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Executives

Kevin Enda – Investor Relations

Michael Weaver – Chairman, President & Chief Executive Office

Curtis Garner – Chief Financial Office

Analysts

Dave Coleman – RBC Capital Markets

Frank Louthan – Raymond James

Tim Horan – Oppenheimer

Neil George – Green Gold Capital

Otelco Inc. (OTT) 3Q 2010 Earnings Call November 3, 2010 11:00 AM ET

Operator

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

Kevin Enda

Thank you and welcome to this Otelco Conference Call to review the company’s results for the third quarter ended September 30th 2010, which were 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 that 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 describe such risks and uncertainties, listeners are urged to consider statements labeled with the terms believes, beliefs, 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 company’s filings with the SEC.

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

Michael Weaver

Thanks Kevin. Good morning everyone. Welcome to our call.

Our business continues to perform well and we are pleased with the third quarter results as we generated revenue of $26.1 million and EBITDA of $12.7 million. Our third quarter metrics, with an increase of almost 1% in our Access line equivalents, was an encouraging indication of the performance of our operations. This third quarter growth was attributable to cyclical demand for broadband facilities and the introduction of new products.

In this third quarter, we experienced a growth in the number of special circuits that we provide to educational institutions as they begin preparing to open their facilities for the school year. Providing Broadband Access to schools is a particularly attractive business proposition for us as the circuits typically stay in place for pretty long periods of time. In addition to the special circuits, we added the rollout of our Hosted PBX product in the CLEC Operations, which has been successful and we had a couple of large sales of this product in this quarter with one of the customers being a large school facility in Northeastern Maine.

For the quarter, our CLEC Operations experienced a 3.6% growth in Access Lines, which is a result of the new Hosted PBX products and our expansion in the new markets in Northeastern Maine.

On the New Hampshire front, we now have two of the three co-location sites installed and are on schedule to have the third site operational by the end of this year. Probably more importantly, our sales efforts in New Hampshire are just beginning to be productive as we are now receiving some of our first sales orders from this new market.

Likewise, our expansion into Northeastern Maine has been successful and our plans for next year include two additional co-location sites in this area. Frankly, we need these additional sites to meet the demand for our Data and Telephony Services.

On the Cable TV front, we continue to expand the product offerings in our Alabama market and in mid-September we added Video on Demand to our service offerings. In addition to generating additional revenue, we expect this will stimulate additional demand for our IPTV Services. While we remain pleased with the IPTV products, sales of this service lagged behind our expectations. For the quarter, we added 43 net IPTV customers.

We are pleased with our cash decision as we have experienced growth of $5.8 million in 2010 and we plan to use $7.5 million of our cash to make a voluntary pre-payment next week to reduce our senior debt.

Finally, we paid our 23rd consecutive IDS distribution in September and remain committed to continuing our policy of returning cash to our shareholders.

Curtis, if you would, please discuss the financial results.

Curtis Garner

Thank you Mike and thanks to everyone on the call for joining us today as I know there is lots of congestion for earnings calls. Let me provide an overview of the financial performance for the third quarter of this year and then we will take questions.

Total revenue decreased 1% for the quarter to $26.1 million from $26.4 million a year ago, continued CLEC growth in New England, as Mike mentioned, and gained some cable television revenue produced positive results which were offset by declines in RLEC subscriber-driven revenues.

Breaking down the pieces, local service revenues grew slightly, remaining at, basically, $12.4 million. Again, expansion of the CLEC revenue which produced a $0.3 million increase was offset by $0.3 million in lower RLEC Basic Services and Toll revenues.

Network Access revenue decreased 5.2% in the third quarter to $8.1 million from $8.5 million a year ago. Access revenue related to RLEC subscriber usage and lower NECA settlements accounted for the decline.

Cable Television revenue for the quarter increased 16.8% to $0.7 million from $0.6 million a year ago. Growth in IPTV and the Digital Family Packages of $0.2 million was partially offset by a $0.1 million decrease in Basic Analogue Cable

Internet revenue for the third quarter increased 0.6%, remaining at $3.5 million for both periods. Growth in Broadband Data Lines, including those in Missouri that we provide outside of our RLEC territory, was offset by the loss of Dial-up subscribers. Our transport revenue increased 2.4%, again holding at $1.4 million for both periods.

Operating expenses in the quarter decreased 3.8% to $19.4 million from $20.2 million a year ago. Cost of services and products decreased 1% to $10.3 million in the quarter from $10.4 in the same period last year. An increase of $0.1 million in Digital and Circuit expense and Reciprocal Compensation expenses primarily relating to the growth from Network Connections was more than offset by a decrease of $0.2 million in Toll Charges, correlated with lower long-distance costs.

Selling, general, and administrative expenses increased 2.6% to $3.3 million in the quarter from $3.2 million a year ago. An increase of $0.3 million for due diligence and $0.2 million for accrued salary expenses in 2010 was primarily offset by lower uncollectible reserves and continued benefits from integrated systems and process improvements which were offset by $0.4 million.

Depreciation and amortization for the quarter decreased 11.5% to $5.8 million from $6.5 million a year ago. Amortization of intangible assets associated with the Country Road acquisition decreased $0.6 million, including a covenant not to compete and contracted customer base intangible assets. The remaining decrease of $0.1 million reflected lower deprecation of plant assets in Alabama, partially offset by a small increase in depreciation in Missouri.

Interest expense decreased 2.3% to $6.3 million in the quarter from $6.5 million a year ago. A decrease of $0.4 million reflects the interest rate caplet expense that was present in the third quarter of 2009 that was fully expensed in the year 2009. This decline was partially offset by increased interest costs associated with our second interest rate swap that became effective in February of 2010 and the senior subordinated debt interest costs associated with the additional IDS units issued in the Class B conversion that occurred last quarter in June.

As a requirement of the existing senior debt, the company has two interest rate swaps intended to hedge changes in interest rates on its senior debt. The swap agreements do not qualify for hedge accounting under the technical requirements of Accounting Standards Codification 815. Changes in value for the two swaps, therefore, are reflected in the change in value of derivatives on the income statement and have no impact on cash, unless we decide to unline them. Over the life of the swaps, the change in the value will be zero with no impact on adjusted EBITDA or operations. The value of swaps declined $0.4 million in the third quarter of 2010 compared to a decrease of $1.5 million in the same period of 2009, as expectations within the market for an increase in interest rates remain low.

Adjusted EBITDA, as Mike mentioned, for the third quarter was $12.7 million compared to $12.8 million for the same period in 2009, and $12.9 million in the second quarter of 2010. Now, the second quarter included some impacts of the bankruptcy settlement that we had with FairPoint, which had a positive impact.

Cash payout ratio, as we expressed it for the year-to-date, was rated 81.6%. Cash flow from operating activities was $12.3 million for the first nine months of the year compared to $19.4 million in the same period of 2009. Cash used in investing activities amounted to $6.4 million, essentially flat with the same period last year, reflecting the expansion of our CLEC capabilities in Maine and New Hampshire. Enhancing our DSL and Wireless Broadband capacity and expanding our IPTV capability in Alabama. Cash flows used in financing activities amounted to $11.7 million in the first nine months of 2009, reflecting our voluntary pre-payment of $5 million on the senior long-term notes last year. That compares to $7.2 million, thus far, in 2010. Both include our dividends paid in the same periods. As Mike mentioned, we have notified our lenders that we plan to make another voluntary pre-payment of $7.5 million on our senior debt next week.

In terms of the balance sheet, we had cash and cash equivalents of $23.5 million compared to $17.7 million at the end of 2009. Total long-term notes payable at $277.7 million did not change during third quarter, reflecting the exchange of the Class B common stock that actually occurred last quarter.

We continued to meet all of our loan covenants, the third quarter distribution of $5.5 million in interest and dividends to our shareowners and $0.3 million in interest to our bondholders occurred on September 30th and reflects the new IDS’s issued in exchange for Class B common stock. This represents the 23rd consecutive quarterly distribution since going public in 2004. Operator, if you could provide directions, we can take some questions at this time.

Question-and-Answer Session

Operator

(Operator Instructions)

We will take our first question from Dave Coleman with RBC Capital Markets.

Dave Coleman – RBC Capital Markets

Thank you. As far as the CLEC business, the Voice Access Line growth of over 1000 Voice Access Lines. I am assuming that was largely attributable to the large PBX sales during the quarter. I just want to confirm that. Then, just curious if there is any sort of additional similar deals that size that you are anticipating either during the balance of this year or in 2011, and also the margins associated with one of those kinds of transactions and if there is any CapEx required on your behalf. Then, looking at the Cable results, I saw the Cable RPU tick up a little bit, about a buck fifty, sequentially. Wondering how much of that is through just further IPTV rollout versus take rates of Video on Demand. Then, my final question, the fourth quarter, typically, we have seen a tick up in SG&A sequentially, wondering if we should be expecting the same this year.

Michael Weaver

Thanks Dave. Let me see if I can answer those questions in the order in which you asked them. You are correct. First, let me confirm that you are correct. The big reason for the increase in the CLEC growth and Access Lines was--actually, we had two large sales in Northern Maine for educational Hosted PBX and that is a winner of a product for us. It is certainly not new in the industry. It is a new product for Otelco and it is relatively new in the markets that we are serving. Those were large deals that we had been working on for some time and we are happy we did install those over the summer and when school started back, we did additional training. I am happy to report that the product worked well and our customers were extremely satisfied with that.

There are other large deals of similar size that we are working on always. There is nothing on that that I feel comfortable enough to comment on at this time. The margins on those are pretty good actually. You mentioned CapEx, typically, we do not make any money on the equipment that we sell, as we do those installations. It is basically provided to customers at cost. We do not lose any money on it either, but certainly there is no margin to speak of in the equipment.

Basically, the CapEx, our network is strong enough and we have spent money and the money we have spent in the past, there is no specific CapEx other than the equipment that is associated with a large Hosted PBX product. For modeling purposes, there would be no reason--it is not necessary to put any costs in for that.

Cable TV, you are right, the increase there that you saw on the RPU is probably more related to the IPTV. Video on Demand, as we mentioned, we just rolled that out and it was mid-September. There was zero impact of Video on Demand in the Cable numbers in the third quarter. We certainly have had some sales of that product, but it would not have been in the billing and accounting cycle, I believe, for the third quarter. The increase you are seeing is the IPTV. We did have some moderate price increases on some of our other Cable TV Services, but the bulk of that, roughly buck-fifty, increase in RPU came from IPTV.

Curtis is probably has better knowledge on your other questions--should we expect an uptick in SG&A in the fourth quarter. Curtis, if you would, I would ask you to comment on that.

Curtis Garner

Hey, Dave. Good question. We have been accruing some expenses in 2010 that last year we took in fourth quarter of 2011. There was an uptick in fourth quarter of 2010 that you will not see in 2011.

Dave Coleman – RBC Capital Markets

I am sorry. Some expenses in 4Q 2009 that you will not recognize in 4Q 2010?

Curtis Garner

Correct. We have been recognizing those as we go throughout the year.

Dave Coleman – RBC Capital Markets

So, 3Q 2010 is sort of a good run rate for 4Q numbers?

Curtis Garner

There may be some other pluses and minuses, but not anything of the size we had last year.

Dave Coleman – RBC Capital Markets

Great. Thank you.

Operator

We will take our next question from Frank Louthan of Raymond James.

Frank Louthan – Raymond James

Great. Thank you. Can you give us an update on the status of the fiber network up in Maine? Did that contribute to the ability to win some of those other contracts? Then, one of your piers reported last week that it is benefitting from some regulatory changes for some smaller study areas, being able to capture a little bit more local switching support. Just curious if any of your exchanges or your study areas may fall into that bucket that might help next year. Thanks.

Michael Weaver

Thank you Frank. First question that you asked was “did our existing fiber network allow us, is that part of the reason for the success on the Hosted PBX” and that answer to that is “absolutely”. Coincidentally, one of those larger sales was in the Northeastern part of Maine, which is an area that we expanded to earlier this year by moving some CLEC facilities there. We are actually continuing that expansion into 2011 by having a full-fledged co-location site and actually, we are going to put two in Northeastern Maine next year. We are doing that because we see a growth in demand for our services there and we can serve it more efficiently and cheaply by having a full-blown co-location location as opposed to just leasing it. I offer that as an example of an area where, because of the money we had spent in expanding our fiber network, we were able to realize additional sales opportunities and revenue from that.

On the second part of your question, we have one company that one of our Alabama companies will see a slight increase in their Universal Service Funding Support as a result of having a smaller stay area. It, frankly, is pretty immaterial and it is not something that you would notice in our numbers. Do not get me wrong, we are pleased to get it but we only had one company that would benefit from that and, again, it is not a material amount of an increase.

Frank Louthan – Raymond James

Great. Can you give us an idea of the breadth of your Video on Demand product, how many titles do you have access to and where do you think that goes over time?

Michael Weaver

First of all, it is true Video On Demand. We have offered Pay Per View, which is, pardon the expression, the old-fashioned kind, where the programs came on at certain times, it was not Video On Demand. This new product is absolutely Video On Demand. You watch it when you want. I want to say that I do not recall the specific numbers off the top of my head, but I want to say that…

Curtis Garner

It is about 200, Mike.

Michael Weaver

It is huge. I cannot image not having something that somebody would want to watch if they were sitting at home trying to do Video On Demand. We are actually pretty excited about that product. It has decent margins on it. We are offering it pretty much to probably 85% of our Alabama market today, 100% of the IPTV market. There are some of our Alabama customers that still have our Basic Analogue Service. They will not be able to receive the Video On Demand without a change of some CPE at their homes. If they request, that is an easy and quick change for us. If they request the service, what it means, is that we swap out the receiver that their house and that is the only CapEx that would be involved in that. We are pretty excited about it. Time will tell if the demand is strong for that product.

Frank Louthan – Raymond James

Great. Thank you.

Operator

(Reminder Instructions)

We will take our next question from Tim Horan with Oppenheimer.

Tim Horan – Oppenheimer

Good morning guys, thanks. Mike, just a quick geography question. Where is Northeast Maine, is that on the coast or up inland?

Michael Weaver

No, it is up inland. Specifically, Tim, if you look around the areas of Caribou and Holton, it is north from Ellsworth and the Bangor area and almost due north/northeast and slightly northwest, both.

Tim Horan – Oppenheimer

Yes, I have that on the map. I did not think there were many people up there.

Michael Weaver

You are right. Is that the most populous area of Maine? Absolutely not. Here is the thing that is kind of neat, though, for us. We have formed some business alliances with agents that are doing business there that are well-established in the area that needed product to sell. They are doing a great job for us. In addition to that, because of the opportunity that we perceive there, we have put some of our own employees, our own salespeople, that are now calling in that area. The other thing that is really neat for us is our customers that are---particularly some educational and financial institutions that we have in Central and Southern Maine have branches and schools and facilities in Northern Maine. By having the same provider, there are certain savings and, probably more importantly, additional new services that we can offer them that they have not been able to get. I understand your comment and we are very pleased with our results and the prognosis we see for that area of our business.

Tim Horan – Oppenheimer

Clearly, there are a lot of little towns up in that area.

Michael Weaver

Actually, you go back and look at where--certainly in mid-Maine which is where our first acquisition in 2006. Where they really served the market was they found a niche of areas where they could serve it efficiently and have decent margins on it. By going in these smaller areas, where it is not quite as competitive--and I am not suggesting there is no competition in Northern Maine, that is not true--Northeastern Maine. But, certainly, there are good opportunities for a company our size with an established network that runs from Portland all the way up, when this is finished, to that northeastern corner of Maine. There is just a good opportunity for us. Our sales guys and sales engineers have done a good job of indentifying that new market for us.

Tim Horan – Oppenheimer

Does anyone else have fiber going up to that area?

Michael Weaver

Not as much as we do, is the honest answer.

Tim Horan – Oppenheimer

I believe it. Curtis, on the Access Charge front, I know it has been bouncing around, what do you think is a more of a normalized number, maybe quarterly or annually, to think about? One of your piers had said that they kind of thought that Access Charges can stay flat over the next couple of years. Just curious of your outlook on that.

Curtis Garner

I hope we can maintain it as flat. We have some positives that are driving some upside usage-driven charges on the Access side, so that is good news. On the other hand, we expect that USF will continue to edge downward and we are just hopeful that the speed on that is fairly slow. Unfortunately, we try to look at it from a quarter-over-quarter basis just to see how we were doing and it looks like, if you look from third quarter back to second quarter, we had like a $500,000.00 change, and it is like “Oh my gosh”. Well, in the second quarter we had a fairly decent positive number in there, related to some settlements in Maine, and then in third quarter we had some adjustments to the NECA receivable accruals that we make and the net of that was about $0.5 million. If you take those two things out of both quarters, they are kind of flat in the $8.1 – $8.2 million range for Access. I am hopeful that we can stem the tide of decrease, absent any major policy changes that impact us.

Tim Horan – Oppenheimer

I know Frank had asked this question, you piers was talking about actually Access revenues starting to grow again because of some regulatory changes, but your answer on that is that you really have not seen those regulatory positive impacts yet? Do you think that you might be able to see them in a couple of years?

Curtis Garner

I do not think we will qualify in terms of our size and for most of the things that we have seen and announced so far. I just think it is going to be hard-pressed to grow except in Maine, where we have a growth in customers, because as you lose customers there are parts of your -- it is the customer that drives Access revenue, whether it is long-distance revenues or things related to USF and NECA contributions.

Tim Horan – Oppenheimer

I guess we can talk offline. They had some specific quirky things on it when you get below a certain size level.

Curtis Garner

Of the five cost companies, I think the only one that will qualify for that is one of the ones here in Alabama and they are really marginal in terms of the difference. The dollars seem to be relatively small.

Tim Horan – Oppenheimer

The year-over-year, if you kind of do these normalizations, overall revenues were probably flattish. Is that a good guesstimate, do you think?

Curtis Garner

I think if you had looked at, quarter-over-quarter, my guess is that we were down maybe, if you take out the two things that we were adjusting for, we would have been pretty much flat, maybe up $50,000.00 to $75,000.00.

Tim Horan – Oppenheimer

Mike, do you think CLEC revenues, you can sell a few more managed services so the revenues there could grow with Access Lines on the CLEC front, or do you think--what type of growth rate do you think on the CLEC side?

Michael Weaver

We are absolutely looking for growth, continued growth, on the CLEC side and we hope to drive that growth. That is a great question. If you look at what we did this year, by the end of the year we will have three new co-location sites in New Hampshire. The significance of that, besides just the sheer volume, is that is a new market for us. It is an area where we have not sold services before, until 2010. We are going to continue to expand in 2011 and expand our footprint. One of the things we want to do in 2011, as I said, continue that expansion. We are looking strongly at the possibility of going into Massachusetts, again, with more footprint. We are hiring additional salespeople, so we can have better market coverage. We actually think that we should be able to generate an 8% to 10% growth rate on our CLEC side in 2011.

Tim Horan – Oppenheimer

What is the revenue growth in CLEC this quarter, do you think?

Michael Weaver

In the fourth quarter?

Tim Horan – Oppenheimer

In the third quarter, what do you think the year-over-year growth rate was? What do you think the CLEC business is growing at this year?

Michael Weaver

It is not growing quite that fast. I do not have those numbers right in front of me. It is probably growing at about 8% this year. There are different components to that growth. What we are trying to do, by expanding that market, is really ramp up the sales that we generate internally.

Tim Horan – Oppenheimer

Thanks a lot guys.

Operator

We will take our next question from Neil George of Green Gold Capital

Neil George – Green Gold Capital

Mike and Curtis, thanks very much. Again, I wanted to comment on my appreciation for your continued transparency. It is always appreciated from the retail investor standpoint. Basically, I want to ask a question about some of the strategic financial plans or thoughts. Given the fact that we have seen a lot of demand for some of the parts of the higher yield bond market, what are your thoughts about potentially instigating some call functions on some of the 2019 bonds, particularly related to the IDS securities?

Michael Weaver

Neil, thank you for your question. I think part of--this is horrible grammar but, I think it makes the point -- “if it is not broke, don’t fix it”. It seems to me that our investors that are in for yield really like our structure and are very comfortable and I think, as we mentioned multiple times in the conversation today, we have gone 23 consecutive quarters paying dividends and also, as we mentioned, we are committed to continuing growing our business and returning cash back to our shareholders.

What I meant by the other comment is I think we are very happy with the maturity date of the bonds and my perception is our shareholders are happy as well. I would have to say I do not see any reason to explore that at this time.

Neil George – Green Gold Capital

I guess I am looking at a perspective of potentially looking to replace that debt with a lower coupon. That is basically my question. Obviously, from a dividend standpoint, it would be, overall dividend including the interest servicing on the IDS, would be detrimental to shareholders owning the securities, but from an Otelco standpoint, the idea of looking to reduce the funding expenditures on the debt part of the IDS, that is what I am asking about.

Michael Weaver

Let me give you another way to, perhaps, look at that. When we, probably three years ago, our payout ratio, when we measured it, was in the mid-90’s. By managing our business appropriately and by making acquisitions and having a lot of hard work, we have gotten that payout ratio, as Curtis mentioned, down into the 80% range, 81%. We are pretty comfortable where we are. We think we have made good progress on managing the business and the payout ratio is something that we pay a lot of attention to. When it is in that range, I am not sure I see a great deal of advantage to do anything with those bonds. The interest on those bonds is deductible for income tax purposes, which is one of the reasons that, through this date, Otelco has not been a cash taxpayer. It is either you pay income taxes or you pay additional interest on your debt. It is another component that we always try to think about when we are thinking about these type of questions.

Neil George – Green Gold Capital

In sum, I would take away from your comments today that we have some level of certainty for the foreseeable future that there are no plans to look at calling those securities related to the IDS’s?

Michael Weaver

What I am telling you is we are very comfortable with our position today.

Neil George – Green Gold Capital

I guess that is the best I am going to get. I appreciate it Mike and thank you Curtis.

Operator

At this time, we have no further questions in the queue.

Michael Weaver

Great. I just want to say thanks to everybody for participating in our call. Great questions. We will do this again in three months. Thanks and I hope you guys have a good day.

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