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Executives

Kevin Enda – Investor Relations

Michael D. Weaver – Chairman, President and Chief Executive Officer

Curtis L. Garner, Jr. – Chief Financial Officer

Analysts

Timothy Horan – Oppenheimer & Co

David Coleman – RBC Capital Markets

Otelco, Inc. (OTT) Q4 2010 Earnings Call February 17, 2010 11:00 AM ET

Operator

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

Kevin Enda

Thank you Felicia and welcome to this Otelco conference call to review the company’s results for the fourth quarter and year ended December 31, 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 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 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’ll turn the call over to Mike Weaver.

Michael D. Weaver

Thanks Kevin. Good morning everyone. Thanks for joining our call. We were pleased with our financial results for the fourth quarter and the year as we experienced an increase in EBITDA for both periods. Increases in total annual revenue and improving EBITDA margins resulted in annual adjusted EBITDA in excess of $50 million for the first time in our corporate history.

For the year, our CLEC operations increased revenue by $3 million, which offset the decline of our RLEC revenue of $2.4 million, which yielded a net increase in revenue of $600,000. The revenue increase in our CLEC markets was due to our expansion into new markets in Northern Maine and New Hampshire as well as the increase in network connections from our relationship with Time Warner.

As a reminder in 2010, we opened new co-location sites in five new areas of Maine and New Hampshire, which expanded our existing market capabilities. We also completed the integration process within our CLEC operations. That coupled with the renewed corporate focus on controlling operating cost were the primary factors in increasing our EBITDA margin by approximately 1.5%.

The RLEC revenue decline is directly related to the decline in subscribers as we experienced a 2.9% decline in our RLEC excess line equivalents for the year. We continue to work to try to find ways to slow this decline including the establishment of customer win back program.

We’ve expanded our network to enable us to offer faster broadband speeds and we’d renewed our marketing efforts in this sector. In our RLEC markets in Alabama and Missouri, we still have a little competition, but then New England RLEC markets are in a big competitive state.

Our plans for 2011 include the continued expansion of our CLEC operations in New Hampshire and more collocation sites in Maine. In addition, we will enter the CLEC market in Western Massachusetts as we are currently in the process of establishing our first collocation sites in the state. As you may recall we've already have an RLEC doing business in adjacent area of Massachusetts and this is the logical expansion of our footprint.

In addition to the expansion of our network capabilities, the reorganization of our sales and marketing departments is now complete. As part of this process, we've more than doubled our inside sales staff as well as provided in-depth training for all of our sales professionals. This investment in resources dedicated to our sales efforts is indicative of our commitment to provide our customers with quality products and services.

With continue expansion of our cable products in Alabama and our plans for 2011 including building fiber-to-the-home in some of our more fluent communities. This project is being driven by our belief that customers will continue to demand higher broadband space and recognition of the changing economics of plant construction and expansion.

In Missouri, we will continue to increase our market coverage for broadband utilizing unlicensed spectrum to bring higher broadband speeds to our markets. In addition, our plans include a VoIP offering that we hope to have in place by the second half of the year. We continue to search for accretive acquisitions that will expand our existing markets and revenue base.

The idea of target risk would have a mix of regulated and non regulated services be in a market that is capable of growth over the next few years. We believe the manage services data storage in the CLEC business models would be a great fit for us and would offer us some additional revenue diversification.

Our cash position remains strong as we finished the year with $18 million on our balance sheet. This represents an increase of 500,000 over the previous year and included a voluntary payment on our senior debt of $6.1 million and an increase in CapEx of $600,000.

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

I’ll now ask Curtis to talk about financial results.

Curtis L. Garner, Jr.

Thank you Mike and thanks to everyone on the call for joining us today. I'll provide a brief overview of our financial performance for the quarter and the year and then we can take questions.

Total revenues decreased 0.4% in the fourth quarter to $26.0 million from $26.1 million a year ago. In general, CLEC revenues gains for local services and network access were offset by lower RLEC revenues. Total revenue for the year increased 0.6% to $104.4 million from $103.8 million in 2009.

Looking at the individual revenue categories, local services revenue decreased slightly holding at $12.1 million in both quarters ended December 31, 2010 and 2009. Expansion of CLEC revenues produced a $0.3 million increase which was offset by $0.3 million in lower RLEC Basic Service revenues.

For the year, local services revenue increased 1.2% to $49 million from $48.4 million in 2009 with the growth of CLEC revenue outpacing the decline in RLEC Basic Services. Network access revenue decreased 1.2% in the fourth quarter to $8.3 million from $8.4 million a year ago. Access Revenue related to RLEC subscriber usage and lower NECA settlements accounted for decrease of $0.3 million including our 2010 current cost study estimates.

CLEC statement special access revenues increased $0.2 million as the company continued its expansion in the New Hampshire market and in Northern Maine. For the year, Network Access revenue decreased 1% to $33 million from $33.3 million, again the CLEC grow offsetting most of the RLEC decline.

Cable television revenue increased 9.3% to just over $0.7 million in the fourth quarter compared to just under $0.7 million in the same period of 2009. Growth in Digital family packages and IPTV subscribers of $0.1 million was partially offset by $0.1 million decrease in basic cable. Cable television revenue for 2010 increased 12.4% to $2.8 million from $2.5 million in 2009. A portion of this increase was driven by the introduction of video-on-demand as well as increases in basic package pricing.

Internet revenue for the fourth quarter 2010, decrease slightly but remained at $3.5 million in both quarters ended December 31, 2010 and 2009. Growth in Broadband data accesses lines was offset by a loss of dial-up subscribers. For the year, Internet revenue was also flat at $14 million compared to 2009.

Transport services revenue increased 2% in the fourth quarter compared to the same period of 2009 holding at $1.4 million. For the year, transport services revenue was up 1.6% at $5.6 million compared to $5.5 million in 2009.

Moving onto expenses, overall operating expenses in the fourth quarter decreased 6.5% to $19.2 million from $20.5 million in the three months ended December 31, 2009. Each category of expense saw a decline for the quarter. For the year, operating expenses decreased 4.6% to $78 million from $81.8 million in 2009.

Breaking them down, the costs of services and products decreased 0.2%, but basically stayed at $9.9 million in both periods. Reductions in RLEC costs and adjustment related to the settlement of the FairPoint bankruptcy were offset by higher costs associated with increasing CLEC revenues.

For 2010, cost of services increased 0.3% to $41.3 million from $41.2 million for basically the same reasons. Just to note, all the FairPoint bankruptcy related claims have been satisfied and are reflected in our 2010 financial statements.

Selling, general and administrative expenses decreased to 18% to $3.3 million in the fourth quarter from $4 million a year-ago. Settlements with several carriers in 2010 decreased on collectable revenues or reserves by $0.5 million coupled with the decrease of $0.2 million in legal fees and insurance costs for net change of $0.7 million. For the full-year 2010, SG&A decreased 7.7% to $13.1 million from $14.2 million in 2009.

Depreciation and amortization for the fourth quarter decreased 8.9% to $6 million from $6.6 million a year-ago. Amortization of intangible assets associated with Country Road acquisition decreased $0.4 million including the covenant not to compete in contract and customer based intangible assets. The remaining decrease of $0.2 million reflected lowered depreciation and planned assets in Alabama partially offset by an increase in depreciation in Missouri.

For the full year 2010, depreciation and amortization decreased 10.6% to $23.7 million from $26.5 million in 2009, again primarily driven by the lower levels of intangible amortization.

Interest expense increased 6% to $6.3 million in the fourth quarter from $5.9 million in the year ago. The increase in interest expense included $0.1 million in interest on the additional senior subordinated notes issued in the Class B conversion that occurred in June 2010. But the remaining change of $0.3 million is due to changes in interest rate associated with the second interest-rate swap becoming effective in 2010.

As a requirement of the existing senior debt, the company has two interest swap agreements intended to hedge changes and interest rates on our senior debt. The swap agreements do not qualify for hedge accounting and the technical requirements of Accounting Standards Codification 815. Changes in value of the two swaps are reflected in the change in fair value of derivatives on the income statement, but there is no impact on cash.

The value of the swap liability increased in 2010 as interest rates remained at historic lows but the increase in liability was less than experienced in 2009 generating a positive change on that line when compared quarter-over-quarter and year-over-year. As a reminder over the life of the swaps, the change in value will be zero and there is no impact on cash adjusted EBITDA or operations.

Adjusted EBITDA as Mike mentioned was $12.8 million for the fourth quarter compared to $12.2 million a year ago and $4.7 million in the third quarter of 2010. For the full year 2010 adjusted EBITDA increased 3.9% to $50.7 million from $48.8 million in 2009.

Couple of items, looking at cash flow and the balance sheet, cash flow from operating activities was $26.4 million for the year compared to $27.9 million a year-ago. Cash used in investing activities amounted to $10.2 million when compared to $9.8 million a year-ago reflecting higher investments in both the CLEC and RLEC businesses.

Cash flows for financing activities for the year amounted to $15.7 million compared to $13.9 million a year-ago. Two items there reflects the dividends for the converted Class B shares for the second half of 2010 and the larger voluntary prepayments on our senior debt that we made in 2010.

On the balance sheet, we ended the year with $18.2 million in cash compared to $17.7 million at the end of 2009. Total long-term notes payable was reduced to $271.6 million reflecting the voluntary prepayment of $6.1 million that we made in November of 2010.

The fourth quarter distribution of $5.6 million of interest in dividends to our shareholders that reflects the Class B conversion also and $0.3 million in interest to our bondholders occurred on December 30, 2010. As Mike mentioned, this represents 24 consecutive quarterly distributions since going public in December of 2004. We anticipate that the company's 2011 dividends will continue to be treated as a return of capital for tax purposes as they were in 2008, ‘09 and ‘10.

Each quarter, the Board will consider the declaration of dividends during its normal scheduled meetings. For this quarter, the Board is meeting next Wednesday, February 23rd to scheduled interest and dividend declared and any dividend that’s declared at that meeting will be paid on March 30 to holders of record as of the close of business on March 15. Our Annual Shareholder Meeting will be held in Atlanta on May the 12th.

Felicia, if you will provide directions, we can take questions at this time.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll go first to Tim Horan of Oppenheimer.

Timothy Horan – Oppenheimer & Co

Good morning guys. Thanks for the detail. Mike, may be any thoughts on your ability to grow EBITDA the next couple of years from here? You've done a phenomenal job on the expense front but I guess volume is just a touch lighter this quarter. And maybe what you're seeing to in that regard on the CLEC competition and who that's currently to coming from? Thanks

Michael D. Weaver

Thanks Tim for joining us and your question. Yeah, it’s gotten tougher and you are right about, we had a little bit harder quarter as far as access line loss on, but the RLEC and the CLEC. On the CLEC side let me speak to that, first if you would. On the CLEC side, it took a little longer than our anticipate for us to get the salespeople hard to as we expand our footprint, the thing that’s different is we need more freedom on the street, and want people to tell that we can make sure that we continue to look to deliver quality services and products to our customers. So when we double our sales step that really took a bit more time than I anticipated.

The other thing that we did is we really wanted to provide even more training than we had in the past. So that we could ensure that our new salespeople really understood the products and the software and how to get orders through our system. So that we hit this ground running with those folks able to be very competitive and really with the great deal of knowledge of our system and products. So the cause of that, we’d lost some days of sales effort, and I think really hurt us in the fourth quarter production there.

The other space is just competitive. It’s competitive in the Northeast as I mentioned in Alabama, and Missouri we have little to no competition in our RLEC areas. It’s certainly very competitive in the New England.

We struggled with that, we’ve got the appropriate programs in place and we are trying to establish the markets that are marketing, rather, for RLECs. But it was a tough quarter from that standpoint. Because of that, and because we continued our expansion in the markets and New Hampshire and Maine and now into Massachusetts on the CLEC side, we do expect to have some top line growth and bottom line growth to for us. I’d think the EBITDA growth on a combined basis would be in the 2% range. So and we would like for that to be higher but I think that’s a pretty reasonable growth rate given the competitiveness of the markets that we are in.

Timothy Horan – Oppenheimer & Co

That's great. The growth this quarter in EBITDA was actually quite strong. I guess that was a surprise despite everything else going on and that's a good outlook.

Michael D. Weaver

Yeah, I think it’s reasonable. So, did that give you the data you are looking for?

Timothy Horan – Oppenheimer & Co

Yeah, yeah. No, that's correct. But it sounds like things have gone a little better here in the first quarter is kind of what you are saying.

Michael D. Weaver

I hope so. That was the plan. Like I said, we really didn't take our eye off the ball. I'm not suggesting that on a sale effort but we always absolutely last time getting people hired and trying on our CLEC certainly that's behind this name. So we’re expecting better metrics I think for the first quarter. That's a fair statement.

Timothy Horan – Oppenheimer & Company

Great, and have your consultants gotten back to you yet on the notice of proposed rulemaking to revamp the access charges and USF? Do you have any thoughts on that yet, Mike? I know it's kind of recent.

Michael D. Weaver

Well we obviously, like everybody else in the industry we’re really concerned about that. And let me, it's hard to know what they're going to do. I don't think anybody does, so as opposed giving you my speculation on what the FCC ultimately does, let me kind of talk just a second about what I see our exposure is.

Today at the end of 2010 about 30%, actually about 31% of our revenue comes from network access which is in my mind that's the ICC that I keep referring to. It's interesting though about 31% only 10% of that comes from the interstate side. The balance of that is of course what we received from wireless carriers, recip comp, and intrastate as well as USF. So it depends on how we are affected depends on exactly the final answer and how much of that is interstate and how much of it is USF, on the High Cost Loop side Otelco's worked really hard and are currently at the end of last year only 4.5% of our revenue came from High Cost Loop.

We have 10 RLEC's as you are aware but only six of those received anything from High Cost Loop. The other four simply don't quantify mathematically, meaning that our cost, average loop cost doesn't exceed the national average by more than 15%. So we have relatively limited exposure on the USF.

I think the proposals that I've seen would indicate that there would be some fewer certified ETCs, CETCs which could work to our benefit. The fact that is again as I understand the proposals that are out there it would be a combination of existing USF and the access reform or the ICC's into one Connect America fund that would concentrate on broadband.

It's difficult, Tim, to know how that might impact us. I do like the fact that only 10% of our revenues are coming from the interstate side of the access revenues and then only 4.5% are really coming from USF. So I think we worked hard to try to limit our USF exposure. And at this point, John (inaudible) paying attention to what's going on and trying to participate in the discussions that’s how I know, that’s the only way I know to try to protect our position.

Timothy Horan – Oppenheimer & Company

No, that's very helpful. Like you said, there are going to be offsets to this.

Michael D. Weaver

I think so. It just depends on the details of it. I'm interested, the timing of this is important too and I don't know, I have seen could something happen by year-end, who knows? There are certainly more, it’s the front runner at the end, but we have been before. So I don’t have a guesses to the timing.

Timothy Horan – Oppenheimer & Company

Thanks a lot, Mike.

Michael D. Weaver

Sure.

Operator

(Operator Instructions) We will go next to David Coleman of RBC Capital Markets.

David Coleman – RBC Capital Markets

Thank you, just on the question on the EBITDA margins. It looked like most of that, the improvement over I guess about 100 basis point sequential improvement came from the lower cost of services during the quarter. Were there any sort of one-time true ups that benefited the lower cost of service or is this sort of a good run rate to go forward with?

Michael D. Weaver

Dave, let me ask Curtis to, at least closer to the details of that. Let me ask Curtis to weigh in on that please.

Curtis L. Garner, Jr.

Dave, yeah, there are some one-time benefits in the cost of services primarily from the fair point settlement as part of the agreement there were some expenses that we would have been had to pay that were clarified in the settlement process. So there is some one-time benefit in the cost of goods for the quarter.

David Coleman – RBC Capital Markets

Can you quantify how much that was?

Curtis L. Garner, Jr.

We've been a little careful about that, because we don't really want to explain exactly what the fair point piece was, because we're kind of keeping that, we don't think that's appropriate public information, but it was at least to $0.5 million.

David Coleman – RBC Capital Markets

Got you. The cable trends still seem a little sluggish. I'm assuming that there's some IPTV growth in there with possibly offset by the loss of some more of the traditional cable subs. So I'm just wondering if you could talk about the cable trends and what initiatives you have in place to increase the market share for cable subscribers. And then just last question, you mentioned a fiber-to-the-home initiative. What kind of CapEx are we looking at on top of the roughly $10 million or so that you've spent this year to support the fiber to the home? Thank you.

Michael D. Weaver

That and excellent question Dave, thank you. We are disappointed in our cable TV, and you’re right, what's happening is we are seeing some growth and certainly not we would like it, but we're still adding every month IPTV subscribers in the new products that we roll out. But we’re losing from our traditional coax plan system, we continue to have cable loss there, we’re [leasing] to primarily to CLEC providers on the traditional which is somewhat, it is disappointing to us, but we're not idle on that, we've done that couple of things.

We’re rolling out a new pricing. Actually we hope to have it out by March 1 if not March 15. for our triple play with, there is some service contracts, we’re pretty we have not really been a proponent of asking our customers to sign a multi-year service contract with us in order to get better pricing, but we're going to try there and we're going to have some introductory specials for Cable TV pricing. We saw and think it will be best part of the new marketing and what we're going to hit the street with shortly.

As Curtis mentioned as we were going through some of the other information, we offer video on demand, true video on demand for the first time in the late third quarter or early fourth quarter of last year. We've had pretty good respond to that so that our total cable package is now competitive with providers we believe are certainly in the price the new pricing that we'll have will solve any pricing differentials that we had on that. So we're hopeful, we’re very hopeful that will be, help us accelerate the rate of that growth and slow down some of the loss from the traditional coax.

Actually we're pretty excited, the second part of your question, we’re pretty excited about the fiber-to-the-home and we do in our largest RLEC in Alabama. It’s located in an area reasonably close to, actually fairly close to Huntsville, Alabama, and we’ve done that in our more fluent communities where demand for broadband speed continues to go up

It’s actually are within that CapEx for that, it’s going to be around $600,000 to $700,000, but it’s already, it’s not additional CapEx, it will be just part of our CapEx budget for next year, which will be slightly higher than the amount that we spent in 2010.

So it’s something we’re planning to do. The other thing that’s interesting in that is as the cost of the fiber and construction. It’s much smaller incrementally additional cost to do fiber-to-the-home than any other type service. So while it is still a slightly more expensive, it doesn't make sense to build copper to homes anymore in our opinion, so.

David Coleman – RBC Capital Markets

Okay. And just you mentioned fair point earlier, any update as to the provisioning backlog, where do that currently stands?

Michael D. Weaver

Fair point continues to get better and better on their operational functions. We have learned to work with them and frankly they are performance has improved. So I don’t want to have a quantity, it’s reached the point where we no longer look at that to see try to determine exactly the backlog of that because their performance has gotten better.

David Coleman – RBC Capital Markets

That’s great. Thank you.

Operator

(Operator Instructions) And gentlemen at this time, there are no further questions in the queue.

Michael D. Weaver

Great, well just as closing, thanks to everyone for joining us on the call and we will do this again in three months. Thank you.

Operator

That concludes today’s conference. Thank you for your participation.

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