

Good day and welcome to the Otelco Inc. conference call. Today’s conference is being recorded. At this time for opening remarks and introductions, I’d like turn the call over to Mr. Kevin Enda. Please go ahead, sir.

Kevin Enda

Thank you Jason, and welcome to this Otelco conference call, to review the company’s results for the third quarter ended September 30, 2009, which we released yesterday afternoon. Conducting the call today will be Michael Weaver, President and Chief Executive Officer, and Curtis Garner, Chief Financial Officer.

Before we start, let me offer the cautionary note that statements made on this conference call but are not statements of historical or current fact constitute forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties, and other unknown factors that could cause the actual results of the company to be materially different from the historical results or from any future results expressed or implied by such forward-looking statements.

In addition to statements, which explicitly describes such risks and uncertainties, listeners are urged to consider statements labeled with the terms believes, belief, expects, intends, anticipates, plans or similar terms to be uncertain and forward-looking. The forward-looking statements contained herein are also described from time-to-time in the company’s filings with the SEC.

With that stated, I’ll turn the call over to Mike Weaver.

Michael Weaver

Thank you Kevin, and good morning and thanks for joining us on the call. Despite the continuing challenges in the economy, Otelco delivered our best quarter ever, with EBITDA of $ 12.8 million, representing a 3.5% increase over the second quarter of this year.

As in the prior quarter the primary driver for the increase was the continuing growth in our CLEC operations, which increased excess loans by almost 4% over the previous quarter. Similar to the second quarter, EBITDA growth occurred in both our CLEC and RLEC operations, with the majority of the growth coming in the CLEC. Other noteworthy accomplishments in the third quarter include positive growth of access line equivalents. Once again the CLEC operations continue to be the growth vehicle for the third quarter.

This quarter CLEC growth was a bit higher than we expected due to increased activity from customers in the medical field, as well as growth in our existing New Hampshire operations. Wholesale network connections also grew 4% over the second quarter. On the RLEC side we experienced a loan loss of 2% this quarter, with the primary reasons for the decline being economic conditions and the higher disconnect rate for vacation homes in the New England market.

On the cash loan, our position remained strong as we finished the quarter with a cash balance of $16.7 million, after making a voluntary payment of $5 million to reduce our senior debt. On IPTV we continue to expand our service area and we expect to pass 5000 plus homes by the end of this year. Based on the penetration rate to date, we should have approximately 300 to 400 IPTV customers by 12/31/09. Our expansion plans for next year will add another 2000 plus homes, pass for a total of 7500 by the end of 2010.

On another subject, October 31 marked the first anniversary of our acquisition of the Country Road entities, and I am pleased with our progress during this past year. With the successful completion of the billing conversion in October, the integration process is essentially complete.

We were making our acquisition plans, we estimate would be able to realize approximately $2.8 million to $3 million in synergies, and we estimate that the total synergies realized to be $3.1 million. Our CLEC operations continue to experience double-digit growth in both revenue and EBITDA, and now comprise 25% of our total EBITDA as of the end of the third quarter.

On another note, as you are probably aware, Fair Point filed for Chapter 11 bankruptcy protection on October 26. Otelco’s exposures with the accounts receivable barred Fair Point to our various operating entities. We anticipated this filing and worked diligently to keep the accounts receivable from third point in the current status.

At this stage in the proceedings and it isn’t possible to estimate any potential loss that we might incur. Finally, we paid our nineteenth consecutive IDS distribution in September, and remain committed to continuing our policy of returning cash to our shareholders.

With that I’ll now ask Curtis to discuss financial results.

Curtis Garner

Thank you Mike, and thanks to everyone on the call for joining us today. As a reminder, all of our 2009 results include the properties acquired from Country Road Communications LLC on October 31, as Mike mentioned we passed the first year. So therefore, the majority of the change in performance over the same period in 2008 can be attributed to the acquisition.

Mike has already mentioned several improvements when comparing third quarter to second quarter, showing nice growth on a more comparable same store basis. With that backdrop, here is a brief overview of the financial performance for the quarter. We expect to file our 10-Q tomorrow, which will have additional details.

Total revenues grew 44.8% in the third quarter to $26.4 million from $18.2 million in the same quarter last year, and grew 2.4% or $0.6 million from the second quarter 2009. The growth in revenue was primarily associated with the acquisition, and the growth in CLEC subscribers partially offset by fewer RLEC access lines, lower billing and collection fees, and lower switched access revenues.

Looking at the categories, local services revenue grew 85.6% in the third quarter, to $12.4 million from $6.7 million a year ago. The acquisition provided an increase of $6 million for the quarter. The smaller RLEC base and lower billing and collecting revenues accounted for a reduction of $0.3 million on the balance of the company.

Network access revenue increased 27.2% in the third quarter to $8.5 million from $6.7 million. The acquisition provided an increase of $2.9 million for the quarter. RLEC switched in special access and universal service revenue and customer related charges decreased by about $1 million for the old Otelco properties.

Cable television revenue in the third quarter increased 2.2% to $614,000 from $601,000 a year ago, basically from additional high definition and IPTV subscribers and satellite installations. Internet revenue for the third quarter 2009 increased to 15.6% to $3.5 million from $3 million last year, primarily associated with the acquisition, the growth in the light of the company and high speed data lines offset the decline in dial-up internet revenue.

Transport services revenues grew 11.3% to $1.4 million in the third quarter, from $1.2 million in the same period in 2008. Continued growth in Wide Area Network revenue in CLEC customers and main drove the increase. When you compare third-quarter 2009 to second quarter 2009, revenue increased in each of the five categories for the total increase of $0.6 million that I mentioned earlier.

Moving on to expenses, operations expenses increased 60.6% to $20.2 million from $12.6 million a year ago. Cost of services and products increased 56.9% to $10.4 million from $6.7 million in the same period last year, reflecting $3.8 million increase from the acquisition.

Selling, general and administrative expenses increased 16.1% to $3.2 million from $2.8 million in the same quarter a year ago. The acquisition accounted for an increase of $0.8 million, certain employee end costs incurred in 2008, which were not incurred in the same period of 2009 and lower external relation costs in 2009 provided for a reduction of $0.04 million on the balance of the properties.

Depreciation and amortization for the third quarter increased to 107.8% to $6.5 million from $3.1 million in the same period last year. Depreciation and amortization included $3.6 million from the acquisition, which includes the amortization of intangible assets acquired, which was partially offset by a reduction of $0.2 million from the existing units. On the year-to-date basis, revenue and operating expenses when compared to the same period in 2008 increased by similar percentages to the third quarter increase in each category.

Interest expense increased 35.5% to $6.5 million from $4.8 million a year ago. The results reflect $1.5 million in interest on the increased senior debt associated with the acquisition, and $0.2 million in capital cost amortization increased associated with the interest rate cap which expires at the end of this year. The company has two interest rate swaps to limit its exposure to changes in interest rates through February 2012.

Provision for income taxes for the quarter was a benefit of $100,000 compared to an expense of $500,000 a year ago. We continue to anticipate that the company’s 2009 dividends will be treated as a return of capital for tax purposes as the 2008 dividends were treated in the same fashion.

As a result of the factors I just mentioned, we basically broke even for the third quarter with a net loss of $12,000, compared to a net income of $0.8 million for the third of 2008. Basic and diluted net loss per share was zero and $0.001 compared to net income of $0.06 and $0.04 from the third quarter of 2008.

As Mike mentioned, adjusted EBITDA was up $3.7 million over third quarter 2009 and $0.4 million over second quarter of this year. EBITDA margin also improved from second quarter, going to 48.8% from 48.4%. Cash flow from operating activities was $21.3 million for the first nine months of this year, compared to $14.4 million a year ago.

Cash used in investing activities for the first nine months of this year amounted to $6.4 million, compared to $7.4 million a year ago. Capital investment in property, plan and equipment was $6.4 million on the year-to-date basis for 2009 compared to $6.8 million in the same period last year. This reflects our conservative approach for the year, although the investment in the third quarter returned to more normal levels in the 10% range, it was 10.6% for the third quarter.

Cash flows used in financing activities for year-to-date amounted to $11.7 million, compared to $6.7 million last year; both years reflected $6.7 million in dividends paid to our shareowners. The increase is the result of the $5 million voluntary repayment on senior debt that Mike mentioned.

In terms of the balance sheet, we entered the quarter with $16.7 million in cash, an increase of $3.2 million since the end of 2008. This would have been a growth of $8.2 million if we hadn’t had the debt repayment that we made. Long term debt was reduced by almost 3% by the $5 million payment to $273.8 million. There’s no covenant or other criteria that required this prepayment as our senior debt runs through October of 2013, and the company assumes compliance with all of its covenants.

Jason, if you’ll provide directions, we can take questions at this time.

Question-And-Answer Session

Operator

(Operator instructions). And we will go first to Frank Louthan with Raymond James.

Frank Louthan - Raymond James

Great, thank you. The video subscribers that you added in the quarter, were those from IPTV or cable or both; and then looking at your CLEC operations, obviously been a big boost, we saw Wind Stream this week making an acquisition of a CLEC. Is that anything that you would consider more diversification in that direction, through M&A of the CLEC property?

Michael Weaver

Thanks Frank. The video service work primarily is a combination of our traditional product in IPTV, and if you just allow me just a couple of minutes to comment on the IPTV portion as well.

As I mentioned, we have in near past 5,000 homes, but 3300 of those were opened less than a month ago. We’re very active in expanding that process, and as I mentioned it’s a big part of our plans for 2010. We are relatively pleased with the acceptance of the product so far. It’s a process to educate our customers that we’re now a cable provider in their area and we have a marketing plan for that that we’re following carefully. So we do expect increased penetration rates in 2010.

The answer to the second part of your question is a resounding yes. As you know, our first venture into the CLEC business was when we bought Mid-Maine in 2006. We expanded that with the acquisition of Country Roads in 2008. Those are of course about the facilities by CLECs.

We really like that model. We think it makes sense in the competitive environment we are in; and yes, we are actively looking for the right opportunities and certainly, part of the definition of the right opportunities would be having some CLEC existing operations or certainly the market would be such that it would be conducive to us expanding the existing operations to include CLEC.

Frank Louthan - Raymond James

Would you buy a peer place CLEC, that’s near your territory, even one that’s just sort of in a different area, but considering you have some experience in operating these kind of properties?

Michael Weaver

We would do it either Frank, that’s a good question. Part of the attraction for the initial Mid-Maine operations was that we recognized back in 2006, that it is just difficult to grow our franchise territory. You are geographically limited and we thought that we needed the ability to grow our operations, our revenue and our EBITDA and to do that you have to add more than just the traditional RLEC I think.

It’s always nice if you can find properties that are contiguous or close to your operations, but because we now have experience that would not be a requirement for us. It would not have to be even in the stage that we currently operate. Our criteria for that would be the same as that always is on the acquisition front, which is do we understand the regulatory environment and more importantly is it a cash accredited deal that we feel like we can from day one be adding to our EBITDA.

Frank Louthan - Raymond James

Great, thank you very much.

Michael Weaver

Sure.

Operator

And we’ll go next to Dave Coleman with RBC Capital Markets

Dave Coleman - RBC Capital Markets

Thank you. Just going back to the IPTV’s business, you mentioned estimating about 300 to 400 IP TV subs at the end of this year. Can you talk about how many you have currently and then, if there is any sort of switchers from your traditional video product over the IPTV.

Michael Weaver

Sure Dave, I would be glad to do that. We currently have about 300 subs on the IPTV, just kind of as a reminder if I could back up a little bit, we introduced that in one of our smallest territories, smallest dollar territories plus blunts with telephone, that was our initial 4A into the business.

The market that we chose was the one that was closest to our central office and closest to our facilities. We chose that market because it was the closest to our facilities and in all honesty it was almost a test market for us. We were wanting to make sure that we understood the product that we can make the product work appropriately, that we could get multiple channels at the distance limits.

So it’s a typical plan and the plan that shows our customers was no better and no worse than what we have in other territories. So we felt like it was a valid taste, yet however was not the best market to open from a results standpoint.

There is a lot of multi-dwelling units, housing units in that area, that the people that live in that area don’t have the highest per capita income. So we weren’t expecting great marketing results or great customer tech right out of that. That was simply to define, to make sure that we understood the product and can make it work appropriately, and we’ve been relatively pleased with that.

The big push has been in our Brendly Mountain market, that’s our northern most Alabama market and we are just now getting into the proper areas and in the last month we are into the residential areas. So, where there is perhaps a higher income per household and more disposable income. So we do expect that penetration right to increase over time.

Dave Coleman - RBC Capital Markets

Is there any of the traditional video, cable video that have switched over to IPTV or is it beginning to market in separate footprints?

Michael Weaver

Generally in the areas where we were rolling in IPTV, it’s our first 4A into the cable market, so they don’t have another product from Otelco that completes with us. Now in our Brendly Mountain area, which again is where we’re really counting heavily on most success, that area Charters already, that we are the incumbent cable provider in that area. So almost without exception, every time we talk to customer in the Brendly Mountain area, we’re talking them away from Charter. At this point in time Otelco was not offering IPTV in areas we have the traditional cable.

Dave Coleman - RBC Capital Markets

Okay great, and then talked about the country road synergies targeted $2.8 million to $3 million, actual synergy is at $3.1 million. Are essentially all synergies been realized at this point?

Michael Weaver

99% of them have. As I mentioned, we just finished the billing conversion in October, and there is a little bit of savings that we’ll realize by the end of the year from that, but it’s not significant.

Dave Coleman - RBC Capital Markets

Okay. So the 3Q OpEx, it’s a pretty good run rate to use going forward.

Michael Weaver

Yes.

Dave Coleman - RBC Capital Markets

Okay and then for the CLEC business very strong voice access, CLEC voice access line additions during the quarter. Is there any benefit from your improved fair point provision in process reflected in that number, or is that pretty much truly an organic number?

Michael Weaver

No, that’s actually pretty much organic. The two as I mentioned that came from, it was actually better than I’d hope for to and part of the reason was that it came from two specific industries, where one industry being the medical industry and then as we mentioned in previous quarters we may offer CLEC services in New Hampshire, and that, we show some pretty good growth there.

Actually the growth that you saw in the third quarter, we should have had in the second quarter. It was delayed to the third quarter, because of the difficulties Fairpoint has experienced. They’re certainly working hard to get their operating system from our standpoint; they are working hard to get the operating system fixed. It’s no better and no worse than it has been in previous quarters.

Dave Coleman - RBC Capital Markets

Okay, great. Thanks a lot.

Operator

(Operator Instructions) And we will go next to Tim Horan with Oppenheimer.

Tim Horan - Oppenheimer

Good morning guys, good quarter.

Michael Weaver

Thank you, Tim.

Tim Horan - Oppenheimer

Michael just hoping maybe just a step back and I had a few industry issues, and I guess somewhat related to you guys is Fairpoint, could you have a sort of guess what you think is going to happen to the company and is there a opportunity for you as they restructure here?

Michael Weaver

Well, I’m reluctant to have sort of guess as to what the outcome of that will be. I mean, Fairpoint, I think they are in 18 states. They are in some of the states where our existing operations are in. They have some of the legacy properties in New England and outside of New England. Our properties that would work well with our existing operations, if and when Fairpoint decides they would like to put those products on the market, we certainly would have an interest in taking a look at that.

That’s probably all I’m pretty comfortable saying, but I don’t mean to be reluctant about it, it’s just there’s so much uncertainty with the bankruptcy and that process is still so new, meaning I think they’ve had their first day hearings and little low at this point in time. So we’re following the process closely. Your right Tim and there potentially could be some opportunities for Otelco and other RLECs if this process works its way to conclusion.

Tim Horan - Oppenheimer

Thanks for that Mike. RLECs in general, you maybe talking about the atmosphere out there for maybe private companies looking to sell and what’s going on with pricing. Now we assume capital was fairly hard to come by and credit to be able to buy all the clients, and you guys clearly have the operational expertise and the capital access if needed. Can you talk about if you were to buy RLEC lines, would they be accretive and do you think and what is your appetite for RLEC versus CLEC at this time. I know you looked at the CLEC base and more cash flows.

Michael Weaver

That’s another good question. First we’re seeing more interest now in the last month on people looking to sell their business than we have in the previous six months. So it’s coming, the soccer is not complete. We are not back to where we were before the worst part of the recession hit, but it has been a longtime since we were receiving, our phone were running again, so we have a deal that you might be interested in.

I do think there has been the pricing on those; the expectation of pricing is down slightly. I don’t know if it is down from the seller’s standpoint to where bars, I think it is if you. If you look at the multiples in the values of obviously in the public market you certainly drew the conclusion that there has been a decline in value that any purchaser would attempt to reflect in the price.

You’re also right on the debt standpoint; debt is still expensive and I think for a sizable deal which would be difficult to obtain, I don’t think it is impossible to get the appropriate deal financed. The trick would be getting rights that you could leave with they wouldn’t still allow the deal to be accredited.

From a Otelco’s standpoint, we still have the RLEC business, with one caveat. It has to have additional revenue opportunities in it beyond just the traditional RLEC. It can be from our standpoint. As I mentioned earlier if we could find identify and obtain a company that was already in the CLEC business or had some fairly significant non-regulated revenue to it; that certainly makes it more attractive to us.

If it’s in a major market in there not yet in the CLEC business, or not in a very meaningful way, that’s deal for us. I do believe we have the expertise within our existing management team to expand in the other states with CLEC operations. So our interest is certainly cottoned by RLEC that have significant non-regulated strengths, albeit transport fiber business, data storage, or maybe on top of others, would be additional CLEC operations.

Tim Horan - Oppenheimer

Then two some more related questions. Access like trends seem to be stabilizing for some of your peers; what’s the industry’s scuttlebutt on access line transfer or more and more private company things, stability or are they are still declining?

Michael Weaver

Well, they’re still declining. I think the right based on our situation and then the people that are thought to, my peers in the industry, we are still experiencing a decline. I think as you pointed out several quarters ago, the real markets always lag the major metropolitan market. So we were the last guys to be affected by the recession, will be the last guys to come out of it.

We’ve seen the rate of decline in the third quarter on our RLECs. We were adversely affected. We have a fair number of homes in the New England market that are vacation homes. When people come for the summer, they’ll reconnect their telephone lines as the weather gets less friendly, they’ll disconnect those lines. So that had a more significant effect on us in the third quarter than obviously in the second quarter. That somewhat skewed our excess line loss in the third quarter. Its better Tim, I don’t know that I’d say it’s stabilized yet. It’s better but there’s still, I’m not sure we bought them.

Tim Horan - Oppenheimer

And then lastly on the regulatory front and Washington, as Washington’s looking at the sector again with this whole net neutrality issue are they looking at restructuring access charges or subsidies as far you can tell?

Michael Weaver

I can’t tell you. I’m not sure that, I’m not sure about he is agenda at this point; I don’t mean that in any semester way. I think that they’re still filling their way along and the net neutrality certainly seems to be raised to hot topic now, I don’t know if we’ll see access reform in 2010 or not. In my book it’s just too early to tell. I don’t like that, I don’t have a definitive opinion on that, but I think as we get into the first quarter of next year that will become much, much clear.

Tim Horan - Oppenheimer

But there seem to be some bad apples in the RLEC, space so that running different services and collecting very high access charges on Google has kind of bought some of that delay. Do you know if the FCC maybe we just clamp down on users like that or would they kind of take it up in a holistic measure?

Michael Weaver

My hope is that they actually give way for the problems, and here’s an interesting side line. I mean as you know, one of the things that came out of the Arkose discussion from last year was the E-psychotics, where they come in and really scrib the books on a lot of the RLECS.

Initially the reports that came out of that, if you just looked at the numbers and didn’t dig down, you would assume that there is a lot of issues of funds being applied, but they just finished their second round of audits and I think the number that I recall saying was that the two non-compliance was less than 30%.

So, I think generally the industry does a good job of playing within the roles. You are always going to have a few problems with people that are perhaps too aggressive in that. My hope is that based on these other results that were announced about the better compliance rate, if that would spur the SEC to look primarily at the problem issues, the problem with publicity is the negative step always gets a lot more press than the corrections or the positives when it comes out. So you really have to look at the entire picture to get a real feel for it I think.

Tim Horan - Oppenheimer

Great. Thanks for your time and a great quarter. Thanks a lot.

Operator

And at this time there are no further questions. So I would like to turn the call back over to Mr. Weaver for any additional or closing remarks.

Michael Weaver

Well, as always guys, we thank you for your time and for joining us, and we look forward to talking to you again in another three months.

Operator

This does conclude today’s conference. Thank you for your participation.

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