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Executives

Kevin Enda – IR

Michael Weaver – President & Chief Executive Officer

Curtis Garner – Chief Financial Officer

Analysts

Tim Horan – Oppenheimer

Ira Socket - Socket & Company

Otelco Inc. (OTT) Q2 2012 Earnings Conference Call August 8, 2012 10:00 AM ET

Operator

Good day everyone and welcome to the Otelco Inc. Second Quarter Conference Call. As a note, today’s conference is being recorded. And now, 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, Cathie, and welcome to this Otelco conference call to review the company's results for the second quarter ended June 30th, 2012, 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 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 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, belief, 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 the company's filings with the SEC.

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

Michael Weaver

Thank you, Kevin. Good morning everyone and welcome to the call. The second quarter press release has both historical results and projections for future years, and I want to make a few comments about both of those. Then, I will ask Curtis to provide a brief summary of our second quarter results. The SEC Form 10-Q will have additional details and will be filed shortly.

What we are trying to accomplish with this change in format is just to allow more time for questions and discussions. From the operational standpoint for the second quarter, we produced adjusted EBITDA of $10.8 million, which included approximately $500,000 of non-recurring expenses. These expenses consisted of severance costs and legal fees, the write-off of deferred costs associated with an expired shelf registration.

Without these costs, our adjusted EBITDA for second quarter would have been closer and more in line with 2012 first quarter results.

If you look forward with the remainder of this year and beyond, the combination of the non-renewal of the Time Warner contract and the recent FCC’s Inter-Carrier Compensation reforms will have a negative impact on our business. The FCC reforms, which affect both our RLEC and CLEC operations, have various implementation dates and there still remains a great deal of uncertainty and confusion surrounding some aspects of the order.

Numerous groups have challenged the FCC order and the appeals process could result in additional changes and modifications to the order that’s in place today. One aspect of the FCC’s order that will materially impact our CLEC operations took effect on July 1st of this year. That portion of the order requires that intrastate access rates be lowered to the applicable federal access rates over the next three years, and then we moved rapidly to a ‘bill and keep’, meaning no inter-carrier compensation payment basis.

In addition to the FCC changes, the Time Warner contract, on April 20th, we announced the anticipated expiration of the contract for wholesale network connections provided by Otelco.

Consistent with their actions in other markets, Time Warner elected to begin to perform the work within their own organization. Official notice of non-renewal by Time Warner Cable was received in June and a transition agreement to provide services through June 2013 is currently being negotiated. Under the terms of the existing agreement, the revenue stream from the contract is unaffected through the end of this year. During the transition period in 2013, the revenue will decline as customers are moved from the Otelco service platform to Time Warner Cable.

Due to the different implementation dates of these changes and the complexities been accurately forecast in the financial impact, we believe that it may be helpful to provide an estimate of adjusted EBITDA for future periods. Based on our financial results through the second quarter and estimating the impact of the FCC reforms on our operations for the second half of this year, our adjusted EBITDA outlook for this year is in the range of $41 million to $43 million. Reflecting the impact of the FCC’s order and the Time Warner Cable transition, our outlook for 2013 adjusted EBITDA is in the range of $34 million to $35 million.

For 2014, we would anticipate adjusted EBITDA in the range of $29 million to $33 million. The projected decline in adjusted EBITDA for future use suggest the need to reduce our total our total debt. We are currently exploring strategic alternatives to restructure our balance sheet and reduce the total debt. To assist us in the process, we have hired Evercore Partners, an investment banking firm. Its areas of expertise include debt and capital market transactions, restructuring of balance sheet obligations and mergers and acquisitions advice.

Our immediate response to the anticipated decline in revenue and cash flow has been to reduce operating costs, carefully control capital expenditures and focus on cash conservation. In the second quarter, we reduced our work force by 13%, reduced the total targeted compensation for senior management by 33% and reduced Board of Directors’ fees by 20%.

When the Time Warner Cable contract transition is completed in 2013, we anticipate another reduction in our staff. When fully implemented, these cost reductions will generate a savings of approximately $4 million annually, including overhead and benefits.

In an effort to conserve cash, we suspended the quarterly dividends in April of this year, which will produce annual cash savings of $9.3 million. In addition, as provided in the terms of indenture, the company may edit selection, defer interest payment on the senior subordinated notes, and the decision has been made to defer the interest payment due on September 30th, 2012. This deferral for the third quarter will result in cash savings of approximately $3.5 million.

We remain committed to growing our business and in addition to working on cost reductions and cash conservations, we have introduced new products in our service area. In Alabama, we recently introduced security services as an addition to our existing platform to residential and business customers.

In addition, we were awarded a five-year contract to provide fiber backbone for the school systems in one of the counties we serve. This contract will take us outside our existing RLEC boundaries and provides an excellent opportunity for growth. In our New England markets, we recently introduced Microsoft-hosted Exchange products in partnership with a third-party provider.

We continue to beef up our sales staff and recently added additional sales professionals to work in our expanded New Hampshire operations. Our operations in Missouri continue to see growth in both the wireless Internet products and providing fiber transport for wireless carriers.

In addition to the new products and services that we have added, we have also implemented

modest price increases where allowed by regulatory agencies, existing contractual obligations and market conditions.

Curtis, if you would, please summarize the financial results, and then, we can take questions.

Curtis Garner

Thank you, Mike. Thanks to everyone on the call for joining us today. I will provide an abbreviated overview of our financial highlights, and then, we will open it up for questions. We expect to file our SEC Form 10-Q later today, which will expand on the details of second quarter and year-to-date performance, as well as the impairment charges taken in second quarter.

As a reminder, we acquired Shoreham last October and it is included in the 2012 results. The acquisition is living up to our expectations. In fact, Shoreham has access line equivalents growth for 2012, as does our West Virginia property, and Missouri is only negative by approximately 30 access line equivalents.

Total revenue decreased 3.1% to $24.7 million from $25.4 million for the same period in 2011, as a result of the declines from the traditional loss of RLEC voice access line related revenues and one-time settlements in the CLEC. These were partially offset, of course by the addition of Shoreham. Details of our five revenue categories are contained in the press release, with cable, Internet, and transport services, all three being flat or having growth when compared to the same period last year.

Operating expenses excluding goodwill and long-lived asset impairment increased 10.9% to $20.2 million from $18.2 million. Cost of services and products increased 1% to $10.6 million from $10.8 million. Shoreham added $0.4 million, which was offset by reduced RLEC expenses and long distance cost and overhead expenses.

Selling, general and administrative expenses increased 24.5% to $3.6 million from $2.9 million. Shoreham added $0.1 million. Severance cost in June, restructuring and related legal and advisory cost and expenses and the write-off of the shelf registration that Mike mentioned, the deferred charges we had associated with that accounted for $0.6 million.

Depreciation and amortization increased 30.5% to $5.9 million from $0.5 million in the second quarter of 2011. Shoreham accounted for an increase of $0.2 million, but the primary change was in the amortization of intangible assets that were associated with the Country Road acquisition, which increased $1.2 million. This reflects in particular the shorter life expected or remaining life expected on the Time Warner Cable contract.

Mike has mentioned that the non-renewal of the Time Warner Cable contract and the projected impact of the FCC’s Inter-Carrier Compensation order will materially reduce revenue, net income and cash generation in the next several years. Coupled with the resulting change in the marketplace of our stock on the NASDAQ global market after the April announcement, which included the suspension of dividends on our Class A shares, we consider that the company had experienced a triggering event, requiring a review of goodwill and other long-lived assets on the company’s balance sheet for potential impairment. This is the task that we normally do annually during fourth quarter.

Using the services of the big four expert in valuation services, the company performed the required analysis to determine that there was impairment of goodwill and other long-lived assets. Property plant and equipment assets now have a fair value of $59.6 million net of accumulated depreciation, representing an impairment reduction of $2.9 million. Other long-lived intangible assets now have a fair value of $10.3 million, representing an impairment reduction of $5.7 million. In addition, goodwill now has a fair value of $45.0 million, representing an impairment reduction of $144 million.

The financial tables and statements in this earnings release reflect the impact of these non-cash changes. There were no comparable expenses in the second quarter of 2011. While the sheer size of these valuations make net income and income taxes look significantly outside of our normal range, they have no impact on cash or cash taxes with the company.

Mike covered several items that impacted adjusted EBITDA in the second quarter. As a reminder, our first quarter adjusted EBITDA does include our annual CoBank dividend of $0.3 million. Our cash balance, adjusted to reflect the payment of the second quarter interest on our IDS debt, which occurred on July 2nd – June 30th was a non-banking day, which was where it would normally have been paid – increased by $3.5 million to $19.5 million.

CapEx continued at a moderate pace of $1.2 million during the quarter and $2.5 million on a year-to-date basis. That covers the highlights for the quarter. Cathie, if you will provide direction, we can take some questions at this time.

Question-And-Answer Session

Operator

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

Tim Horan – Oppenheimer

Good morning guys. Thanks. Mike, the guidance was kind of way below what we have been expecting, and I think we understood the Time Warner contract, but the access impact I guess in U.S., that’s impacted a little bit higher than we had expected or you had expected. Could you talk about maybe how that should play out, because most of your peers that we are hearing from, I think is going to be relatively mutual, but you are going to have expenses, kind of decline in relation to some of the revenue declines and that there will maybe other offsets on USF. I know a lot is up in the air right now, so just trying to get a sense of how conservative the guidance is at this point and maybe what has changed in your outlook in the excess charge side? Thanks.

Michael Weaver

Thank you, Tim. I will be happy to talk about that. Couple of things before we start. The risk, and as other people know, there is quite a bit of (inaudible) about the FCC reforming, the orders have been out there. The devil is always in the details. And we continue to see some change in those big deals as it goes forward.

As you pointed out, some of our – our situation is a bit unique, and I think to explain that would be the following. We have a significant number of long distance minutes in our CLEC operations, perhaps larger than some of our peers. And the impact that started in on July 1st of this year, really in the state of mind what the order does – you have to take the state rates, the intra state rates in the state of mind and lower those to the federal over a three-year period of time. And the first cut was quite significant.

So, that’s an impact that we will see in the last half of this year. As I mentioned earlier, we started July 1st. So that’s a pretty significant impact for us. If you are trying to make the comparison with some of our peers, that situation is different. You are also right in one of your other comments that over time, I think the expenses will go down and perhaps turn into an advantage. Particularly, as reseller told as we are.

The advantageous part of this change because we have been so aggressive in obtaining great processing for our long distance that we resale, we will not see the effects of that until probably for two additional years. We have a really good competitive rate on the resale. The other thing that we have particularly hovered here, while we are not very dependent on High Cost Loop, we got hit pretty hard on one of our Alabama RLEC companies, that change will not start until 2013, and the combination of the FCC reforms for the defect to CLEC and the RLEC, particularly the High Cost Loop is what is making that, perhaps higher than you would have thought it would have been.

I wouldn’t hasten to add that this information was prepared on the best information we have at the time we prepared the model and disclose these numbers. I think that it’s a very good estimate, we worked very hard and diligently. We had some hit from third parties to assess the impact the FCC reforms and this maps to our best estimate at this time.

Tim Horan – Oppenheimer

Sure. But I guess that estimate is going to change from 3, 6 months ago, when the order first came out and you kind of first letting it, is that a fair assessment?

Curtis Garner

Here is what changed. Initially, when the order first came out, I don’t know how much detail you want to get into, let me just give you some. The first pass of the order that was published would not have affected the High Cost Loop portion of the Alabama company. When there was clarity on the regression analysis, that’s very controversial, but a big part of the order over that as hailed to be a – the FCC was truly going down that path, the regression analysis is the difference. And we did not, that change was not announced until, I think until May of this year, yes, that would indeed going to stick with that part of the reform measure.

That was pretty significant until that change occurred until we knew exactly that that’s how that was going to be administered. It appeared to us that we are going to be able to avoid any significant High Cost Loop productions. So, that’s one of the changes, one of the facts that (inaudible) the increased negative impact from the reform.

Tim Horan – Oppenheimer

Great. And just can you give us an update on how much you get from high cost support? I know accesses maybe kind of hard to measure, but just an update on how much you think is really a risk of the total?

Michael Weaver

Well, the one company in Alabama, and all of this by the way is reflected in the model. That one company is over $1 million a year, and that comes away. I will ask Curtis to make sure he would keep me honest on this, but I think the High Cost Loop revenue that we have as a percentage of total revenues, somewhere around 4% to 4.5%. Is that generally accurate, Curtis?

Curtis Garner

Yes, I think that’s right. I think that the key, Tim, is as you were saying, if with the exception of Alabama Hopper property, the rest of the RLEC portions are relatively neutral. I mean, there is a 5% decline per year, which is intended to happen, but it’s that one property, it’s $1 million that has the big swing on the RLEC side. And if you are thinking about other RLECs and most of them are probably finding things fairly neutral.

Tim Horan – Oppenheimer

Very good. And on the access side, what percentage of that revenue you think is at risk? Or what percent of revenue is it now and what percentage is kind of going away?

Curtis Garner

I mean, the access piece you can see in the –

Tim Horan – Oppenheimer

Sure. But a lot of that special access right, and maybe it’s hard for you to measure but, what percentage of that is really switched access that will be really declining?

Curtis Garner

I think the impact in New England, in particular, is just over $1 million on an annual basis and it’s actually cumulative for the first two years.

Tim Horan – Oppenheimer

Great. And then I know, Missouri, you had really high interest day rates and a few other states, you had fairly high interest day rates. Are they not impacting you this year, or early next year, is there an offset for that?

Michael Weaver

You have an excellent memory. In addition to mine, the other state where we were impacted was Missouri, and those rates are coming down. We were able in Missouri to raise rates to help offset it somewhat. As a matter of additional color, the local rates prior to, for Missouri were $6, meaning the residential subscribers basic phone service, the charge per month was $6. We were able to increase that, the maximum we could increase was $2 and we did, which that will help offset some of the changes that we will lose on the RLEC due to lowering rates, but it’s not enough. So, that’s another impact. In my statement that I closed with where I mentioned that we had modest price increases, we have done that in all of the territories where that was available to us and truly we have taken advantage of that, which is the right thing to do.

As a matter of fact, the FCC order mandates that if your local charges for basic service are below specified levels, that can actually be a penalty for that. And so, in addition to making good business seems to charge to bump those rates. We had a regulatory reason to do it as well. The model reflects all those increases. As you might suspect, those increases to local rates are not enough to offset the excess revenue charges. And the last point I would make on the FCC reforms is on excess, that’s a relatively high margin product for us. Local rates is probably one of the lowest products that we have to offer as far as margin. So, even if you were able to swap even dollars and we are not, it is nowhere close to, the margin on that significantly different, so it’s kind of a double negative effect. It’s not good grammar, but that’s the appropriate expression for that I think.

Tim Horan – Oppenheimer

For example, like in Missouri, is there any way to get the rates up from like $8 to more like $15, $16 where they probably should be close to $20?

Michael Weaver

What we have done, Tim, is we have also done some bundling in an effort to – we have been doing bundling but we have added something to it. It will take a long time to get those rates up to the competitive $15 to $20 range, which I would – still perhaps a bit low. And Otelco, it’s important for you also to understand that our rates in Missouri, those are the peers rates as well, we are not an abnormally low rate in Missouri, that’s the rates traditionally in that state have been very, very low because the excess rates were so high. So, this order is certainly changing the dynamics of the telephone service and how it’s priced in Missouri.

Tim Horan – Oppenheimer

Great. And sorry, just lastly, maybe it seems like cable companies are really ramping up the competition. Do you think you have to increase your CapEx spending to improve the network to compete more effectively with the cable companies?

Michael Weaver

What we would like to do with the network, the expansion we need to do on our network is really for broadband. We have excellent broadband coverage, and by that I mean, it’s available to large percentage of our customers.

The expenditures we need to make for that network or increase the capacity of that. When cable companies heard Otelco and others like us is that they, because their plan is a lot of time to newers and it’s designed quite differently, they have greater capacity. Meaning, they can get to the 8 Mbps to 10 Mbps that now seem to be more towards what people want.

We certainly will offer generally up to 3 Mbps, but that’s and we were proud of that, that’s no longer enough. So the expenditures that we need to make for that, that’s where we would focus. Just one bit of (inaudible) we have done a really decent job of controlling CapEx in the first half of the year, our expectations remain the same for CapEx that we would – for the year will be around $7 million in total CapEx.

Tim Horan – Oppenheimer

How much do you need to spend really to get up that kind of 10 megabit type of speeds throughout your network?

Michael Weaver

It various, depending on what territory, where we are. Some of the expansion we are doing like the project I mentioned in Alabama where we have a 5-year contract, that will probably deal with fiber of course. So, it’s part of projects that we have for expansion. We are gaining a great benefit and that we will be able to fund that project from the proceeds of the contract and it also gives us great way to upgrade the network and increase the bandwidth.

In Missouri, since we have spent a fair amount of time talking about that, one of the things we are very pleased with us they have been reasonably successful providing fiber back haul to the towers, wireless towers in their territory, and of course, that’s the best way in whole world to expand your territory because you got a revenue source that if you pay for it and it is bringing ample bandwidth that will allow you to really be able to compete and offer the much higher and desired bandwidth that customers are demanding there.

Tim Horan – Oppenheimer

Thank you very much.

Operator

(Operator Instructions) We will go next to Ira Socket [ph] of Socket & Company [ph]

Ira Socket - Socket & Company

Good morning.

Michael Weaver

Good morning.

Ira Socket – Socket & Company

On your last conference call, you focused on your debt with General Electric and that you are in negotiations. Can you give us any more news on that?

Michael Weaver

Thank you Ira for the questions. There is not a lot of news I could share with you on that other than to tell you that we are in frequent negotiations with GE and I think we are making some progress on that. But that’s really the extent of what I am prepared to say on that.

Ira Socket - Socket & Company

Okay. Based on the numbers you have released, can you confirm that you would be looking at something like $40 million at the end of this year? Assuming you deferred your interest again in the final quarter?

Michael Weaver

Let me answer your question this way. The way Curtis explained the cash is very, very accurate. On the financial statements at the end of the second half of the year, at the end of June, over $22 million. On June 2nd we paid $3.5 million. So you take that away. So, essentially at the end of June, we had $20 million.

What we have added by the third quarter deferral, we’ll add the $3.5 million to, I think we have been adding cash excluding that savings of $3.5 million of – at only per quarter basis of $2.5 million to $3.0 million. So, you can do the math. That would mean we have reasonable expectation for the fourth quarter based on prior history and based on the fact that (inaudible) somewhere around $5 million cash, $5 million to $6 million cash increase. I don’t think I am comfortable projecting cash beyond the third quarter at this point in time.

Ira Socket - Socket & Company

Okay. Is paying down the GE debt as part of negotiation under consideration?

Michael Weaver

Let me answer that this way. I think as I said in my remarks, one of the things we are focused on is cash conservation. It’s evidenced by the suspension of the dividend and then the deferral of the interest payment on the sub debt. We think the smart thing for us to be doing right now is to try and save as much as cash as we can. I certainly think that when we look at debt deals that are in the market and the recent debt deals where companies have either obtained or renewed their financing arrangements that the leverage is lower than what our leverage is, which begs the question that, we would like to be in a position to make a meaningful reduction in that debt, if that appears to be in the company’s best interest at that time. Thus the strategy of trying to conserve cash, we hope to occur.

Ira Socket - Socket & Company

Last question, is there a timeframe that you have with Evercore to come up with some of your plan of restructuring or whatever it may be?

Michael Weaver

There is no timetable that’s set in stone because it is a fairly complex negotiation. And the other thing that we’re being very careful to do is to be sure that we explore all alternatives available to us, and we want to be thorough in that approach and we want to be very diligent. Having said that, we are working on that as you would suspect everyday and with maximum effort. So, I know that you would like for me to give you a date sort of, and I would like to be able to do that, I simply don’t know the specific answer to that question. I can assure you that we’re working very, very hard to try to get this done as quickly as we possibly can to reach the optimum solution for all of our shareholders.

Ira Socket - Socket & Company

Okay. Alright, do you expect to do it before year-end, some announcement of some form of the plan or everything you said in the news release, restructuring or sale or partial sale or whatever, from your end?

Michael Weaver

I know you would like for me to give you a date. I just can’t do that, I’m sorry, I can’t. The only assurance I can give you is just that we’re working as we’re doing everything we can to bring it to a successful conclusion as rapidly as we can.

Ira Socket - Socket & Company

Again, let me ask you if you can reaffirm that. You don’t have a crisis date until the expiration of the GE loan in October?

Michael Weaver

The maturity date that is, the maturity date you’re exactly right for the existing GE loan is October 2013.

Ira Socket - Socket & Company

At the end of October?

Michael Weaver

Yes, I believe it’s the, I would have to refer – Curtis has better-owned details with me. I think it’s the 31st.

Ira Socket - Socket & Company

Thank you

Michael Weaver

Sure, thank you Ira.

Operator

(Operator Instructions) And gentlemen, it appears at this time, there are no further questions. I would like to turn the conference back over to you for any additional or closing remarks.

Michael Weaver

Okay, thank you Cathie, and thanks to everyone, appreciate you joining us this morning. Welcome your presence, your questions and we plan to keep you informed regarding developments in our business. Thank you.

Operator

And again, that does conclude today’s conference call. We’d like to thank you for your participation.

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