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 March 31, 2012, we operated approximately 101,885 access line equivalents and supplied an additional 159,560 wholesale network connections, primarily to Time Warner Cable ("TW"). 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 76.7% of our total revenues in the first quarter of 2012. We also provide cable and satellite television service in some markets and digital high-speed data lines and 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.

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 based on rates approved by the Alabama Public Service Commission, the Maine Public Utilities Commission ("MPUC"), the Massachusetts Department of Telecommunications and Cable, the Missouri Public Service Commission, the New Hampshire Public Utilities Commission ("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 Federal Communications Commission.

? 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 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 a general trend in the RLEC industry, the number of rural voice access lines we serve has been decreasing gradually when normalized for territory acquisitions. We expect that this trend will continue, and may be potentially impacted by the effect of the economy on our customers. 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 and providing better service and support levels than the incumbent carrier to our competitive customer base.

Key Operating Statistics(2)
(unaudited)                                                                              Quarterly
                                                                                         % Change
                                                December 31,           March 31,       from December
                                             2010          2011           2012           31, 2011
Otelco access line equivalents(1)             99,639       102,378        101,885                (0.5 )%

RLEC and other services:
Voice access lines                            45,461        46,202         45,200                (2.2 )%
Data access lines                             20,852        22,904         23,105                 0.9 %
Access line equivalents(1)                    66,313        69,106         68,305                (1.2 )%
Cable television customers                     4,227         4,201          4,216                 0.4 %
Satellite television customers                   125           226            229                 1.3 %
Additional internet customers                  6,975         5,414          5,159                (4.7 )%
RLEC dial-up                                     393           301            273                (9.3 )%
Other dial-up                                  4,300         2,797          2,501               (10.6 )%
Other data lines                               2,282         2,316          2,385                 3.0 %

CLEC:
Voice access lines                            29,944        30,189         30,476                 1.0 %
Data access lines                              3,382         3,082          3,104                 0.7 %
Access line equivalents(1)                    33,326        33,271         33,580                 0.9 %
Wholesale network connections                149,043       157,144        159,560                 1.5 %



                                   For the Three Months
                                      Ended March 31,
                                   2011             2012
Total revenues (in millions):   $     25.4       $     25.4
RLEC                            $     14.2       $     14.2
CLEC                            $     11.2       $     11.2

(2) We acquired Shoreham Telephone Company, Inc. on October 14, 2011. At December 31, 2011, Shoreham 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.

In our RLEC territories, access line equivalents decreased by 801 during first quarter 2012, or 1.2%, compared to December 31, 2011. Voice access lines declined 2.2% while data access lines increased by 0.9% during the period. 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 increased by 309 during first quarter 2012, or 0.9%, compared to December 31, 2011. Voice access lines increased 1.0% and data access lines increased 0.7% during the period. This increase is primarily driven by installations of our new hosted private branch exchange ("PBX") product. 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 December 31, 2011 to 4,216 as of March 31, 2012. We upgraded 23 customers to our digital offerings and added 31 new IPTV customers during the same period. Our other internet customers decreased 4.7% to 5,159 as of March 31, 2012 compared to December 31, 2011. This also includes the subscribers we service outside of our telephone service area throughout Missouri and Maine, reflecting the shift to digital high-speed internet services. In Missouri, we are expanding our data access lines for digital high-speed internet in selected areas outside of our telephone service territory. Approximately 46% of the other internet customers are served by high-speed data capability from Otelco.

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.

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. We expect to control expenses while we continue to grow our business.

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 March 31,
                                                   2011                2012
Revenues
Local services                                          47.2 %              45.9 %
Network access                                          31.0                30.8
Cable television                                         3.0                 3.2
Internet                                                13.6                14.7
Transport services                                       5.2                 5.4
Total revenues                                         100.0 %             100.0 %
Operating expenses
Cost of services                                        43.4 %              43.5 %
Selling, general and administrative expenses            13.1                12.6
Depreciation and amortization                           22.5                17.8
Total operating expenses                                79.0                73.9

Income from operations                                  21.0                26.1

Other income (expense)
Interest expense                                       (24.3 )             (23.0 )
Change in fair value of derivatives                      2.0                 0.9
Other income                                             1.3                 1.3
Total other expense                                    (21.0 )             (20.8 )

Income before income tax                                 0.0                 5.3

Income tax expense                                      (0.0 )              (2.1 )

Net income available to common stockholders              0.0 %               3.2 %

Total revenues. Total revenues of $25.4 million in the three months ended March 31, 2012 were nominally lower than revenues for the three months ended March 31, 2011. The table below provides the components of our revenues for the three months ended March 31, 2012 compared to the same period of 2011.

                        Three Months Ended March 31,              Change
                         2011                2012          Amount       Percent
                                       (dollars in thousands)
Local services       $      12,006       $      11,653     $  (353 )        (2.9 )%
Network access               7,861               7,814         (47 )        (0.6 )
Cable television               752                 805          53           7.0
Internet                     3,456               3,726         270           7.8
Transport services           1,317               1,376          59           4.5
Total                $      25,392       $      25,374     $   (18 )        (0.1 )

Local services. Local services revenue decreased 2.9% in the three months ended March 31, 2012 to $11.7 million from $12.0 million in the three months ended March 31, 2011. The acquisition of STC added $0.2 million, which was offset by lower RLEC basic services revenue of $0.3 million and lower long distance revenue of $0.3 million.

Network access. Network access revenue decreased 0.6% in the three months ended March 31, 2012 to $7.8 million from $7.9 million in the three months ended March 31, 2011. The acquisition of STC added $0.4 million, which was offset by lower access revenue related to RLEC subscriber usage and lower National Exchange Carrier Association ("NECA") settlements of $0.5 million.

Cable television. Cable television revenue in the three months ended March 31, 2012 increased 7.0% to $0.8 million compared to just under $0.8 million in the same period in 2011. Growth in digital family packages and IPTV of $0.1 million was partially offset by a decrease in basic cable services and satellite television installation revenue of less than $0.1 million.

Internet. Internet revenue for the three months ended March 31, 2012 increased 7.8% to $3.7 million from $3.5 million in the three months ended March 31, 2011. The acquisition of STC accounted for the growth, while the loss of dial-up subscribers was offset by growth in fiber backhaul circuits and RLEC data lines.

Transport services. Transport services revenue increased 4.5% to $1.4 million in the three months ended March 31, 2012 from $1.3 million for the three months ended March 31, 2011. The increase was associated with additional wholesale transport services.

Operating expenses. Operating expenses in the three months ended March 31, 2012 decreased 6.5% to $18.8 million from $20.1 million in the three months ended March 31, 2011. The table below provides the components of our operating expenses for the three months ended March 31, 2012 compared to the same period of 2011.

                                   Three Months Ended March 31,                  Change
                                     2011                 2012           Amount        Percent
                                                     (dollars in thousands)
Cost of services                $       11,020       $       11,029     $       9            0.1 %
Selling, general and
administrative expenses                  3,327                3,206          (121 )         (3.6 )
Depreciation and amortization            5,724                4,523        (1,201 )        (21.0 )
Total                           $       20,071       $       18,758     $  (1,313 )         (6.5 )

Cost of services. Cost of services was $11.1 million for the three months ended March 31, 2012 and March 31, 2011. Costs related to STC added $0.4 million and our hosted PBX product costs increased $0.2 million, reflecting our success with that product in the last year. These increases were offset by lower toll costs of $0.4 million and a one-time NECA adjustment in 2011 of $0.2 million.

Selling, general and administrative expenses. Selling, general and administrative expenses decreased 3.6% to $3.2 million in the three months ended March 31, 2012 from $3.3 million in the three months ended March 31, 2011. An increase associated with the STC acquisition of $0.1 million was more than offset by lower management expenses of $0.2 million.

Depreciation and amortization. Depreciation and amortization for the three months ended March 31, 2012 decreased 21.0% to $4.5 million from $5.7 million in the three months ended March 31, 2011. An increase associated with the acquisition of STC of $0.2 million and CLEC investment of $0.2 million was more than offset by a decrease of $0.3 million in the amortization of intangible assets associated with the acquisition of three entities from Country Road Communications LLC, including a covenant not to compete and contract and customer base intangible assets, and a decrease of $1.3 million reflecting lower depreciation expense of plant assets in our regulated properties.

                                        Three Months Ended
                                             March 31,                   Change
                                         2011          2012       Amount       Percent
                                                   (dollars in thousands)
Interest expense                      $   (6,170 )   $ (5,834 )   $  (336 )        (5.4 )%
Change in fair value of derivatives          506          241        (265 )          NM
Other income                                 349          318         (31 )        (8.9 )
Income tax expense                            (1 )       (524 )      (523 )          NM

Interest expense. Interest expense decreased 5.4% to $5.8 million in the three months ended March 31, 2012 from $6.2 million in the three months ended March 31, 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.

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. Over the life of the swaps, the change in value was zero, with no cumulative impact on net income, Adjusted EBITDA (as defined below) or operations. The value of the swaps increased $0.2 million in the three months ended March 31, 2012 compared to $0.5 million in the same period of 2011. 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, in each case plus a bank margin of 4.25%.

Income tax expense. Provision for income taxes was an expense of $0.5 million in the three months ended March 31, 2012. There was a nominal expense for the three months ended March 31, 2011.

Other income. Other income of $0.3 million in the three months ended March 31, 2012 was nominally lower than other income for the three months ended March 31, 2011, reflecting slightly lower CoBank dividends and interest income on invested cash.

Net income. As a result of the foregoing, there was net income of $0.8 million in the three months ended March 31, 2012 and a nominal net income in the three months ended March 31, 2011.

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; (iii) working capital requirements; and (iv) potential acquisitions. We suspended dividends on our common stock on April 20, 2012 in order to free up cash for other purposes.

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 three months ended March 31, 2012, we generated cash from our business to invest in additional property and equipment, pay interest on our senior debt, pay interest associated with the senior subordinated debt inherent in our Income Deposit Securities ("IDSs") and fund a dividend (as declared by our board of directors) on the shares of common stock that are inherent in our IDSs, which was paid on March 30, 2012. After meeting all of these needs of our business, cash increased from $12.4 million at December 31, 2011 to $16.0 million at March 31, 2012.

Cash flows from operating activities for the first three months of 2012 amounted to $7.3 million compared to $5.4 million for the first three months of 2011. Net income, when adjusted for its non-cash components, declined by $0.1 million. The changes in operating assets and liabilities of $1.9 million reflect 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 and an additional month's receivable on the TW contract in 2011.

Cash flows used in investing activities for the first three months of 2012 were $1.3 million compared to $2.8 million in the first three months of 2011. The lower rate of capital expenditures for property and equipment in the first three months of 2012 accounted for the difference.

Cash flows used in financing activities for the first three months of 2012 and 2011 were $2.3 million, reflecting payments of dividends to stockholders in both periods. The dividend was $0.17625 per common share per quarter in both periods.

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.

We anticipate that operating cash flow, together with borrowings under our senior credit facility, will be adequate to meet our currently anticipated operating and capital expenditure requirements for at least the next 12 months.

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.

                                                  Three Months Ended March 31,
                                                    2011                 2012
                                                     (dollars in thousands)
Cash generation
. . .