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TMCNet:  OTELCO INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

[November 07, 2012]

OTELCO INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) Overview General We operate eleven rural local exchange carriers ("RLECs") serving subscribers in north central Alabama, central Maine, western Massachusetts, central Missouri, western Vermont and southern West Virginia. We are the sole wireline telephone services provider for many of the rural communities we serve. We also operate a competitive local exchange carrier ("CLEC") serving subscribers throughout the states of Maine and New Hampshire. Our services include local and long distance telephone services, network access, other telephone related services, cable and satellite television (in some markets) and internet access.



We view, manage and evaluate the results of operations from the various telecommunications services as one company and therefore have identified one reporting segment as it relates to providing segment information.

As of September 30, 2012, we operated approximately 100,195 access line equivalents and supplied an additional 162,700 wholesale network connections, primarily to Time Warner Cable ("TW"). On April 20, 2012, we announced that TW had indicated that it will not renew its existing contract for wholesale network connections provided by us. Formal notification of non-renewal was received in June 2012. Accordingly, this contract will expire on December 31, 2012. We are currently negotiating an expected six month transition period into 2013 during which TW's customers will be moved to TW's facilities. Revenue received directly from TW represented approximately 11.7% and 12.3% of our consolidated revenue for the nine months ended September 30, 2011 and 2012, respectively.

Additionally, other unrelated telecommunications providers pay us access revenue for terminating calls through us to TW's customers representing another 3% to 4% of our revenue.

The Federal Communications Commission (the "FCC") issued its Universal Service Fund and Intercarrier Compensation ("ICC") order in November 2011. This order makes substantial changes in the way telecommunications carriers are compensated for serving high cost areas and for completing traffic with other carriers. We began seeing the significant impact of the FCC's ICC order to our business in July 2012. The expected initial consequences to our business will be to reduce access revenue from intrastate calling in Maine and other states where intrastate rates are higher than interstate rates. A portion of this revenue loss is returned to us through the Connect America Fund for our RLEC properties.

There is no recovery mechanism for the lost revenue in our CLEC. The impact of this order in conjunction with the non-renewal of the TW contract is expected to reduce our revenue and net income in the coming years.

On April 20, 2012, we announced the suspension of dividends on our common stock. On August 7, 2012, the Company announced that its board of directors had exercised its contractual right under the indenture governing the Company's senior subordinated notes to defer interest on the senior subordinated notes for the third quarter 2012. On November 6, 2012, the Company announced that its board of directors had exercised its contractual right under the indenture governing the Company's senior subordinated notes to defer interest on the senior subordinated notes for the fourth quarter 2012. Under the indenture, the Company's board of directors is permitted to defer interest on up to four occasions with respect to up to two quarters per occasion before resuming interest payments, including interest on the deferred interest. Before deferring interest for an additional period beyond fourth quarter 2012, the Company would be required to pay the deferred interest of $7.0 million plus interest on the deferred interest. The Company has engaged Evercore Partners, an investment banking firm, to assist us in exploring our strategic alternatives to address our existing levels of debt and to strengthen our balance sheet. Evercore Partners' areas of expertise include debt and capital market transactions, restructuring of balance sheet obligations and mergers and acquisitions advice.

On October 5, 2012, the Company retained restructuring counsel to aid in this process. Together with its advisors, the Company will evaluate its alternatives.

Our acquisition of all of the issued and outstanding capital stock of Shoreham Telephone Company, Inc. ("STC"), a privately-held integrated telecommunications services provider serving customers in western Vermont, on October 14, 2011, added approximately 5,100 access line equivalents on that date.

Our core businesses are local and long distance telecommunications services, wholesale access to the local and long distance network and network access to other wireline, long distance and wireless carriers for calls originated or terminated on our network. Our core businesses generated approximately 75.7% of our total revenues in the third quarter of 2012. The impacts associated with the implementation of the FCC's ICC order will be reflected in core business revenue. We also provide cable and satellite television service in some markets and digital high-speed data lines and residual dial-up internet access in all of our markets.

The following discussion and analysis should be read in conjunction with our financial statements and the related notes included in Item 1 of Part I and the other financial information appearing elsewhere in this report. The following discussion and analysis addresses our financial condition and results of operations on a consolidated basis.

17 -------------------------------------------------------------------------------- Revenue Sources We offer a wide range of telecommunications and entertainment services to our subscribers. More than half of our residential customers receive packages of services that are delivered and billed together. Our CLEC subscribers contract with us for selected services that meet their specific telecommunications requirements. Our revenues are derived from five sources: Local services. We receive revenues from providing local exchange telecommunications services in our eleven rural territories, from the wholesale network services in New England and on a competitive basis throughout Maine and New Hampshire. These revenues include monthly subscription charges for basic service, calling beyond the local territory on a fixed price and on a per minute basis, local private line services and enhanced calling features, such as voicemail, caller identification, call waiting and call forwarding. We also provide billing and collections services for other carriers under contract and receive revenues from directory advertising. A growing portion of our rural subscribers take bundled service plans which include multiple services, including unlimited domestic calling, for a flat monthly fee.

Network access. We receive revenues from charges established to compensate us for the origination, transport and termination of calls of long distance and other interexchange carriers. These include subscriber line charges imposed on end users and switched and special access charges paid by carriers. Switched access charges for long distance services within Alabama, Maine, Massachusetts, Missouri, New Hampshire, Vermont and West Virginia are generally based on rates approved by the Alabama Public Service Commission, the Maine Public Utilities Commission (the "MPUC"), the Massachusetts Department of Telecommunications and Cable, the Missouri Public Service Commission, the New Hampshire Public Utilities Commission (the "NHPUC"), the Vermont Public Service Board and the West Virginia Public Service Commission, respectively, where appropriate. Switched and special access charges for interstate and international services are based on rates approved by the FCC. The FCC's ICC order has and will significantly change the way telecommunication carriers receive compensation for exchanging traffic. Over the next three years, all intrastate rates that exceed the interstate rate will be reduced to the interstate rate. Beginning in 2014, the interstate rate will be reduced over three years to "bill and keep" in which carriers bill their customers for services and keep those charges but neither pay for nor receive compensation from traffic sent to or received from other carriers. In addition, subsidies to carriers serving high cost areas will be phased out over an extended period. These changes began to reduce access revenue beginning in July 2012.

Cable television. We offer basic, digital, high-definition, digital video recording and pay per view cable television services to the majority of our telephone service territory in Alabama, including Internet Protocol television ("IPTV") and Video on Demand ("VOD"). We are a reseller of satellite services for DirecTV and Dish in Missouri.

Internet. We receive revenues from monthly recurring charges for digital high-speed data lines, dial-up internet access and ancillary services such as web hosting and computer virus protection.

Transport. We receive monthly recurring revenues for the rental of fiber to transport data and other telecommunications services in New England.

Voice and Data Access Line Trends The number of access lines served is a fundamental factor in determining revenue stability for a telecommunications provider. Reflecting the historical trend in the RLEC industry, the number of rural voice access lines we serve has been decreasing when normalized for territory acquisitions. We expect that this trend will continue, and may continue to be impacted by the effect of the economy on our customers as well as the availability of alternative telecommunications products, such as cellular and Internet Protocol-based services. These trends will be partially offset by the growth of data access lines, also called digital high-speed internet access service. Our competitive carrier voice and data access lines have grown as we continue to further penetrate our chosen markets. Our ability to continue this growth and our response to the rural trends will have an important impact on our future revenues. Our primary strategy consists of leveraging our strong incumbent market position, selling additional services to our rural customer base such as alarm services and providing better service and support levels than the incumbent carrier to our competitive customer base.

18 -------------------------------------------------------------------------------- Key Operating Statistics(2) (Unaudited) Quarterly % Change December 31, March 31, June 30, September 30, from 2010 2011 2012 2012 2012 June 30, 2012 Otelco access line equivalents(1) 99,639 102,378 101,885 101,184 100,195 (1.0 ) % RLEC and other services: Voice access lines 45,461 46,202 45,200 44,546 43,816 (1.6 ) % Data access lines 20,852 22,904 23,105 23,156 22,977 (0.8 ) % Access line equivalents(1) 66,313 69,106 68,305 67,702 66,793 (1.3 ) % Cable television customers 4,227 4,201 4,216 4,163 4,181 0.4 %Satellite television customers 125 226 229 231 232 0.4 % Additional internet customers 6,975 5,414 5,159 4,896 4,690 (4.2 ) % RLEC dial-up 393 301 273 248 211 (14.9 ) % Other dial-up 4,300 2,797 2,501 2,266 2,083 (8.1 ) % Other data lines 2,282 2,316 2,385 2,382 2,396 0.6 % CLEC: Voice access lines 29,944 30,189 30,476 30,355 30,341 (0.0 ) % Data access lines 3,382 3,082 3,104 3,127 3,061 (2.1 ) % Access line equivalents(1) 33,326 33,271 33,580 33,482 33,402 (0.2 ) % Wholesale network connections(3) 149,043 157,144 159,560 161,766 162,700 0.6 Years Ended Three Months Ended December 31, March 31, June 30, September 30, 2010 2011 2012 2012 2012Total revenues (in millions): $ 104.4 $ 101.8 $ 25.4 $ 24.7 $ 24.4 RLEC $ 58.4 $ 57.4 $ 14.2 $ 14.1 $ 13.6 CLEC $ 46.0 $ 44.4 $ 11.2 $ 10.6 $ 10.8 (1) We define access line equivalents as voice access lines and data access lines (including cable modems, digital subscriber lines and dedicated data access trunks).

(2) We acquired STC on October 14, 2011. At December 31, 2011, STC's successor, Shoreham Telephone LLC, had 3,309 voice access lines and 1,672 data access lines, or 4,981 access line equivalents, and 55 dial-up internet customers which are included in the Key Operating Statistics.

(3) TW is the source for approximately 98% of wholesale network connections.

In our RLEC territories, access line equivalents decreased by 909 during third quarter 2012, or 1.3%, compared to June 30, 2012. Voice access lines declined 1.6% and data access lines declined by 0.8% during the period. The continued impacts of the economy, wireless substitution and cable competition in Maine and Massachusetts accounted for the decline. We offer location specific bundled service packages, many including unlimited domestic calling, tailored to the telecommunications requirements of our customers and priced competitively.

In our Maine and New Hampshire CLEC operations, access line equivalents decreased by 80 during third quarter 2012, or 0.2%, compared to June 30, 2012.

Voice access lines were basically flat and data access lines decreased 2.1% during the period. Our hosted private branch exchange ("PBX") product continues to grow with positive market acceptance, adding approximately 535 seats at 63 locations during third quarter 2012. Virtually all of our competitive customers are businesses, with service bundles tailored to their specific business requirements.

Competitive pricing and bundling of services have led Otelco's long distance service to be the choice of the majority of the customers in the rural markets we serve. In addition, almost all of our Maine and New Hampshire CLEC customers have selected us as their long distance carrier. Our cable television customers increased 0.4% from June 30, 2012 to 4,181 as of September 30, 2012. The continued expansion of IPTV was partially offset by a decrease in basic cable customers. Our other internet customers decreased 4.2% to 4,690 as of September 30, 2012 compared to June 30, 2012. This also includes the subscribers we service outside of our RLEC telephone service area throughout Missouri and Maine, reflecting the shift to digital high-speed internet services. In Missouri, we are continuing the expansion of our data access lines for digital high-speed internet in selected areas outside of our telephone service territory. Approximately 51% of the other internet customers are served by high-speed data capability from Otelco.

19 --------------------------------------------------------------------------------Our Rate and Pricing Structure Our CLEC pricing is based on market requirements. We combine varying services to meet individual customer requirements, including technical support, and provide multi-year contracts which are both market sensitive for the customer and profitable for us. The MPUC and the NHPUC impose certain requirements on all CLECs operating in their markets for reporting and for interactions with the various incumbent local exchange and interexchange carriers. These requirements provide wide latitude in pricing services.

Our RLECs operate in six states and are regulated in varying degrees by the respective state regulatory authorities. The impact on pricing flexibility varies by state. In Maine, two of our wholly owned subsidiaries, Saco River Telephone LLC and Pine Tree Telephone LLC, have obtained authority to implement pricing flexibility while remaining under rate-of-return regulation. Our rates for other services we provide, including cable, long distance, data lines and dial-up and high-speed internet access, are not price regulated. The market for competitive services, such as wireless, also impacts our ability to adjust prices. With the increase of bundled services offerings, including unlimited long distance, pricing for individual services takes on reduced importance to revenue stability. We expect this trend to continue into the immediate future.

Categories of Operating Expenses Our operating expenses are categorized as cost of services; selling, general and administrative expenses; and depreciation and amortization.

Cost of services. This includes expenses for salaries, wages and benefits relating to plant operation, maintenance, sales and customer service; other plant operations, maintenance and administrative costs; network access costs; and costs of services for long distance, cable television, internet and directory services.

Selling, general and administrative expenses. This includes expenses for salaries, wages and benefits and contract service payments relating to engineering, financial, human resources and corporate operations; information management expenses, including billing; allowance for uncollectible revenue; expenses for travel, lodging and meals; internal and external communications costs; insurance premiums; stock exchange and banking fees; and postage.

Depreciation and amortization. This includes depreciation of our telecommunications, cable and internet networks and equipment, and amortization of intangible assets. Certain of these amortization expenses continue to be deductible for tax purposes.

Impairment. During second quarter 2012, we evaluated goodwill and other long-lived assets for impairment. On April 20, 2012, we announced that TW had indicated that it will not renew its wholesale network contract when it expires at the end of 2012. Formal notification of non-renewal was received in June 2012. We currently expect that the transition of services to TW will take no more than six months from the expiration date of the contract. In addition, the implementation of industry changes required by the FCC's ICC order began reducing our CLEC revenue in July 2012 and will reduce our RLEC revenue beginning in 2013. Also, during second quarter 2012, the market price of our Income Deposit Securities ("IDSs") on the NASDAQ Global Market dropped materially and has remained below historical levels. The impact of these changes was considered a triggering event for the Company to review all of its long-lived assets, including goodwill, to determine if any of the assets were impaired. The results of that review are reflected in three separate operating expenses categories included in our consolidated statements of operations in Item 1 of Part I: Long-lived assets impairment - PP&E; Long-lived assets impairment - intangibles; and Goodwill impairment. During third quarter 2012, we finalized the calculation of the deferred income tax liability associated with the acquisition of STC. We determined the deferred income tax liability to be $1,889,202, rather than $2,233,458 as previously reported. The reduced liability would have reduced goodwill by $344,256, except for the fact that the goodwill impairment testing conducted during second quarter 2012 had determined that all of the goodwill in our New England reporting unit was impaired, including the goodwill associated with the STC acquisition. See Liquidity and Capital Resources below for additional information.

Our Ability to Control Operating Expenses We strive to control expenses in order to maintain our strong operating margins.

As our revenue shifts to non-regulated services and CLEC customers, operating margins decrease reflecting the lower margins associated with these services.

The non-renewal of the TW contract is expected to lower margins in 2013. We reduced employee costs at the end of second quarter 2012 and expect to further reduce these costs once the TW conversion is completed during 2013.

20 --------------------------------------------------------------------------------Results of Operations The following table sets forth our results of operations as a percentage of total revenues for the periods indicated: Three Months Ended Nine Months Ended September 30, September 30, 2011 2012 2011 2012 Revenues Local services 46.3 % 45.0 % 46.8 % 45.7 % Network access 31.8 30.7 31.5 30.6 Cable television 3.0 3.2 2.9 3.2 Internet 13.6 15.1 13.6 14.9 Transport services 5.3 6.0 5.2 5.6 Total revenues 100.0 % 100.0 % 100.0 % 100.0 % Operating expenses Cost of services 43.4 % 42.4 % 43.0 % 43.0 % Selling, general and administrative expenses 12.8 13.6 12.5 13.6 Depreciation and amortization 19.5 18.9 19.9 20.2 Long-lived assets impairment - PP&E - - - 3.9 Long-lived assets impairment - intangibles - - - 7.7 Goodwill impairment - (1.4 ) - 192.8 Total operating expenses 75.8 73.5 75.4 281.1 Income (loss) from operations 24.2 26.5 24.6 (181.1 ) Other income (expense) Interest expense (24.6 ) (23.2 ) (24.4 ) (23.0 ) Change in fair value of derivatives 2.6 - 2.2 0.3 Other income 0.0 0.0 0.5 0.4 Total other expenses (22.0 ) (23.2 ) (21.7 ) (22.3 ) Income (loss) before income taxes 2.2 3.3 2.9 (203.4 ) Income tax benefit (expense) 1.3 (2.0 ) (0.0 ) 33.1 Net income (loss) available to common stockholders 3.5 % 1.3 % 2.9 % (170.3 ) % Three Months and Nine Months Ended September 30, 2012 Compared to Three Months and Nine Months Ended September 30, 2011 Total revenues. Total revenues decreased 3.5% in the three months ended September 30, 2012 to $24.4 million from $25.3 million in the three months ended September 30, 2011. Total revenues decreased 2.2% in the nine months ended September 30, 2012 to $74.5 million from $76.2 million in the nine months ended September 30, 2011. The tables below provide the components of our revenues for the three months and nine months ended September 30, 2012 compared to the same periods of 2011.

21--------------------------------------------------------------------------------For the three months ended September 30, 2012 and 2011 Three Months Ended September 30, Change 2011 2012 Amount Percent (dollars in thousands) Local services $ 11,715 $ 11,003 $ (712 ) (6.1 ) % Network access 8,048 7,500 (548 ) (6.8 ) Cable television 770 788 18 2.3 Internet 3,442 3,682 240 7.0 Transport services 1,328 1,455 127 9.6 Total $ 25,303 $ 24,428 $ (875 ) (3.5 ) Local services. Local services revenue decreased 6.1% in the three months ended September 30, 2012 to $11.0 million from $11.7 million in the three months ended September 30, 2011. The acquisition of STC added $0.2 million and hosted PBX and wholesale network connection revenue increased $0.2 million. The FCC's ICC order reduced or eliminated intrastate and local cellular revenue categorized as local services revenue. A portion of the RLEC decrease is recovered through the Connect America Fund, which is categorized as interstate access in network access revenue. The impact in third quarter 2012 was a decrease of $0.9 million in local services revenue. The decline in RLEC voice access lines accounted for a decrease $0.2 million.

Network access. Network access revenue decreased 6.8% in the three months ended September 30, 2012 to $7.5 million from $8.0 million in the three months ended September 30, 2011. The acquisition of STC added $0.3 million and special access added $0.2 million. Interstate and intrastate toll decreases primarily associated with the FCC's ICC order were partially offset by the new Connect America Fund revenue, but still represented a decline of $1.0 million. The reduction mandated by the FCC's ICC order in intrastate toll rates had a significant negative impact on CLEC revenue in Maine for which there is no recovery mechanism.

Cable television. Cable television revenue in the three months ended September 30, 2012 increased 2.3% to remain at $0.8 million in the three months ended September 30, 2012 and 2011. Growth in IPTV subscribers, VOD and the shift to high-definition packages in Alabama was offset by the decline in basic cable subscribers.

Internet. Internet revenue for the three months ended September 30, 2012 increased 7.0% to $3.7 million from $3.4 million in the three months ended September 30, 2011. The growth was attributable to the STC acquisition. Growth in other RLEC data lines was offset the loss of dial-up subscribers outside of our service territory.

Transport services. Transport services revenue increased 9.6% to $1.5 million in the three months ended September 30, 2012 from $1.3 million in the three months ended September 30, 2011 from growth in both wide area network and wholesale transport services.

For the nine months ended September 30, 2012 and 2011 Nine Months Ended September 30, Change 2011 2012 Amount Percent (dollars in thousands) Local services $ 35,659 $ 34,074 $ (1,585 ) (4.4 ) % Network access 23,987 22,813 (1,174 ) (4.9 ) Cable television 2,229 2,387 158 7.1 Internet 10,356 11,095 739 7.1 Transport services 3,965 4,147 182 4.6 Total $ 76,196 $ 74,516 $ (1,680 ) (2.2 ) 22-------------------------------------------------------------------------------- Local services. Local services revenue decreased 4.5% to $34.1 million in the nine months ended September 30, 2012 from $35.7 million in the nine months ended September 30, 2011. The acquisition of STC accounted for an increase of $0.6 million, growth in our hosted PBX product accounted for an increase of $0.4 million and growth in wholesale network connections accounted for an increase of $0.4 million. These gains were more than offset by reduced subscribers to our traditional local services, including long distance revenue, accounting for a reduction of $1.4 million in our CLEC and $1.5 million in our RLEC service territories. A portion of the RLEC decrease is recovered through the Connect America Fund, which is categorized as interstate access in network access revenue.

Network access. Network access revenue decreased 4.9% to $22.8 million in the nine months ended September 30, 2012 from $24.0 million in the nine months ended September 30, 2011. The acquisition of STC added $1.1 million. Interstate and intrastate toll decreases primarily associated with the FCC's ICC order were partially offset by the new Connect America Fund revenue, but still represented a decline of $2.3 million primarily in state access revenue.

Cable television. Cable television revenue increased 7.1% to $2.4 million in the nine months ended September 30, 2012 from $2.2 million in the nine months ended September 30, 2011. Growth in IPTV subscribers, the shift to high-definition packages and growth in pay-per-view increased revenue $0.3 million, which was partially offset by a $0.1 million decline associated with the conversion of our Missouri cable customers to satellite services during first quarter 2011 and fewer basic cable customers.

Internet. Internet revenue increased 7.1% to $11.1 million in the nine months ended September 30, 2012 from $10.4 million in the nine months ended September 30, 2011. The acquisition of STC accounted for growth of $0.8 million and increased fiber leases accounted for an increase of $0.1 million. The decline of dial-up internet customers associated with the conversion to digital data access lines, including those customers in Maine and Missouri that are outside of our local service areas, accounted for a decrease of $0.2 million.

Transport services. Transport services revenue increased 4.6% to $4.1 million in the nine months ended September 30, 2012 from $4.0 million in the nine months ended September 30, 2011 from growth in wide area network revenue.

Operating expenses. Operating expenses in the three months ended September 30, 2012 decreased 6.5% to $17.9 million from $19.2 million in the three months ended September 30, 2011. Operating expenses in the nine months ended September 30, 2012 increased to $191.5 million from $38.2 million in the nine months ended September 30, 2011. The tables below provide the components of our operating expenses for the three months and nine months ended September 30, 2012 compared to the same periods of 2011.

For the three months ended September 30, 2012 and 2011 Three Months Ended September 30, Change 2011 2012 Amount Percent (dollars in thousands) Cost of services $ 10,986 $ 10,361 $ (625 ) (5.7 ) % Selling, general and administrative expenses 3,249 3,310 61 1.9 Depreciation and amortization 4,944 4,614 (330 ) (6.7 ) Goodwill impairment - (344 ) (344 ) NM Total $ 19,179 $ 17,941 $ (1,238 ) (6.5 ) Cost of services. Cost of services decreased 5.7% to $10.4 million for the three months ended September 30, 2012 from $11.0 million in the three months ended September 30, 2011. Costs related to the acquisition of STC added $0.3 million.

These increases were offset by lower toll and access costs of $0.5 million and lower operating costs, including the reduction in employees implemented at the end of second quarter 2012.

Selling, general and administrative expenses. Selling, general and administrative expenses increased 1.9% to $3.3 million in the three months ended September 30, 2012 from $3.2 million in the three months ended September 30, 2011. Expenses associated with the acquisition of STC added $0.1 million and restructuring and legal costs added $0.6 million. These increases were mostly offset by lower operating costs, including the reduction in employees implemented at the end of second quarter 2012.

Depreciation and amortization. Depreciation and amortization for the three months ended September 30, 2012 decreased 6.7% to $4.6 million from $4.9 million in the three months ended September 30, 2011. The acquisition of STC accounted for an increase of $0.2 million. Amortization of intangible assets associated with the acquisition of three entities from Country Road Communications LLC increased $0.2 million, reflecting the shorter remaining life of the TW contract. The depreciation of RLEC assets decreased by $0.7 million.

23 -------------------------------------------------------------------------------- Impairment. There was a goodwill impairment decrease of $0.3 million in the three months ended September 30, 2012 compared to no impairment in the three months ended September 30, 2011. During third quarter 2012, we finalized the calculation of deferred income tax liability associated with the STC acquisition, reducing the amount of goodwill associated with the acquisition. In second quarter 2012, the review of goodwill and long-lived assets had already shown all of the New England reporting units' goodwill to be impaired resulting in the decrease in goodwill impairment. See Liquidity and Capital Resources below for additional information.

For the nine months ended September 30, 2012 and 2011 Nine Months Ended September 30, Change 2011 2012 Amount Percent (dollars in thousands) Cost of services $ 32,762 $ 32,038 $ (724 ) (2.2 ) % Selling, general and administrative expenses 9,486 10,140 654 6.9 Depreciation and amortization 15,176 15,019 (157 ) (1.0 ) Long-lived assets impairment - PP&E - 2,874 2,874 NM Long-lived assets impairment - intangibles - 5,748 5,748 NM Goodwill impairment - 143,654 143,654 NM Total $ 57,424 $ 209,473 $ 152,049 NM Cost of services. Cost of services decreased 2.2% to $32.0 million in the nine months ended September 30, 2012 from $32.8 million in the nine months ended September 30, 2011. Costs related to the acquisition of STC added $1.2 million and our hosted PBX product costs increased $0.1 million, reflecting continued success with the product this year. These increases were more than offset by lower toll and access costs of $0.7 million, lower sales and customer service costs of $0.2 million, Universal Service Fund and federally mandated program costs of $0.3 million and lower operating costs of $0.9 million, including the reduction in employees implemented at the end of second quarter 2012.

Selling, general and administrative expenses. Selling, general and administrative expenses increased 6.9% to $10.1 million in the nine months ended September 30, 2012 from $9.5 million in the nine months ended September 30, 2011. Expenses related to the acquisition of STC added $0.3 million, restructuring expenses added $0.9 million and consultant expense associated with the goodwill impairment study and the FCC's ICC order interpretation added $0.2 million. These increases were partially offset by reduction in property and operating taxes of $0.2 million and lower operating costs of $0.4 million, including the reduction in employees implemented at the end of second quarter 2012.

Depreciation and amortization. Depreciation and amortization decreased 1.0% to $15.0 million in the nine months ended September 30, 2012 from $15.2 million in the nine months ended September 30, 2011. The acquisition of STC accounted for an increase of $0.6 million, the shortened life associated with the TW contract increased amortization by $1.7 million and internet and CLEC depreciation increased $0.3 million. These increases were more than offset by $0.5 million associated with a telephone plant adjustment that was fully amortized in 2011, lower RLEC depreciation of $1.5 million and lower amortization of intangibles of $0.8 million.

Impairment. During the nine months ended September 30, 2012, impairment charges were recorded totaling $152.3 million to reflect impairment of long-lived assets, including goodwill. There were no similar charges in the same period of 2011. These charges recognize an impairment of property, plant and equipment of $2.9 million, an impairment of intangible assets of $5.7 million and an impairment of goodwill of $143.7 million. Based on a decline in the projected revenue of the Company due to the non-renewal of the TW wholesale network contract and the impacts of the FCC's ICC order, the fair value of the related assets was below the book value. See Liquidity and Capital Resources below for additional information.

For the three months ended September 30, 2012 and 2011 Three Months Ended September 30, Change 2011 2012 Amount Percent (dollars in thousands) Interest expense $ (6,222 ) $ (5,674 ) $ (548 ) (8.8 ) % Change in fair value of derivatives 655 - (655 ) NM Other income 6 1 (5 ) NM Income tax benefit (expense) 323 (498 ) (821 ) NM Interest expense. Interest expense decreased 8.8% to $5.7 million in the three months ended September 30, 2012 from $6.2 million in the three months ended September 30, 2011. The decrease in interest expense was primarily driven by the lower effective interest rate on the outstanding balance of our senior long-term notes payable upon expiration of our interest rate swaps on February 8, 2012.

Interest expense includes interest on our senior subordinated notes. The payment of this interest was deferred for third quarter 2012 by our board of directors.

24 -------------------------------------------------------------------------------- Change in fair value of derivatives. As was required by our senior credit facility, we had two interest rate swap agreements intended to hedge our exposure to changes in interest rate costs associated with that facility. The swap agreements did not qualify for hedge accounting under the technical requirements of Accounting Standards Codification ("ASC") 815, Derivatives and Hedging ("ASC 815"). Changes in value for the two swaps are reflected in change in fair value of derivatives on the statements of operations and have no impact on cash. The swaps expired on February 8, 2012, effectively lowering our interest rate beginning February 9, 2012 from approximately 2.0% to the current LIBOR rate, plus, in either case, a bank margin, which was 4.00% in third quarter 2011 and 4.25% in third quarter 2012.

Other income. Other income, primarily interest income and gain on the sale of equipment, was less than $0.1 million in the three months ended September 30, 2011 and 2012.

Income tax benefit (expense). Provision for income taxes was an expense of $0.5 million in the three months ended September 30, 2012, compared to a benefit of $0.3 million in the three months ended September 30, 2011. The impact of changes in goodwill impairment and the change in fair value of derivatives on the effective tax rate caused the differences.

For the nine months ended September 30, 2012 and 2011 Nine Months Ended September 30, Change 2011 2012 Amount Percent (dollars in thousands) Interest expense $ (18,592 ) $ (17,162 ) $ (1,430 ) (7.7 ) % Change in fair value of derivatives 1,641 241 (1,400 ) NM Other income 389 312 (77 ) (19.8 ) Income tax benefit (expense) (36 ) 24,690 24,726 NM Interest expense. Interest expense decreased 7.7% to $17.2 million in the nine months ended September 30, 2012 from $18.6 million in the nine months ended September 30, 2011. The decrease in interest expense was primarily driven by the lower effective interest rate on the outstanding balance of our senior long-term notes payable upon expiration of our interest rate swaps on February 8, 2012.

Interest expense includes interest on our senior subordinated notes. The payment of this interest was deferred for third quarter 2012 by our board of directors.

Before deferring interest for an additional period beyond fourth quarter 2012, the Company would be required to pay the deferred interest of $3.5 million for each of the two deferred quarters plus interest on the deferred interest.

Change in fair value of derivatives. As was required by our senior credit facility, we had two interest rate swap agreements intended to hedge our exposure to changes in interest rate costs associated with that facility. The swap agreements did not qualify for hedge accounting under the technical requirements of ASC 815. Changes in value for the two swaps are reflected in change in fair value of derivatives on the statements of operations and have no impact on cash. The swaps expired on February 8, 2012, effectively lowering our interest rate beginning February 9, 2012 from approximately 2.0% to the current LIBOR rate, plus, in either case, a bank margin, which was 4.00% in the first nine months of 2011 and 4.25% for the majority of the first nine months of 2012.

Other income. Other income decreased 19.8% to $0.3 million in the nine months ended September 30, 2012 from $0.4 million in the nine months ended September 30, 2011, reflecting the annual CoBank dividends of $0.3 million that we receive in the first quarter of each year. The difference was associated with lower interest income in 2012 and a loss on the sale of equipment in 2012, as opposed to a gain on the sale of equipment in 2011.

Income tax expense. Provision for income taxes was a benefit of $24.7 million in the nine months ended September 30, 2012, reflecting the impact of the long-lived asset and goodwill impairment, compared to an expense of less than $0.1 million in the nine months ended September 30, 2011.

Net income. As a result of the foregoing, there was net income of $0.3 million in the three months ended September 30, 2012 and $0.9 million in the three months ended September 30, 2011. There was a net loss of $127.9 million in the nine months ended September 30, 2012 and net income of $2.2 million in the nine months ended September 30, 2011, which was primarily attributable to the impact of long-lived asset and goodwill impairment recognized in second quarter 2012.

25 --------------------------------------------------------------------------------Liquidity and Capital Resources Our liquidity needs arise primarily from: (i) interest payments related to our senior credit facility and our senior subordinated notes; (ii) capital expenditures; and (iii) working capital requirements. We suspended dividends on our common stock on April 20, 2012 in order to free up cash for other purposes.

On August 7, 2012, we announced that our board of directors had exercised its right under the indenture governing our senior subordinated notes to defer interest on the senior subordinated notes for the third quarter 2012. In addition, on November 6, 2012, we announced that our board of directors had exercised its right under the indenture governing our senior subordinated notes to defer interest on the senior subordinated notes for the fourth quarter 2012.

The deferred interest expense is $3.5 million for each of the third and fourth quarters. Before deferring interest for an additional period beyond fourth quarter 2012, the Company would be required to pay the deferred interest of $7.0 million plus interest on the deferred interest.

Historically, we satisfy our operating cash requirements from the cash generated by our business and utilize borrowings under our senior credit facility to facilitate acquisitions; however, we financed our acquisition of STC using cash on hand. For the nine months ended September 30, 2012, we generated cash from our business to invest in additional property and equipment and pay interest on our senior debt. After meeting all of these needs of our business, cash increased from $12.4 million at December 31, 2011 to $27.2 million at September 30, 2012. The most recent interest payment on our senior subordinated debt of $3.5 million was made on July 2, 2012, as the normal distribution date of June 30, 2012 fell on a non-banking day. The third quarter payment on our senior subordinated debt was deferred by our board of directors.

Cash flows from operating activities for the first nine months of 2012 amounted to $21.1 million compared to $15.4 million for the first nine months of 2011.

Net income, when adjusted for its non-cash components, declined by $0.5 million.

The changes in operating assets and liabilities of $6.3 million reflects the deferral of $3.5 million of interest on our senior subordinated debt in third quarter 2012, a reduction of one month's accrued liability for interest on our senior debt associated with electing one month LIBOR contracts in 2012 versus three month LIBOR contracts in 2011, the recognition of prepaid expenses associated with our shelf offering that is now unlikely to occur and an additional month's receivable on the TW contract in 2011.

Cash flows used in investing activities for the first nine months of 2012 were $3.4 million compared to $8.4 million in the first nine months of 2011, reflecting a lower rate of capital expenditures for property and equipment in the first nine months of 2012.

Cash flows used in financing activities for the first nine months of 2012 were $2.9 million compared to $7.4 million in the first nine months of 2011, reflecting payments of dividends to stockholders in three quarters of 2011 and one quarter of 2012. The dividends paid were at the rate of $0.17625 per common share per quarter. We suspended dividends on our common stock on April 20, 2012.

There was a repayment of $0.4 million on our long-term senior debt in 2011. In 2012, we have paid $0.6 million in pursuing an amendment to our senior credit facility.

We do not invest in financial instruments as part of our business strategy. The Company had two interest rate swaps that expired on February 8, 2012. From an accounting perspective, the documentation for the swaps did not meet the technical requirements of ASC 815 to allow the swaps to be considered highly effective as hedging instruments and therefore the swaps did not qualify for hedge accounting.

We also have received patronage shares, primarily from one of our lenders, over a period of years for which there is a limited market to determine value until the shares are redeemed by the issuing institution. Historically, these shares have been redeemed at a value similar to their issued value. Due to the uncertainty of this future value, these shares are carried at $1.5 million, or approximately 55% of their issued value.

ASC 350, Intangibles - Goodwill and Other ("ASC 350"), requires that goodwill be tested for impairment annually, unless potential interim indicators exist that could result in impairment. During the second quarter of 2012, an interim goodwill impairment test was performed in response to indicators revealed in the annual forecasting process. Due to the expected expiration of the TW wholesale network contract, and recent FCC reform, forecasted operating profits were reduced below the levels projected during the fourth quarter of 2011 and first quarter of 2012. Including an adjustment in third quarter 2012 for STC deferred taxes that reduced goodwill associated with the acquisition, long-lived assets have been reduced in 2012 by $8.6 million and goodwill has been reduced by $143.7 million.

The impairment charges reflect our expectation that future cash flows will decline from current levels as a consequence of the FCC's ICC order and the non-renewal of the TW contract, in addition to the attrition of voice access lines inherent in our business. The impairment of goodwill and other long-lived assets has no cash impact.

26-------------------------------------------------------------------------------- We anticipate that operating cash flow will be adequate to meet our currently anticipated operating and capital expenditure requirements for at least the next 12 months. The announced non-renewal of the TW contract will reduce future cash flows of the business beginning in 2013 and the impacts of the FCC's ICC order began reducing cash flows of the business in third quarter 2012. The Company has taken steps to conserve cash, including the suspension of dividends on our common stock beginning second quarter 2012, the exercise of our contractual right to defer interest on our senior subordinated debt for third and fourth quarter 2012, reductions in employees in second quarter 2012, with additional reductions planned for 2013 upon completion of the TW customer transfers, reductions in senior management and board of directors compensation and reduced capital spending. Because of the negative impact of the FCC's ICC order and the expiration of the TW contract, we are exploring our strategic alternatives to address our existing levels of debt and strengthen our balance sheet. The Company has engaged Evercore Partners, an investment banking firm, to assist us in this process. Evercore Partners' areas of expertise include debt and capital market transactions, restructuring of balance sheet obligations and mergers and acquisitions advice. In addition, on October 5, 2012, the Company retained restructuring counsel to aid in this process. Together with its advisors, the Company will evaluate its alternatives.

The following table provides a summary of the extent to which cash generated from operations is reinvested in our operations, used to pay interest on our senior debt and senior subordinated notes or distributed as dividends to our stockholders for the periods indicated.

Nine Months Ended September 30, 2011 2012 (dollars in thousands) Cash generation Revenues $ 76,196 $ 74,516 Other income 389 312 Cash received from operations $ 76,585 $ 74,828 Cost of services $ 32,762 $ 32,038 Selling, general and administrative expenses 9,486 10,140 Cash consumed by operations $ 42,248 $ 42,178 Cash generated from operations $ 34,337 $ 32,650 Cash utilization Capital investment in operations $ 8,448 $ 3,396 Senior debt interest and fees 7,190 5,772 Interest on senior subordinated notes 10,497 6,998 Dividends 6,991 2,330 Cash utilized by the Company $ 33,126 $ 18,496 Percentage of cash utilized of cash generated 96.5 % 56.6 % We use adjusted earnings before interest, taxes, depreciation and amortization ("Adjusted EBITDA") as an operational performance measurement. Adjusted EBITDA, as presented in this Form 10-Q, corresponds to the definition of Adjusted EBITDA in the indenture governing our senior subordinated notes and our senior credit facility. Adjusted EBITDA, as presented in this Form 10-Q, is a supplemental measure of our performance that is not required by, or presented in accordance with, accounting principles generally accepted in the United States ("U.S.

GAAP"). Our senior credit facility requires that we report performance in this format each quarter and involved lending institutions utilize this measure to determine compliance with credit facility requirements. We report Adjusted EBITDA in our quarterly earnings press release to allow current and potential investors to understand this performance metric and because we believe that it provides current and potential investors with helpful information with respect to our operating performance and cash flows. However, Adjusted EBITDA should not be considered as an alternative to net income or any other performance measures derived in accordance with U.S. GAAP or as an alternative to net cash provided by operating activities as a measure of our liquidity. Our presentation of Adjusted EBITDA may not be comparable to similarly titled measures used by other companies. Adjusted EBITDA for the three months and nine months ended September 30, 2011 and 2012, and its reconciliation to net income (loss), is reflected in the table below: 27-------------------------------------------------------------------------------- Three Months Ended September 30, Nine Months Ended September 30, 2011 2012 2011 2012 (dollars in thousands) Net income (loss) $ 885 $ 316 $ 2,173 $ (126,876 ) Add: Depreciation 2,922 2,467 8,751 7,942 Interest expense - net of premium 5,880 5,332 17,566 16,136 Interest expense - amortize loan cost 342 342 1,026 1,026 Income tax expense (benefit) (323 ) 498 36 (24,690 ) Change in fair value of derivatives (654 ) - (1,641 ) (241 ) Loan fees 19 19 57 57 Amortization - intangibles 2,023 2,147 6,425 7,076 Goodwill impairment - (344 ) - 143,654 Impairment of long-lived assets - - - 8,622 Restructuring expense - 592 - 953 Adjusted EBITDA $ 11,094 $ 11,369 $ 34,393 $ 33,659 Recent Accounting Pronouncements During 2012, the Financial Accounting Standards Board (the "FASB") issued Accounting Standards Update ("ASU") 2012-01 through 2012-07. Except for ASU 2012-02, which is discussed below, these ASUs provide technical corrections to existing guidance and to specialized industries or entities and therefore, have minimal, if any, impact on the Company.

In July 2012, the FASB issued ASU 2012-02, Testing Indefinite-Lived Intangible Assets for Impairment, an amendment to ASC 350 Intangibles - Goodwill and Other.

This ASU provides an option for companies to use a qualitative approach to test indefinite-lived intangible assets for impairment if certain conditions are met.

The amendments are effective for annual and interim indefinite-lived intangible asset impairment tests performed for fiscal years beginning after September 15, 2012. The implementation of this ASU is not expected to have a material impact on our consolidated financial position or results of operations.

Subsequent Events The Company is continuing negotiations with the lenders under its senior credit facility with respect to a potential balance sheet restructuring. On October 5, 2012, the Company retained restructuring counsel to aid in these negotiations.

Together with its advisors, the Company will evaluate its alternatives.

On November 6, 2012, the Company announced that its board of directors had exercised its contractual right under the indenture governing the Company's senior subordinated notes to defer interest on the senior subordinated notes for the fourth quarter 2012. Under the indenture, the Company's board of directors is permitted to defer interest on up to four occasions with respect to up to two quarters per occasion before resuming interest payments, including paying interest on the deferred interest. The Company previously deferred interest on the senior subordinated notes for the third quarter 2012. The deferral of the interest for fourth quarter 2012 will conserve $3.5 million in cash.

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