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Executives

Kevin Enda - IR

Michael Weaver - President and CEO

Curtis Garner - CFO

Analysts

Frank Louthan - Raymond James

Tim Horan - Oppenheimer

Neil George - Green & Gold LLC

Otelco, Inc. (OTT) Q2 2011 Earnings Call August 4, 2011 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 would like to turn the call over to Mr. Kevin Enda.

Kevin Enda

Welcome to this Otelco conference call to review the company's results for the second quarter ended June 30, 2011, 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. The 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 describes such risks and uncertainties, listeners are urged to consider statements labeled with the terms believes, expects, intends, anticipates, 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 Weaver

Thanks, Kevin. Good morning, everyone, and welcome to our call. Before I start to review the second quarter results, I'd like to provide updates on a few topics.

First, the acquisition process for Shoreham Telephone, which we announced earlier this year, continues to move forward in a timely manner. We've completed several meetings with the appropriate regulatory authorities. And at this point, we expect to close the transaction early in the fourth quarter.

As we've discussed on prior calls, Shoreham is family-owned RLEC located in Western Vermont offering telephone, long distance and broadband services throughout the rural county area.

Our plans include expanding the existing broadband coverage, adding bundled services to the current offerings and using the existing network as our anchor into the CLEC business in Vermont.

In many ways, the Shoreham acquisition represents the ideal acquisition target for us. It's an established RLEC with predictable and stable revenue streams that also provides an opportunity for further expansion into the non-regulated aspects of our businesses in New England.

The damage to our plant facilities resulting from the late April tornadoes in our Alabama service area has been completely restored. The total cost of the restoration was approximately $700,000 with the majority of the costs has been reimbursed this week by our insurer. The storm negatively affected our broadband subscribers as a number of the subscribers that sustained serious tornado damage have not yet renewed their service with us.

The other impact the storm had was to delay our plans to place our soft switch in service, which caused us to push back the planned service offerings that were provided by the optic switch, thus deferring our expansion in the hosted PBX market in Alabama until the fourth quarter of this year.

In an effort to promote our hosted PBX service and increase our overall service penetration in Alabama, we introduced a $99 bundled service offering that includes telephone service features, 60 minutes of long distance, cable TV and broadband services. Our results from this offering have been encouraging with the addition of approximately 200 customers since the introduction of the plan.

We'd planned to roll this plan out in April. Three weeks later, the tornado hit. So our momentum was disrupted by the storm, but we have recently reintroduced this offering in our markets and are receiving positive results.

For our New England CLEC operations, the process for the additional colocation sites is 90% complete. At the end of June, we had eight of our nine planned sites online and operating. And the final site which is located in Springfield, Missouri, will be in operation by the end of this month.

Originally, we expect these sites to be available to our sales department in the first quarter. And this unexpected delay has hampered our CLEC sales expansion efforts.

Our newest product in the CLEC services area, hosted PBX has been implemented and continues to show great promise. In the first six months of the year, we've installed over 450 lines of this service and generated approximately $200,000 in recurring billings.

We continue to monitor the ongoing discussions and actions at the FCC regarding regulatory reform and the potential impact on Otelco. Yesterday, the FCC issued the Notice of Proposed Rulemaking, seeking comments on three specific proposals for reform. Those three proposals are the plan submitted by the State Members of the Federal-State Universal Service Joint-Board known as the State Member plan, the plan submitted by the Joint Rural Associations known as the RLEC plan, and a plan filed by six Price Cap Companies known as the ABC or America's Broadband Connectivity plan.

From the NPRM, it appears that FCC is attempting to keep this issue on the fast track as comments are due by August 24, and the reply comment date is only a week later at August 31.

Until there is more clarity on the content and timing of the ultimate proposed plan, it's impossible to gage any potential impact on us. However, it is worth noting that the (inaudible) absolute portion of USA represents only 4% of our revenues. Finally, we put our 26th consecutive IDS distribution in June and we remain committed to continuing our policy of returning cash to shareholders.

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

Curtis Garner

Thank you, Mike. Thanks to everyone for joining us today. As a reminder, before we cover the financial results for the quarter, we had a positive non-recurring expense in the second quarter of 2010, which was related to the settlement of certain issues associated with the FairPoint Communications bankruptcy proceedings.

The impact increased our net income and EBITDA for 2010, which there is no similar event in 2011. That negatively affects our year-over-year comparisons for the quarter. Our team at Maine did a great job on the negotiations last year, but it does make the comparisons a bit more difficult this year.

I'll provide a brief overview of the financial performance for the quarter, and then we can take questions. Starting with revenue, total revenue decreased 3.8% in the second quarter to $25.5 million from $26.5 million a year ago due to one-time settlement in 2010 that I mentioned accounted for the majority of the difference. Declines from our traditional loss of RLEC voice access lines, the revenue related to those were not fully offset by growth in CLEC revenue, particularly in those new markets, as well as growth in the cable television revenues.

Local services revenue decreased 2.8% in the second quarter to $11.9 million from $12.3 million. The growth in CLEC revenue accounted for an increase of $0.1 million. RLEC revenue decreased $0.4 million, reflecting the decline in RLEC voice lines.

Network access revenue decreased 6.1% in the second quarter to $8.1 million from $8.6 million last year. Interstate and intrastate switched access declined $0.1 million. A one-time settlement in 2010 accounted for the balance of the difference.

Cable television revenue increased 1.1% to remain at $0.7 million in both periods. Growth in IPTV subscribers and the shift to high-definition packages in Alabama was offset by the decline in revenue associated with the conversion of our Missouri cable customers to satellite services during first quarter 2011.

Internet revenue decreased 2% to stay basically flat at $3.5 million in both quarters. Growth in broadband data lines offset the loss of dial-up subscribers. Transport revenue decreased 5.4% to $1.3 million from $1.4 million. Market price changes for new and existing customers caused the decline.

Shifting to costs and expenses, operating expenses in the second quarter decreased 6.8% to $18.2 million from $19.5 million. Cost of services and products increased 3.2% to $10.8 million from $10.4 million in the quarter ended June 30, 2010. Higher costs associated with the hosted PBX product support were partially offset by reduced overhead expenses.

Selling, general and administrative expenses decreased 10.1% to $2.9 million from $3.2 million. That's primarily related to a non-recurring reduction in employee and benefit costs and operating taxes plus lower legal expenses, which were partially offset by higher uncollectibles associated with carrier billing and customer credits.

Depreciation and amortization for the second quarter decreased 22.7% to $4.5 million from $5.8 million. Amortization of intangible assets associated with the Country Road acquisition in 2008 decreased $0.3 million, including contract and customer base intangible assets. The remaining decrease of $1 million reflects lower depreciation of plant assets in Otelco's regulated entities as the assets become fully depreciated.

Interest expense was constant at $6.2 million compared to a year ago. The increase in interest expense associated with the additional senior subordinated notes issued in the exchange of our Class B shares in June of 2010 was offset by lower interest costs on our senior long-term notes resulting from voluntary principal prepayments of $6.5 million since second quarter 2010.

Adjusted EBITDA was $11.9 million for the second quarter compared to $12.9 million a year ago and $11.4 million in the first quarter of 2011. And as we discussed at the beginning of this call, the one-time settlement a year ago was a significant factor in the difference from a year ago. I'd also like to remind you that in first quarter of 2011, we got our annual dividend of $0.3 million.

Cash from operating activities was $9.6 million in the first six months of this year compared to $14 million during the same period last year. Cash used in investing activities amounted to $6.3 million compared to $4.1 million a year ago, reflecting continued investment in both our CLEC and RLEC businesses and the tornado damage repair.

Cash flow used in financing activities for the first six months amounted to $4.9 million compared to $5 million during the same period last year, reflecting the dividends on the converted Class B shares.

As of June 30, the company had cash and cash equivalents of $16.4 million compared to $18.2 million at the end of 2010. The company made a $0.4 million voluntary prepayment in May of this year on our senior long-term notes payable, reducing the balance to $162 million. This represents a combined reduction of $11.5 million since October 2008.

The second quarter distribution of $5.6 million in interest and dividends to our shareowners and $0.3 million in interest to our bond holders occurred on June 30. This represents the twenty-sixth consecutive quarterly distribution since going public in 2004. We anticipate that the company's 2011 dividends will continue to be treated as return of capital for tax purposes, as they were in 2008, '09 and '10.

Each quarter, the Board considers the declaration of dividends during its normal scheduled meeting. For this quarter, the Board is meeting on August 11. The scheduled interest and any dividend declared will be paid on September 30 to holders of record as of the close of business on September 15. The interest payment will cover the period from June 30 through September 29.

With that math, if you'll provide directions, we can take questions.

Question-and-Answer Session

Operator

(Operator Instructions) We will go first to Frank Louthan with Raymond James.

Frank Louthan - Raymond James

Just quickly if you could comment on the industry filed a plan for reforming USF (inaudible), your thoughts on that. I know you have some rate of return on properties that might affect you differently. But just any thoughts on how that would possibly affect your operations, positive or negative?

Mike Weaver

As I mentioned earlier, we have been monitoring not just this plan, but all the other plans that are out there. We actually have a model that we use so we can calculate the potential impact on us. And we don't do that exercise. The plan that you're referring is one that's been favorable of course since it's the RLEC plan. And there would be some minor decrease in our revenue that could potentially be offset depending on how some of the funds we'll use to improve and expand existing broadband services.

So I don't want to give you a double-speak for an answer. But at this time, it's almost impossible to accurately assess exactly the impact on us. And the other hesitancy I have to give real specific on that is just that the plan is designed and then firstly, will that be the plan that's chosen; and then secondly, even if it's chosen, how many changes look like in this final plan.

So I guess the only comfort of (deducting) deals on that is that plan is more favorable than some of the others that have been introduced for us. But all three other plans that appear to be the frontrunners in the FCC's mind are it's just impossible to accurately assess the impact.

Operator

(Operator Instructions) We'll move along to Tim Horan with Oppenheimer.

Tim Horan - Oppenheimer

Mike, what do you think the FCC is trying to accomplish here, their ultimate goal? Do you think they can actually get something done here, because we've been back and forth on this for quite a few years?

Mike Weaver

Honestly, Tim, I don't know. And depending on people in the industry that follow this even closer then we do, there is no consensus. It appears clear to me, particularly with the short-term NPRM that was issued yesterday, with comments due in three weeks and then the reply to those comments a week later, there is a big attempt to try to get something accomplished this year.

One of the consensus, opinions is if this doesn't get done by the end of this calendar year, then it will be deferred yet again. So I mentioned to Frank, I'm not trying to avoid the issue. I simply don' know the answer to it. There is not much I know.

Tim Horan - Oppenheimer

In conversations with your consultants who advise you on the FCC, my opinions are trying to get more broadband connectively out there and for the initiative to spend more CapEx on getting more broadband. Just how do you feel about that? And if you have to offer broadband speeds and coverage, what might be the model?

Mike Weaver

We have broadband coverage throughout every market we're in today. It's in the 90% to 96% capability today. Generally, the highest three, we can typically offer in some of our more metropolitan, if that's the right word. The towns and cities that we serve is up to 6-meg to 7-meg, and that's primarily in the Portland, Maine area.

But generally speaking, our customers within the 90% to 96% range can get up with the up to 1-meg to 1.5-meg. It's top speed. The reason we don't already have those facilities out there today is because there is not that much demand for it.

The other thing with Otelco is that we're constantly upgrading our network in an effort to be able to offer more speeds. We see the market like everyone else, that the demand for broadband, more speed is consistent and constant and will continue. So we're trying to do that anyway.

More specifically to your question, it would be great to have some federal funds to help us offset some of the costs for that. Those plans are in place to continue to expand that broadband. So any financial help we receive from that would be a benefit for us. And it's my opinion too that in the rural industry, it's pretty consistent. There is a good bit of broadband capability. There is a lot of broadband capability in the markets today that you see us in. And I think that generally operators are using their existing funds and included in their plans to explain that, because there is a market demand for that sort of the work.

So short-term answer is it'd be great to have some additional funds to pay for the continued expansion of broadband.

Tim Horan - Oppenheimer

Most of your households have 10-megabit speeds. How much do you think it would cost you to do something like that for a household or maybe over the entire market?

Mike Weaver

There is so much diversity in our markets that I don't know the answer to that question. Let me give you an example. We've been talking about our IPTV project in one of our Northernmost territory in Alabama. That network could largely do that. We have that capability to do that, because the money has already been spent.

And Missouri in our RLEC plan where there is like four homes per mile, where there is just a big geographic area, not that many customers, it will cost quite a bit of money to be offer 10-meg to those customers. In those same areas in Missouri, we have the ability to have up to 1-meg to 1.5-meg. The demand is not there for that service.

So if federally we were mandated to do that service, using your example of 10-meg, there would have to be federal funds to offset that cost. Today, it's hard to think that demand would reach 10-meg in those particular areas in the foreseeable future.

Tim Horan - Oppenheimer

It's not just you guys, but it seems like in the whole RLEC sector volumes remain under pressure here. Are you seeing increased cable competition or is the wireless coverage getting better? What do you think that the economy is still impacting customers? What do you think is going on?

Mike Weaver

In some of our markets, cable competition is getting better and better. Again, this is market-by-market. In Missouri, the wireless coverage is excellent. It's probably only RLEC we have that has high quality of wireless service. So that's what we try to have there.

In our New England markets, the cable competition is very, very good. They are continuing to expand services in that area. So that's gotten better completely with this. In Alabama, it's the economy. It's certainly the economy in all of our major markets within Alabama (inaudible) come back as quickly as the economy (inaudible). It's a combination of all three, and it's between the markets. So that's what we see. It's just a longer, slower climb back for us than we anticipated.

Operator

(Operator Instructions) We will move along to (inaudible).

Unidentified Analyst

Can you walk through the puts and takes in SG&A this quarter? What was the one-time employee benefit impact?

Curtis Garner

There was a change in some of the bonus processes between the two years. That's the primary difference.

Unidentified Analyst

What was the financial impact?

Curtis Garner

We didn't disclose the absolute amount.

Unidentified Analyst

And then in terms of the increased approval for uncollectible, any color on that?

Curtis Garner

In particular, there is one company that provides traffic to us in Missouri as well as the other parts of the country. The Missouri number of the RLECs out there, all of them were not being paid and they jointly cut off service to that provider. They had not paid us for bills prior to being cut off. And those bills age out to uncollectibles during a 90-day period. So that's the primary jump in that. There was one other carrier that hasn't paid, and we took a reserve against that.

Operator

This will be from Neil George with Green & Gold LLC.

Neil George - Green & Gold LLC

You mentioned earlier about some of the lack of renewals from your broadband customers in Alabama post the storm damage. I wonder if you can comment a bit about what some of the (inaudible) for that is and if you're going to expect some of those customers would return.

Michael Weaver

I think we were down about 200 customers out of that market after the storm. And in a lot of the cases, those folks, because their homes were destroyed, they're just not there anymore. So it's really that simple. In the damaging areas of our plant was that extensive. Those customers I am referring to were almost entirely in the one RLEC in Northernmost Alabama, Brindlee Mountains.

Neil George - Green & Gold LLC

Very specific to that, the geographic damage that we all saw as far as total devastation. But beyond that core area, you haven't really seen any major run-off in your broadband customer base. Think of the business side outside of your damaged area.

Curtis Garner

The other decline we've seen has been more economy-related than anything else.

Neil George - Green & Gold LLC

And then we talked lot looking on the broadband initiatives and as well some of the television and entertainment area. What' going on as far as some of the potential wireless developments, especially wireless capabilities in some of your other areas beside some of the current areas that are being served?

Michael Weaver

In all of our RLEC markets, the wireless is completely built there. It's primarily along the interstates now. Are they going to 4G and improving their networks? Yes, they are. We see those processes have already been started. In some instances, we believe there is a short-term opportunity for us to build at those sites that are located within our RLEC footprint. We believe we'll have the opportunity to build (inaudible).

So it's certainly a short-term benefit for Otelco as those opportunities materialize. We certainly are paying the fees of the activity within our RLEC footprints. In some cases in Alabama, and in Missouri too for that matter, we've provided power to some of the existing towers again within the RLEC territory.

Our special access lines and our circuits that we're providing along with power, we've seen some increase in those parts of our business. And that's related to the deal for the wireless power

Neil George - Green & Gold LLC

I have ongoing concerns about the longer-term capital plan of the company. As far as IDF security in 2019, I'm always interested in some of the long-term comments or plans as far as the potential rollover of that issue and sort of longer-term perspective beyond 2019 for the IDF. As well as some of the additional capital permits for further expansion and investments.

Earlier, Curtis had mentioned about some of the debt paydown that's been occurring. I wonder if you could kind of talk in broader terms as far as some of your long-term outlook as far as the capital formation for the company.

Michael Weaver

We have no concern about the maturity of the IDSs in 2019. But I am confident that there are alternative ways to finance that if that becomes an an appropriate path for us. I just have no concerns about our ability to care of that at the appropriate time. I am not prepared to comment on it. We've said that's probably looking in the future.

Senior debt, which is $163 million, as Curtis mentioned, we continue to chip away at that as our excess cash has a maturity date of 2013. We're very comfortable with the process that's in place to take care of renewal for that. We will start that in a timely manner and certainly will not wait until it's time to stop that process. That's really all the further outlook we're prepared to give on that.

Operator

It appears we have no further questions in queue. At this time, I'll turn things back over to Mr. Garner and Mr. Weaver for any additional or closing remarks.

Michael Weaver

As always, thanks for joining us this morning. Your comments and questions are usually focused and to the point, and I appreciate that. And I would ask and hope that you can join us again in three months for our next call. Thank you.

Operator

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

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