Overview

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.

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.

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.

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 ) %

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             2012
Total 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.

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.

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.

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 ) %
. . .