10-K 1 t72665_10k.htm FORM 10-K t72665_10k.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-K
 
x         ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the Fiscal Year Ended December 31, 2011
 
OR
 
o          TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the Transition Period from            to
 
Commission File Number: 1-32362
 
OTELCO INC.
(Exact Name of Registrant as Specified in Its Charter)
 
Delaware
 
52-2126395
(State or Other Jurisdiction of
Incorporation or Organization)
 
(I.R.S. Employer
Identification No.)
     
505 Third Avenue East, Oneonta, Alabama
 
35121
(Address of Principal Executive Offices)
 
(Zip Code)
     
205-625-3574
(Registrant’s Telephone Number, Including Area Code)
 
Securities registered pursuant to Section 12(b) of the Act:
     
Title of Each Class
 
Name of Each Exchange on Which Registered
Income Deposit Securities, each representing shares of
Common Stock and Senior Subordinated
Notes due 2019
 
The NASDAQ Stock Market LLC
     
Securities registered pursuant to Section 12(g) of the Act: None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer o
Accelerated filer x
Non-accelerated filer o
(Do not check if a smaller reporting company)
Smaller reporting company o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
 
As of June 30, 2011, the aggregate market value of the registrant’s Income Deposit Securities (IDSs) held by non-affiliates of the registrant was $247.1 million based on the closing sale price as reported on NASDAQ. Each IDS represents one share of Common Stock, par value $0.01 per share, and $7.50 principal amount of senior subordinated notes due 2019. In determining the market value of the registrant’s IDSs held by non-affiliates, IDSs beneficially owned by directors, officers and holders of more than 10% of the registrant’s IDSs have been excluded. This determination of affiliate status is not necessarily a conclusive determination for other purposes.
 
As of March 5, 2012, the registrant had 13,221,404 shares of Common Stock, par value $0.01 per share, outstanding.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Certain information required in Part III of this report is incorporated by reference from the registrant’s proxy statement to be filed pursuant to Regulation 14A with respect to the registrant’s 2012 annual meeting of stockholders.
 
 
 

 

OTELCO INC.
 
TABLE OF CONTENTS

         
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Unless the context otherwise requires, the words “we,” “us,” “our,” the “Company” and “Otelco” refer to Otelco Inc., a Delaware corporation, and its consolidated subsidiaries as of December 31, 2011.
 
FORWARD-LOOKING STATEMENTS
 
This report contains forward-looking statements that are subject to risks and uncertainties. Forward-looking statements give our current expectations relating to our financial condition, results of operations, plans, objectives, future performance and business. These statements may include words such as “anticipate,” “estimate,” “expect,” “project,” “plan,” “intend,” “believe” and other words and terms of similar meaning in connection with any discussion of the timing or nature of future operating or financial performance or other events. These forward-looking statements are based on assumptions that we have made in light of our experience in the industry in which we operate, as well as our perceptions of historical trends, current conditions, expected future developments and other factors we believe are appropriate under the circumstances. Although we believe that these forward-looking statements are based on reasonable assumptions, you should be aware that many factors could affect our actual financial condition or results of operations and cause actual results to differ materially from those in the forward-looking statements. These factors include, among other things, those discussed under the caption “Risk Factors” in Item 1A.
 
 
 

 

PART I
 
Business
 
History
 
We were formed in Delaware in 1998 for the purpose of operating and acquiring rural local exchange carriers, or RLECs. Since 1999, we have acquired eleven RLEC businesses, four of which serve contiguous territories in north central Alabama; three of which serve territories adjacent to either Portland or Bangor, Maine; and one each serving a portion of western Massachusetts, central Missouri, western Vermont and southern West Virginia. We provide competitive services through several subsidiaries in certain of these territories. In addition, we acquired three facilities based competitive local exchange carriers, or CLECs, which are collectively offering services under the trade name OTT Communications in Maine, New Hampshire, and Massachusetts. The Company completed an initial public offering of income deposit securities, or IDSs, in December 2004 at which time it converted from a Delaware limited liability company into a Delaware corporation and changed its name to Otelco Inc. In July 2007, the Company completed an additional offering of 3,000,000 IDS units. On June 8, 2010, we exchanged all of our issued and outstanding shares of Class B common stock, which were issued in connection with our initial public offering, for an equal number of IDSs registered under the Securities Act of 1933.
 
The following table shows the aggregate number of our voice and data access lines (which together are access line equivalents) and other services we offer such as wholesale network connections, television, and other internet customers as of December 31, 2011:
 
Voice and data access lines, or access line equivalents
102,378
 
     
Wholesale network connections
157,144
 
     
Cable television customers
4,201
 
     
Additional internet customers
5,414
 
 
The RLEC companies we acquired can trace their history as local communications providers to the introduction of telecommunications services in the areas they serve. We are able to leverage our long-standing relationship with our local service customers by offering them a broad suite of telecommunications and information services, such as long distance, internet/broadband data access and, in some areas, cable or satellite television, thereby increasing customer loyalty and revenue per access line.
 
Our RLECs have historically experienced relatively stable operating results and strong cash flows and operate in supportive regulatory environments. Each RLEC qualifies as a rural telephone company under the Federal Communications Act of 1934, or the Communications Act, so we are currently exempt from certain costly interconnection requirements imposed on incumbent or historical local telephone companies, or incumbent local exchange carriers, by the Communications Act. While this exemption helps us maintain our strong competitive position, we do have direct competition in portions of our RLEC market, primarily where a cable provider also serves the same market. The cost of operations and capital investment requirements for new entrants is high, discouraging such investments.
 
In Maine and New Hampshire, our facilities based CLEC serves primarily business customers, utilizing our 423 miles of owned and leased fiber as a backbone network. In thirteen years of operations, the CLEC has grown to provide more than 33,000 voice and data access lines and 157,000 wholesale network connections. Facilities were installed in 2011 to expand services into western Massachusetts in the coming year.
 
Acquisitions have represented a significant part of our growth. A summary of each acquisition follows:
 
Otelco Telephone. On January 5, 1999, through Otelco Telephone LLC, or Otelco Telephone, we acquired certain telecommunications businesses from Oneonta Telephone Company, Inc., a rural local exchange carrier that serves a portion of Blount county in Alabama. In connection with the transaction, we acquired 8,127 voice and data access lines.
 
Hopper. On September 30, 1999, we acquired Hopper Telecommunications Company, Inc., or Hopper, a rural local exchange carrier that serves portions of Blount and Etowah counties in Alabama. In connection with the transaction, we acquired 3,827 voice and data access lines.
 
 
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Brindlee. On July 19, 2000, we acquired Brindlee Mountain Telephone Company, or Brindlee, a rural local exchange carrier that serves portions of Marshall, Morgan, Blount and Cullman counties in Alabama. In connection with the transaction, we acquired 14,013 voice and data access lines.
 
Blountsville. On June 30, 2003, we acquired Blountsville Telephone Company, Inc., or Blountsville, a rural local exchange carrier that serves a portion of Blount county in Alabama. In connection with the transaction, we acquired 4,080 voice and data access lines.
 
Mid-Missouri. On December 21, 2004, we acquired Mid-Missouri Telephone Company, or Mid-Missouri, a rural local exchange carrier that serves portions of Cooper, Moniteau, Morgan, Pettis and Saline counties in central Missouri. In connection with the transaction, we acquired approximately 4,585 voice and data access lines. In addition, we provide internet services in areas surrounding our territory.
 
Mid-Maine. On July 3, 2006, we acquired Mid-Maine Communications, Inc., or Mid-Maine, a rural local exchange carrier that serves portions of Penobscot, Somerset and Piscataquis counties adjacent to Bangor, Maine and a competitive local exchange carrier, serving customers adjacent to its fiber network along the I-95 corridor in Maine. In connection with the transaction, we acquired approximately 22,413 voice and data access lines. In addition, we provide dial-up internet services throughout Maine.
 
Country Road. On October 31, 2008, we acquired Pine Tree Holdings, Inc., Granby Holdings, Inc. and War Holdings, Inc., which we collectively refer to as the CR Companies, from Country Road Communications LLC. The three holding companies had four RLEC operating subsidiaries: War Acquisition Corp., or War, serves areas in and around War, West Virginia; The Granby Telephone and Telegraph Co. of Mass., or Granby, serves areas in and around Granby, Massachusetts; and Saco River Telegraph and Telephone Company, or Saco River, and The Pine Tree Telephone and Telegraph Company, or Pine Tree, which collectively serve areas in and around Buxton, Hollis, Waterboro, Gray and New Gloucester, Maine (adjacent to Portland). There are also two CLEC subsidiaries providing services primarily to business customers in Maine and New Hampshire – CRC Communications of Maine, Inc. and Communications Design Acquisition Corporation. In connection with the transaction, we acquired approximately 29,112 voice and data access lines and 93,994 wholesale network connections.
 
Shoreham. On October 14, 2011, we acquired Shoreham Telephone Company, Inc. or Shoreham, a rural local exchange carrier that serves portions of Addison county in western Vermont. In connection with the transaction, we acquired approximately 4,990 voice and data access lines.
 
The following table reflects the percentage of total revenues derived from each of our service offerings for the year ended December 31, 2011:
 
Revenue Mix
 
Source of Revenue
     
Local services
 
46.6
Network access
 
31.6
 
Cable television
 
2.9
 
Internet
 
13.7
 
Transport services
 
5.2
 
Total
 
100.0
 
Local Services
 
We are the sole provider of wireline telephone services in seven of the eleven RLEC territories we serve. In the remaining four territories, the incumbent cable provider also offers local services in portions of our territory. Local services enable customers to originate and receive telephone calls. The amount that we can charge a customer for certain basic services in Alabama, Maine, Massachusetts, Missouri, Vermont and West Virginia is regulated by the Alabama Public Service Commission, or APSC; the Maine Public Utilities Commission, or MPUC; the Massachusetts Department of Telecommunications and Cable, or MDTC; the Missouri Public Service Commission, or MPSC; the Vermont Public Service Board, or VPSB; and the West Virginia Public Service Commission, or WVPSC. We also have authority to provide service in New Hampshire from the New Hampshire Public Utilities Commission, or NHPUC. The regulatory involvement in pricing varies by state and by type of service. Increasingly, bundled services generally involve less regulation.
 
 
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Revenue derived from local services includes monthly recurring charges for voice access lines providing local dial tone and calling features, including caller identification, call waiting, call forwarding and voicemail. We also receive revenue for providing long distance services to our customers, billing and collection services for other carriers under contract, and directory advertising. We provide local services on a retail basis to residential and business customers. With the high level of acceptance of local service bundles, a growing percentage of our customers receive a broad range of services, including long distance, for a single, fixed monthly price.
 
We also offer long distance telephone services to our local telephone customers who do not purchase a local service bundle. We resell long distance services purchased from various long distance providers. At December 31, 2011, customers representing more than 62% of our regulated access lines subscribed to our long distance services. We intend to continue to make our long distance business an integral part of the services we provide to our RLEC customers principally through bundling of services.
 
In Maine and New Hampshire, our CLEC provides communications services tailored to business customers, including specialized data and voice network configurations, to support their unique business requirements. Our fiber network allows us to offer our customers affordable and reliable voice and data solutions to support their business requirements and applications, which is a significant differentiator for our Company in the competitive local exchange carrier environment in which we operate. In connection with the acquisition of the CR Companies, the Company acquired a multi-year contract with Time Warner Cable, or TW, a large multiple system operator, for the provision of wholesale network connections to TW’s customers in Maine and New Hampshire. The contract extends through December 31, 2012 and represented approximately 11.7% of our consolidated revenue for 2011. In addition, we receive access revenue from carriers for completing calls to TW’s customers.
 
We derive revenue from other telephone related services, including leasing, selling, installing, and maintaining customer premise telecommunications equipment and the publication of local telephone directories in certain of our RLEC territories. We also provide billing and collection services for long distance carriers (also referred to as interexchange carriers) through negotiated billing and collection agreements for certain types of toll calls placed by our local customers.
 
Network Access
 
Network access revenue relates primarily to services provided by us to long distance carriers in connection with their use of our facilities to originate and terminate interstate and intrastate long distance, or toll, telephone calls. As toll calls are generally billed to the customer originating the call, network access charges are applied in order to compensate each telecommunications company providing services relating to the call. Network access charges apply to both interstate and intrastate calls. Our network access revenues also include revenues we receive from wireless carriers for terminating their calls on our networks pursuant to our interconnection agreements with those wireless carriers. Blountsville, Hopper, Mid-Missouri, Shoreham and War also receive Universal Service Fund High Cost Loop, or USF HCL, revenue which is included in our reported network access revenue.
 
Intrastate Access Charges. We generate intrastate access revenue when a long distance call involving a long distance carrier is originated and terminated within the same state. The interexchange carrier pays us an intrastate access payment for either terminating or originating the call. We record the details of the call through our carrier access billing system. Our access charges for our intrastate access services are set by the APSC, the MPUC, the MDTC, the MPSC, the NHPUC, the VPSB, and the WVPSC for Alabama, Maine, Massachusetts, Missouri, New Hampshire, Vermont and West Virginia, respectively. A Federal Communications Commission, or FCC, Order of October 27, 2011 (the “FCC Order”) preempted the state commissions’ authority to set intrastate access service rates, and requires states with terminating access rates higher than interstate rates to reduce their terminating intrastate access rates to a rate equal to interstate access service rates by July 1, 2013, and to move to a “bill and keep” arrangement by July 1, 2020. The FCC Order prescribes a recovery mechanism for the recovery of any decrease in intrastate terminating access revenues through the Connect America Fund. This recovery is limited to 95% of the previous year’s revenue requirement. The FCC Order is being contested by a number of states.
 
Interstate Access Charges. We generate interstate access revenue when a long distance call originates from an area served by one of our local exchange carriers and terminates outside of that state, or vice versa. We bill interstate access charges in a manner similar to intrastate access charges. Our RLEC interstate access charges are regulated by the FCC through our participation in tariffs filed by the National Exchange Carriers Association, or NECA. The FCC regulates the prices local exchange carriers charge for access services in two ways: price caps and rate-of-return. All of our rural local exchange carriers are rate-of-return carriers for purposes of interstate network access regulation. Interstate access revenue for rate-of-return carriers is based on an FCC regulated rate-of-return currently authorized up to 11.25% on investment and recovery of operating expenses and taxes, in each case solely to the extent related to interstate access. The FCC Order requires terminating interstate access rates to move to a “bill and keep” arrangement by July 1, 2020. Initial reductions in interstate access rates occur July 1, 2014, with additional reductions through July 1, 2019. The FCC Order prescribes a recovery mechanism for the recovery of any decrease in terminating interstate access revenues through the Connect America Fund. This recovery is limited to 95% of the previous year’s revenue requirement.
 
 
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Federal Universal Service Fund High Cost Loop Revenue. Blountsville, Hopper, Mid-Missouri, Shoreham and War recover a portion of their costs through the USF HCL, which is regulated by the FCC and administered by the Universal Service Administrative Company, or USAC, a non-profit organization. Based on historic and other information, a nationwide average cost per loop is determined by USAC. Any incumbent local exchange carrier whose individual cost per loop exceeds the nationwide average by more than 15% qualifies for USF HCL support. Although all of our rural local exchange carriers have been designated as eligible telecommunications carriers, or ETCs, Otelco Telephone, Brindlee, Granby, Mid-Maine, Pine Tree and Saco River do not receive USF HCL support because their cost per loop does not exceed the national average by more than fifteen percent. The USF HCL, which is funded by assessments on all United States telecommunications carriers as a percentage of their revenue from end-users of interstate and international service, distributes funds to our participating RLECs based upon their respective costs for providing local services. USF HCL payments are received monthly. The FCC Order introduced new requirements for carriers to become certified as ETCs. ETCs must now, upon their customers’ reasonable request, provide broadband service at minimum speeds of 4 Mbps download and 1 Mbps upload, at prices reasonably comparable to those provided in urban areas. In addition, the FCC Order placed limits on the recovery of certain operating expenses, implemented a benchmark floor for local service rates, and placed limits on the overall support an ETC can receive. Not all of our RLECs provide services to all of their customers at these minimum speeds. The FCC has not provided guidance as to what constitutes a reasonable request. Depending on how a reasonable request ultimately gets defined, some of our RLECs may not qualify as ETCs, which could have a material adverse effect on our financial position and results of operations.
 
Transition Service Fund Revenue. Otelco Telephone, Hopper, Brindlee, and Blountsville recover a portion of their costs through the Transition Service Fund, or TSF, which is administered by the APSC. All interexchange carriers originating or completing calls in Alabama contribute to the TSF on a monthly basis, with the amount of each carrier’s contribution calculated based upon its relative originating and terminating minutes of use compared to the aggregate originating and terminating minutes of use for all telecommunications carriers participating in the TSF. The TSF reduces the vulnerability of our Alabama rural local exchange carriers to a loss of access and interconnection revenue. TSF payments are received monthly.
 
Maine Universal Service Fund. Mid-Maine recovers a portion of its costs through the Maine Universal Service Fund, or MUSF, which is administered by the MPUC. All local and interexchange carriers in Maine contribute to the MUSF on a monthly basis, with the amount of each carrier’s contribution calculated based upon a percentage of retail intrastate revenues. The MUSF was created to support RLEC universal service goals in response to legislative mandates to reduce intrastate access rates.
 
Cable Television
 
We provide cable television services, including high definition, digital video recording capability and video on demand, or VOD, over networks with 750 MHz of transmission capacity or by Internet Protocol TV, or IPTV, in our Alabama service area. Our cable television packages offer from 20 to 200 channels. We are a licensed installer of satellite television and have deployed these services to customers in our Missouri territory. In 2011, we converted our Missouri cable customers to satellite television.
 
Internet
 
We provide a variety of internet access data lines to our customers, including bulk broadband data access to support large corporate users; digital high-speed data lines in varying capacity speeds for business and residential use; and residential dial-up connectivity. Digital high-speed data lines are provided via digital subscriber line, or DSL; cable modems; and wireless broadband, depending upon the location in which the service is offered and via dedicated fiber connectivity to larger business customers. We charge our internet customers a flat rate for unlimited internet usage and a premium for higher speed internet services. We are able to provide digital high-speed internet data lines to over 90% of our RLEC access lines and all of our CLEC lines. We intend to expand the availability of our high-speed internet services as warranted by customer demand by installing additional equipment at certain switching locations. In Maine and Missouri, we provide legacy dial-up internet services throughout the state.
 
Transport Services
 
Our CLEC receives monthly recurring revenues for the rental of fiber to transport data and other telecommunications services in Maine and New Hampshire from businesses and telecommunications carriers along our 423 mile owned and leased fiber route.
 
Network Assets
 
Our telephone networks include carrier grade advanced switching capabilities provided by traditional digital as well as software based switches; fiber rings and routes; and network software supporting specialized business applications, all of which meet industry standards for service integrity, redundancy, reliability and flexibility. Our networks enable us to provide traditional and Internet Protocol, or IP, wireline telephone services and other calling features; long distance services; digital internet access services through DSL and cable modems and dedicated circuits; and specialized customer specific applications.
 
 
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Our cable television network in Alabama has been upgraded to a transmission capacity of 750 MHz or utilizes IPTV delivery. We offer digital signals, high-definition program content, digital video recording capability and VOD through both our traditional cable plant and IPTV.
 
Sales, Marketing & Customer Service
 
In Maine and New Hampshire, our CLEC provides services under the brand name OTT Communications. We compete with the incumbent carriers throughout each state, utilizing both an employee and agent sales force. Service configurations are tailored to meet specific customer requirements, utilizing customer designed voice and data telecommunications configurations. Increased service monitoring for business customers is provided through a state of the art network operations center and serves as a differentiator for our offers. We offer an IP based Hosted Private Branch Exchange, or PBX, service that provides industry leading capability for our customers that is not generally available from our current competitors.
 
Our RLEC marketing approach emphasizes locally managed, customer-oriented sales, marketing and service. We believe that we are able to differentiate ourselves from any competition by providing a superior level of service in our territories. Each of our RLECs has a long history in the communities it serves, which has helped to enhance our reputation among local residents by fostering familiarity with our products and level of service. To demonstrate our commitment to the markets we serve, we maintain local offices in most of the population centers within our service territories. While customers have the option of paying their bills on-line or by mail, credit card or automatic withdrawal from their bank account, many elect to pay their monthly bill in person at the local office. This provides us with an opportunity to directly market our services to our existing customers. These offices typically are staffed by local residents and provide sales and customer support services in the community. Local offices facilitate a direct connection to the community, which we believe improves customer satisfaction and enhances our reputation with local residents. We also build upon our strong reputation by participating in local activities, such as local fund raising and charitable events for schools and community organizations and, in Alabama, by airing local interest programs on our local access community cable channels.
 
In order to capitalize on the strong branding of each of our rural local exchange carriers, while simultaneously establishing and reinforcing the “Otelco” and “OTT Communications” brand names across our service territories, we often identify both the historical name of the RLEC and Otelco or OTT Communications on our marketing materials and other customer communications. Part of our strategy is to increase customer loyalty and strengthen our brand name by deploying new technologies and by offering comprehensive bundling of services, including digital high-speed internet access, cable and satellite television, long distance and a full array of calling features. In addition, our ability to provide our customers with a single, unified bill for all of our services is a major competitive advantage and helps to enhance customer loyalty.
 
Competition
 
Local Services
 
We believe that many of the competitive threats to wireline telephone companies are not as significant in portions of our RLEC service areas as in more urban areas. The demographic characteristics of rural telecommunications markets generally require significant capital investment to offer competitive wireline telephone services with low potential revenues. As a result, rural local exchange carriers generally do not face the threat of significant wireline telephone competition except in markets where a cable company provides existing services. We face current or future direct competition from cable providers in portions of six of our eleven RLEC territories. New market entrants, such as providers of satellite broadband or voice over electric lines and indirect competition such as voice over internet protocol, or VoIP, may gain traction in the future.
 
We currently qualify for the rural exemption from certain interconnection obligations which support industry competition, including obligations to provide services for resale at discounted wholesale prices and to offer unbundled network elements. If the APSC, MPUC, MDTC, MPSC, VPSB or WVPSC terminates this exemption for our rural local exchange carriers, we may face competition from resellers and other wireline carriers.
 
In our markets, we face competition from wireless carriers. We have experienced a decrease in access lines as a result of customers switching their residential wireline telephone service to a wireless service. We have also experienced an increase in network access revenue associated with terminating wireless calls on our telephone network. The introduction of residential bundled offerings including unlimited calling appears to have recaptured minutes back from wireless carriers. A portion of the wireless technology threat to our business is reduced due in part to the topography of some of our telephone territories and current inconsistent wireless coverage in some areas. However, as wireless carriers continue to employ new technologies in our territories, we expect to experience increased competition from these carriers.
 
 
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The long distance market remains competitive in all of our rural local exchange carrier territories. We compete with major national and regional interexchange carriers, including AT&T and Verizon, as well as wireless carriers, and other service providers. However, we believe that our service bundling that includes long distance, our long-standing local presence in our territories and our ability to provide a single, unified bill for all of our services, are major competitive advantages. At December 31, 2011, more than 62% of our regulated access lines subscribed to our long distance services. The majority of our CLEC customers have also selected us for their long distance services as part of their overall package of services.
 
In addition, under the Communications Act, a competitor can obtain USF HCL support if a state public service commission (or the FCC in certain instances) determines that it would be in the public interest and designates such competitor as an ETC. While access to USF HCL support by our competitors currently would not reduce our current USF HCL revenue, such economic support could facilitate competition in our RLEC territories, particularly from wireless carriers. The FCC Order will impact amounts paid to and received from, as well as eligibility for payments from, USF HCL. As discussed above, the FCC Order also introduces new requirements for carriers to become certified as ETCs. ETCs must now, upon their customers’ reasonable request, provide broadband service at minimum speeds of 4 Mbps download and 1 Mbps upload, at prices reasonably comparable to those provided in urban areas. In addition, the FCC’s Order placed limits on the recovery of certain operating expenses, implemented a benchmark floor for local service rates, and places limits on the overall support an ETC can receive. Not all of our RLECs provide services to all of their customers at these minimum speeds. The FCC has not provided guidance as to what constitutes a reasonable request. Depending on how a reasonable request ultimately gets defined, some of our RLECs may not qualify as ETCs, which could have a material adverse effect on our financial position and results of operations.
 
In Maine and New Hampshire, we operate as a facilities based competitive local exchange carrier in areas primarily served by FairPoint Communications as the incumbent local exchange carrier. There are other competitors who serve these markets today as both facilities based and resale carriers. Our focus has been on the small to medium size business customer with multiple locations and enterprise telecommunications requirements, where we offer a combination of knowledge, experience, competitive pricing and new IP based products to meet their specialized needs.
 
Cable Television
 
We offer cable television services, including VOD, in our Alabama territory and are a licensed agent for a satellite provider. Services are delivered through traditional cable technology and IPTV. Charter Communications, Inc., or Charter, provides cable service, passing about 30% of our telephone subscribers. In Maine, TW provides cable service, passing approximately 60% of our RLEC telephone subscribers. In Massachusetts, Comcast Corporation, or Comcast, provides cable service, passing more than 90% of our telephone subscribers. In addition, we compete against digital broadcast satellite providers including Dish Network and DirecTV. Our broadband subscribers also have access to “Over The Top” entertainment services offered by numerous providers.
 
Internet
 
Competition in the provision of RLEC data lines and internet services currently comes from alternative digital high-speed internet service providers. Competitors vary on a market-to-market basis and include Charter, TW and Comcast. At December 31, 2011, we provided data access lines to approximately 49% of our rural voice access lines. In Maine and Missouri, we also provide high-speed data lines and dial-up internet services to approximately 5,100 subscribers outside of our rural telephone services territory, where approximately 45% of those customers receive high-speed data services. Our CLEC customers are provided a variety of data access service options, based on their individual requirements.
 
Transport Services
 
Other local telephone companies, long distance carriers, cable providers, utilities, governments, and industry associations deploy and sell fiber capacity to users. Existing and newly deployed capacity could impact market pricing. Multi-year contracts generally protect existing relationships and provide revenue stability. The cost of and time required for deploying new fiber can be a deterrent to adding capacity. We have expanded our fiber network in Maine to reach additional locations and serve incremental customers.
 
Information Technology and Support Systems
 
We have integrated software systems that function as operational support and customer care/billing systems. One system serves our Alabama and Missouri local exchange subscribers, one serves our additional internet subscribers in Missouri, and one serves our Maine, Massachusetts, New Hampshire, Vermont and West Virginia subscribers. The systems include automated provisioning and service activation, mechanized line records and trouble reporting. These services are provided through the use of
 
 
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licensed third-party software. By utilizing integrated software systems, we are able to reduce individual company costs and standardize functions resulting in greater efficiencies and profitability.
 
        Each system allows us to provide a single, unified bill for all our services which we believe is a significant competitive advantage. Additionally, the systems provide us an extensive database that enables us to gather detailed marketing information in our service territories. This capability allows us to market new services as they become available to particular customers. The Company has implemented all currently established safeguards to Customer Proprietary Network Information as established by the FCC for telecommunications providers and is compliant with the “red flag” provisions of the Fair and Accurate Credit Transactions Act.
 
Environment
 
We are subject to various federal, state and local laws relating to the protection of the environment. We believe that we are in compliance in all material respects with all such laws. The environmental compliance costs incurred by us to date have not been material, and we currently have no reason to believe that such costs will become material in the foreseeable future.
 
Employees
 
As of December 31, 2011, we employed 325 full-time and 5 part-time employees. None of our employees are members of, or are represented by, any labor union or other collective bargaining unit. We consider our relations with our employees to be good.
 
Available Information
 
Under the Securities Exchange Act of 1934, we are required to file with or furnish to the Securities and Exchange Commission, or the SEC, annual, quarterly and current reports, proxy and information statements and other information. You may read and copy any document we file with or furnish to the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information about the Public Reference Room. The SEC maintains a website at http://www.sec.gov that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. We file electronically with the SEC.
 
We make available, free of charge, through the investor relations section of our website, our reports on Forms 10-K, 10-Q and 8-K, and amendments to those reports, as soon as reasonably practicable after they are filed with or furnished to the SEC. The address for our website is http://www.OtelcoInc.com.
 
Our Code of Ethics applies to all of our employees, officers and directors, including our chief executive officer and our chief financial officer and principal accounting officer. The full text of the Code of Ethics is available at the investor relations section of our website, http://www.OtelcoInc.com. We intend to disclose any amendment to, or waiver from, a provision of the Code of Ethics that applies to our chief executive officer or chief financial officer and principal accounting officer in the investor relations section of our website. The investor relations section of our website also includes charters for the audit committee, compensation committee and nominating and corporate governance committee of our board of directors.
 
The information contained on our website is not part of, and is not incorporated in, this or any other report we file with or furnish to the SEC.
 
Risk Factors
                    
In evaluating our business, every investor should carefully consider the following risks. Our business, financial condition or results of operation could be materially adversely affected by any of the following risks.
 
The Telecommunications Industry Has Experienced Increased Competition.
 
Although we have historically experienced limited wireline telephone competition in many of our RLEC territories, the market for telecommunications services is highly competitive. Certain competitors benefit from brand recognition and financial, personnel, marketing and other resources that are significantly greater than ours. We cannot predict the number of competitors that will emerge, especially as a result of existing or new federal and state regulatory or legislative actions. Increased competition from existing and new entities could have an adverse effect on our business, revenue and cash flow.
 
In all of our markets, we face competition from wireless carriers, including the potential for customers to export existing wireline telephone numbers to wireless services. As wireless carriers continue to build-out their networks and add products and
 
 
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services aimed at the fixed wireless market, we may experience increased competition, which could have an adverse effect on our business, revenue and cash flow.
 
The current and potential competitors in our RLEC territories include cable television companies; competitive local exchange carriers and other providers of telecommunications and data services, including internet and VoIP service providers; wireless carriers; satellite television companies; alternate access providers; neighboring incumbent local exchange carriers; long distance companies and electric utilities that may provide services competitive with those products and services that we provide or intend to provide.
 
In Maine and New Hampshire, our competitive local exchange carrier operations may encounter a change in the competitive landscape that would impact its continued ability to grow and/or retain customers, sustain current pricing plans, and control the cost of access to incumbent carrier customers.
 
Although our long distance operations have historically been modest in relation to our competitors, we have expanded our long distance business within our territories, primarily through bundling long distance with other local services and providing a single bill for these services. Our existing long distance competitors, including those with significantly greater resources than us, could respond to such initiatives and new competitors may enter the market with attractive offerings. There can be no assurance that our local services revenue, including long distance services, will not decrease in the future as competition and/or the cost of providing services increase.
 
We Have a Significant Amount of Debt Maturing in October 2013.
 
We currently have outstanding $162.0 million of debt under our senior credit facility that matures in October 2013. We will be in default under the senior credit facility if we are unable to refinance this debt at or prior to its maturity. There can be no assurance that market conditions will allow us to refinance this debt at or prior to its maturity on terms that are acceptable to us, or at all. Any such refinancing may contain covenants that could limit in a significant manner our ability to pay interest on our senior subordinated notes and dividends on our common stock.
 
Changes in the Regulation of the Telecommunications Industry Could Adversely Affect Our Business, Revenue or Cash Flow.
 
We operate in an industry that is regulated at the federal, state and local level. The majority of our revenue has historically been supported by and subject to regulation. Certain federal and state regulations and local franchise requirements have been, are currently, and may in the future be, the subject of judicial proceedings, legislative hearings and administrative proposals. Such proceedings may relate to, among other things, federal and state universal service funds (including USF HCL), the rates we may charge for our local, network access and other services, the manner in which we offer and bundle our services, the terms and conditions of interconnection, unbundled network elements and resale rates, and could change the manner in which telecommunications companies operate. The FCC Order will significantly reduce access revenue received by us beginning as soon as this year and USF HCL revenue over a five to ten year period. In addition, the FCC Order imposes certain costs and rate increases on carriers that we may not be able to pass on to our customers without experiencing further access line loss.
 
We Are Dependent on One Large Services Contract for More than Ten Percent of Our Revenue.
 
We provide more than 150,000 wholesale network connections for TW in Maine and New Hampshire. The current five year contract with TW expires at the end of 2012 and represented approximately 11.7% of our consolidated revenue for 2011. There can be no assurance that TW will renew the contract or that any extension of the contract will cover the same services currently provided or the same level of pricing contained in the existing contract. Termination of our relationship with TW could have a material adverse effect on our financial performance and cause us to reduce or eliminate dividends or, pursuant to the terms of our senior credit facility, defer interest on our senior subordinated notes, including the senior subordinated notes that are part of the IDSs.
 
We Are Subject to Restrictive Debt Covenants That Limit Our Business Flexibility By Imposing Operating and Financial Restrictions on Our Operations.
 
The agreements governing our indebtedness impose significant operating and financial restrictions on us. These restrictions prohibit or limit, among other things:
 
 
the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock;
 
 
the making of certain types of restricted payments, including investments and acquisitions;
 
 
the payment of dividends on our common stock;
 
 
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specified sales of assets;
 
 
specified transactions with affiliates;
 
 
the creation of a number of liens;
 
 
consolidations, mergers and transfers of all or substantially all of our assets; and
 
 
our ability to change the nature of our business.
 
We May Not Be Able to Integrate New Technologies and Provide New Services in a Cost-Efficient Manner.
 
The telecommunications industry is subject to rapid and significant changes in technology, frequent new service introductions and evolving industry standards. We cannot predict the effect of these changes on our competitive position, our capital expenditure requirements, our profitability or the industry generally. Technological developments may reduce the competitiveness of our networks and require additional capital expenditures or the procurement of additional products that could be expensive and time consuming to install and integrate into our network. In addition, new products and services arising out of technological developments may reduce the attractiveness of our services. If we fail to adapt successfully to technological advances or fail to obtain access to new technologies, we could lose customers and be limited in our ability to attract new customers and/or sell new services to our existing customers. In addition, delivery of new services in a cost-efficient manner depends upon many factors, and we may not generate the revenue anticipated from such services.
 
Disruptions in Our Networks and Infrastructure May Cause Us to Lose Customers and Incur Additional Expenses.
 
To be successful, we will need to continue to provide our customers with reliable and timely service over our networks. We face the following risks to our networks and infrastructure:
 
 
our territories could have significant weather events which physically damage access lines and network infrastructure;
 
 
our rural geography creates the risk of security breaches, break-ins and sabotage;
 
 
power surges and outages, computer viruses or hacking, and software or hardware defects which are beyond our control; and
 
 
unusual spikes in demand or capacity limitations in our or our suppliers’ networks.
 
Disruptions may cause interruptions in service or reduced capacity for customers, either of which could cause us to lose customers and/or incur expenses, and thereby adversely affect our business, revenue and cash flow. In addition, the APSC, MPUC, MDTC, MPSC, NHPUC, VPSB and/or WVPSC could require us to issue credits on customer bills for such service interruptions, further impacting revenue and cash flow. Wholesale network contracts could impose service level penalties for service disruptions.
 
Our Operating Activities Are Subject to Risks Caused by Misappropriation, Misuse, Leakage, Falsification and Accidental Release or Loss of Information Maintained in Our Information Technology Systems.
 
Our operating activities are subject to risks caused by misappropriation, misuse, leakage, falsification and accidental release or loss of information maintained in our information technology systems, including customer, personnel and vendor data. We could be exposed to significant costs if such risks were to materialize, and such events could damage the reputation and credibility of us and our business and have a negative impact on our revenues. We could also be required to expend significant capital and other resources to remedy any such security breach.
 
Our Business is Geographically Concentrated and Dependent on Regional Economic Conditions.
 
Our business is conducted primarily in north central Alabama, Maine, New Hampshire, western Massachusetts, central Missouri, western Vermont and southern West Virginia and, accordingly, our business is dependent upon the general economic conditions of these regions. There can be no assurance that future economic conditions in these regions, including as a result of the recent global economic downturn, will not impact demand for our services or cause residents to relocate to other regions, which may adversely impact our business, revenue and cash flow.
 
 
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Our Success Depends on a Small Number of Key Personnel.
 
Our success depends on the personal efforts of a small group of skilled employees and senior management. The rural nature of much of our service area provides for a smaller pool of skilled telephone employees and increases the challenge of hiring employees. The loss of key personnel could have a material adverse effect on our financial performance.
 
We Provide Services to Our Customers Over Access Lines, and if We Lose Access Lines, Our Business and Results of Operations May Be Adversely Affected.
 
Our business generates revenue by delivering voice and data services over access lines. We have experienced net voice access line loss in our RLEC territories due to challenging economic conditions, wireless substitution, loss of second lines and increased competition. RLEC voice access lines, adjusted for the acquisition of Shoreham, declined by approximately 5.4% during 2011. We expect to continue to experience net voice access line loss in our rural markets. If voice access line losses are not substantially offset by data access line gains, it could adversely affect our business and results of operations.
 
Our Performance Is Subject to a Number of Other Economic and Non-Economic Factors, Which We May Not Be Able to Predict Accurately.
 
There are factors that may be beyond our control that could affect our operations and business. Such factors include adverse changes in the conditions in the specific markets for our products and services, the conditions in the broader market for telecommunications services and the conditions in the domestic and global economies, generally.
 
Although our performance is affected by the general condition of the economy, not all of our services are affected equally. Voice access revenue is generally linked to relatively consistent variables such as population changes, housing starts and general economic activity levels in the areas served. Data access and cable television revenue is generally related to more variable factors such as changing levels of discretionary spending on entertainment and the adoption of e-commerce and other on-line activities by our current or prospective customers. It is not possible for management to accurately predict all of these factors and the impact of such factors on our performance.
 
Changes in the competitive, technological and regulatory environments may also impact our ability to increase revenue and/or earnings from the provision of local wireline services. We may therefore have to place increased emphasis on developing and realizing revenue through the provision of new and enhanced services with higher growth potential. In such a case, there is a risk that these revenue sources as well as our cost savings efforts through further efficiency gains will not grow or develop at a fast enough pace to offset slowing growth in local services. It is also possible that as we invest in new technologies and services, demand for those new services may not develop. There can be no assurance that we will be able to successfully expand our service offerings through the development of new services, and our efforts to do so may have a material adverse effect on our financial performance.
 
Governmental Authorities Could Decrease Network Access Charges or Rates for Local Services, Which Would Adversely Affect Our Revenue.
 
Approximately 10.1% of our revenue for the year ended December 31, 2011 was derived from interstate network access charges paid by long distance carriers for use of our facilities to originate and terminate interstate and intrastate telephone calls. The interstate network access rates that we can charge are regulated by the FCC, and the intrastate network access rates that we can charge are regulated by the regulatory commissions in each state in which we operate. Those rates may change from time to time. The FCC has reformed and continues to reform the federal network access charge system, including proposed changes intended to promote deployment of broadband data services. In October 2011, the FCC released the FCC Order, which will reduce access revenue received by us beginning as soon as 2012. The FCC Order requires the phase down of our intrastate access rates to interstate levels by July 1, 2013 with rates transitioning to zero by July 1, 2020. It is unknown at this time what additional changes, if any, the FCC or state regulatory commissions may adopt. Such regulatory developments could adversely affect our business, revenue and cash flow.
 
The local services rates and intrastate access fees charged by our rural local exchange carriers are regulated by state regulatory commissions which have the power to grant and revoke authorization to companies to provide telecommunications services and to impose other conditions and penalties. If we fail to comply with regulations set forth by the state regulatory commissions, we may face revocation of our authorizations in a state or other conditions and penalties. It is possible that new plans would require us to reduce our rates, forego future rate increases, provide greater features as part of our basic service plan or limit our rates for certain offerings. We cannot predict the ultimate impact, if any, of such changes on our business, revenue and cash flow.
 
Our RLECs operating in Maine, Massachusetts, Missouri, Vermont and West Virginia charge rates for local services and intrastate access service based in part upon a rate-of-return authorized by the state regulatory commissions. These authorized rates are
 
 
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subject to audit at any time and may be reduced if the regulatory commission finds them excessive. If any company is ordered to reduce its rates or if its applications to increase rates are denied or delayed, our business, revenue and cash flow may be negatively impacted.
 
The NECA may file revisions to its average schedule formula each year which are subject to FCC approval. Six of our subsidiaries participate in average schedule rates. The FCC Order contains provisions which extend limits on corporate operations expense to the Interstate Common Line Support portions of the USF HCL, which will reduce the level of funding some of our operating subsidiaries receive by approximately $0.1 million.
 
A Reduction in Universal Service Fund High Cost Loop Support Would Adversely Affect Our Business, Revenue and Cash Flow.
 
Six of our RLECs receive federal USF HCL revenue to support their high cost of operations. Such support payments represented approximately 4.0% of our revenue for the year ended December 31, 2011, and were based upon each participating rural local exchange carrier’s average cost per loop as compared to the national average cost per loop. These support payments fluctuate based upon the historical costs of our participating rural local exchange carriers as compared to the national average cost per loop. Each year, the average cost per loop has increased, putting pressure on the USF HCL funds received by our companies to the extent that our costs do not increase at the same rate. If our participating rural local exchange carriers are unable to receive support from the USF HCL, or if such support is reduced, our business, revenue and cash flow would be negatively affected.
 
On October 27, 2011, the FCC adopted the FCC Order reforming the current high-cost universal support rules. The FCC Order places limits on certain operating expenses that can be recovered from the Universal Service Fund, or USF, and places additional service requirements to be eligible to receive USF HCL support. The FCC has yet to issue orders addressing all aspects of the high-cost universal support which could affect the amount of USF HCL support we receive. We cannot predict the total impact these orders could have on USF HCL support. The outcome of any future FCC proceedings and other regulatory or legislative changes could affect the amount of USF HCL support that we receive, and could have an adverse effect on our business, revenue and cash flow. If a wireless or other telecommunications carrier receives ETC status in our service areas or even outside of our service areas, the amount of support we receive from the USF HCL could decline under current rules, and under some proposed USF HCL rule changes, could be significantly reduced.
 
USAC serves as the administrative agent to collect data and distribute funds for USF. In 2006, it began conducting High Cost Beneficiary audits, designed to ensure compliance with FCC rules and program requirements and to assist in program compliance. Carriers are chosen from a random sample of each type of ETC, including average schedule and cost companies, incumbents and competitors, and rural and non-rural, from various states. Audits are designed to ensure proper designation of a carrier as ETC, accuracy of data submissions, documentation of accounting procedures, physical inventory of assets, true-up of projected data, and samples of detailed documentation (for example, invoices, continuing property records). Audits of Blountsville, Hopper, Granby, Otelco Telephone and Brindlee Mountain Telephone, initiated during 2007 and 2008, have been completed and no material action is pending. These audits were conducted widely across our industry as directed by the FCC. There is no guidance on the likelihood of the continuation of the audit process currently available.
 
If We Were to Lose Our Protected Status Under Interconnection Rules, We Would Incur Additional Administrative and Regulatory Expenses and Face More Competition.
 
As a “rural telephone company” under the Communications Act, each of our RLECs is exempt from the obligation to lease its unbundled facilities to competitive local exchange carriers, to offer retail services at wholesale prices for resale, to permit competitive co-location at its facilities and to comply with certain other requirements applicable to larger incumbent local exchange carriers. However, we eventually may be required to comply with these requirements in some or all of our service areas if: (i) we receive a bona fide request from a telecommunications carrier; and (ii) the state regulatory commissions, as applicable, determine that it is in the public interest to impose such requirements. In addition, we may be required to comply with some or all of these requirements in order to achieve greater pricing flexibility from state regulators. If we are required to comply with these requirements, we could incur additional administrative and regulatory expenses and face more competition which could adversely affect our business, revenue and cash flow.
 
Our Current Dividend Policy May Negatively Impact Our Ability to Maintain or Expand Our Network Infrastructure and Finance Capital Expenditures or Operations.
 
Our board of directors has adopted a dividend policy pursuant to which a significant portion of the cash generated by our business in excess of operating needs, interest and principal payments on indebtedness, and capital expenditures sufficient to maintain our network infrastructure, would in general be distributed as regular quarterly cash dividends to the holders of our common stock and not retained by us. As a result, we may not have sufficient cash to fund our operations in the event of a significant business downturn,
 
 
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finance growth of our network or unanticipated capital expenditure needs. We may have to forego growth opportunities or capital expenditures that would otherwise be necessary or desirable if we do not find alternative sources of financing or if we do not modify our dividend policy. If we do not have sufficient cash for these purposes, our financial condition and our business will suffer or our board of directors may change our dividend policy.
 
Unresolved Staff Comments
                      
None.
 
Properties
 
Our property consists primarily of land and buildings; central office, internet and cable equipment; computer software; telephone lines; and related equipment. Our telephone lines include aerial and underground cable, conduit, poles and wires. Our central office equipment includes digital and software defined switches, internet and other servers and related peripheral equipment. We own substantially all our real property in Alabama, Missouri and Vermont, including our corporate office. We primarily lease real property in Maine, Massachusetts, New Hampshire and West Virginia, including our primary office locations in Bangor, New Gloucester and Portland, Maine; Granby, Massachusetts; Bedford, New Hampshire; and War, West Virginia. We also lease certain other real property, including land in Oneonta, Alabama, pursuant to a long-term, renewable lease. A small portion of our Alabama cable television service equipment is located on this leased property. As of December 31, 2011, our property and equipment consisted of the following:
 
   
(In Thousands)
Land
  $         1,157  
Buildings and improvements
           12,247  
Telephone equipment
        227,826  
Cable television equipment
          10,918  
Furniture and equipment
            2,967  
Vehicles
             6,090  
Computer software and equipment
            15,591  
Internet equipment
             3,923  
Total property and equipment
         280,719  
Accumulated depreciation
    (214,837 )
Net property and equipment
  $        65,882  
 
Our senior credit facility is secured by substantially all of the assets of our subsidiaries that are guarantors of the senior credit facility. As of December 31, 2011, the subsidiary guarantors represented $64.5 million of the $65.9 million in net property and equipment.
 
Legal Proceedings
 
From time to time, we may be involved in various claims, legal actions and regulatory proceedings incidental to and in the ordinary course of business, including administrative hearings of the APSC, MPUC, MDTC, MPSC, NHPUC, VPSB and WVPSC relating primarily to rate making and customer service requirements. Currently, none of the legal proceedings are expected to have a material adverse effect on our business.
 
Mine Safety Disclosures
 
Not applicable.
 
Executive Officers of the Registrant
             
The following table sets forth the names and positions of our executive officers and certain other officers, and their ages as of December 31, 2011.
 
 
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Name
 
Age
 
Position
 
 
Michael D. Weaver
 
59
 
President, Chief Executive Officer and Director
 
 
Curtis L. Garner, Jr.
 
64
 
Chief Financial Officer
 
 
Dennis Andrews
 
55
 
Senior Vice President and General Manager, Alabama
 
 
Jerry C. Boles
 
59
 
Senior Vice President and Controller
 
 
E. Todd Wessing
 
46
 
Vice President and General Manager, Missouri
 
 
Jon C. P. Henderson
 
39
 
Senior Vice President, New England CLEC Sales
 
 
Robert J. Souza
 
58
 
Senior Vice President, New England Operations
 
 
Edwin D. Tisdale
 
52
 
Senior Vice President, New England RLEC
 
 
Michael D. Weaver has served as our President, Chief Executive Officer and a Director since January 1999. Prior to this time, he spent 10 years with Oneonta Telephone Co., Inc., the predecessor to Otelco Telephone, serving as Chief Financial Officer from 1990 to 1998 and General Manager from January 1998 to January 1999.
 
Curtis L. Garner, Jr. has served as our Chief Financial Officer since February 2004. Prior to this position, he provided consulting services to a number of businesses and not-for-profit organizations from October 2002. He served PTEK Holdings, Inc. from November 1997 through September 2002 (including one year as a consultant), first as President of one of its divisions, and later as Chief Administrative Officer for another division. Prior thereto, he spent 26 years at AT&T Corp., retiring in 1997 as the Chief Financial Officer of the Southern and Southwestern Regions of AT&T Corp.’s consumer long distance business.
 
Dennis Andrews was appointed Senior Vice President and General Manager of our Alabama division in August 2006. He served as our Vice President and General Manager, Brindlee and Blountsville since November 2005 and Vice President — Regulatory Affairs since July 2000. Prior to this position, he spent 21 years at Brindlee where he held several positions, including Vice President — Finance, General Manager, Operations Manager and Accounting Department Manager.
 
Jerry C. Boles became our Senior Vice President and Controller in July 2010. He joined Otelco in January 1999 as Vice President and Controller. Prior to joining Otelco, he was controller for McPherson Oil Company for 14 years. He also worked in public accounting for 10 years, is licensed as a CPA by the state of Alabama, and is a member in good standing of the American Institute of Certified Public Accountants.
 
E. Todd Wessing was appointed as our Vice President and General Manager for Missouri in December 2010. He has worked for the Company (or its predecessor prior to being acquired by Otelco in 2004) since 1988 with experience in outside plant maintenance and installation; construction; and central office switching.
 
Jon C. P. Henderson became our Senior Vice President for New England CLEC Sales in July 2011. He joined Otelco in July 2006 as the Director of Sales and Marketing of our New England division (previously known as our Maine division). From 1999 until its acquisition by Otelco in 2006, he served in various leadership positions in the sales organization of Mid-Maine, building its successful competitive sales team.
 
Robert J. Souza became our Senior Vice President for New England Operations in July 2010. He joined Otelco in October 2008 as the Vice President of Operations for New England. He served as President for the CR Companies from 2001 until they were acquired by Otelco in October 2008. Prior to that role, he served as Operations Manager for Saco River, having joined that company in 1983. His 35 years experience in the industry includes three years with Ooltewah-Collegedale Telephone Company in Tennessee and five years with New England Telephone in Maine.
 
Edwin D. Tisdale has served as our Senior Vice President for New England RLECs since July of 2010 and as Vice President for New England Support Services from November 2008 to 2010. From 1996 until October 2008, he served as General Manager of Pine Tree and Chief Financial Officer of the CR Companies until they were acquired by Otelco. Prior to that time, he worked in banking and real estate.
 
Officers are not elected for a fixed term of office but hold their position until a successor is named.
 
 
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Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
Market Information
 
Our IDSs, each representing one share of common stock and $7.50 principal amount of senior subordinated notes due 2019, trade on the NASDAQ Global Market, or NASDAQ, under the symbol “OTT” and on the Toronto Stock Exchange under the symbol “OTT.un.” The high and low closing sales prices for the IDSs on NASDAQ during the quarters indicated are as follows:
 
   
High ($US)
   
Low ($US)
 
2011
           
Fourth Quarter
  $ 16.72     $ 13.50  
Third Quarter
  $ 18.47     $ 14.40  
Second Quarter
  $ 19.65     $ 17.27  
First Quarter
  $ 20.30     $ 18.18  
2010
               
Fourth Quarter
  $ 18.80     $ 15.33  
Third Quarter
  $ 16.10     $ 13.80  
Second Quarter
  $ 16.98     $ 14.41  
First Quarter
  $ 16.87     $ 13.82  
 
Holders
 
As of March 5, 2012, there were approximately 16,250 record holders of our IDSs. Holders of our IDSs have the right to separate the IDSs into the shares of common stock and senior subordinated notes represented thereby. As of the date of this report, no holder has elected to separate the IDSs.
 
Dividends
 
The board of directors declared and the Company paid dividends of $0.17625 per common share each quarter in 2009, 2010 and 2011 for a total of $0.705 per share for each year. For 2009, 2010 and 2011, all of the dividends were considered a non-taxable return of capital. The Company has paid dividends each quarter since the completion of its initial public offering in December 2004.
 
Our board of directors has adopted a dividend policy for our common stock pursuant to which, in the event and to the extent we have any available cash for distribution to the holders of shares of our common stock and subject to applicable law and the terms of our credit facility, the indenture governing our senior subordinated notes and any other then outstanding indebtedness of ours, our board of directors will declare cash dividends on our common stock. Our dividend policy reflects a basic judgment that our stockholders would be well served by distributing cash available after business requirements in the form of dividends rather than retaining it. Under this dividend policy, cash generated by our business in excess of operating needs, principal and interest payments on indebtedness, capital expenditures and income taxes would in general be distributed as regular quarterly dividends to the holders of our common stock rather than retained by us as cash on our consolidated balance sheet. In determining our expected dividend levels, we review and analyze, among other things, our operating and financial performance; the anticipated cash requirements associated with our capital structure; our anticipated capital expenditure requirements; our expected other cash needs; the terms of our debt instruments, including our credit facility; changes in the financial market requirements associated with our industry; other potential sources of liquidity; and various other aspects of our business. As these factors change, the board will regularly reassess our dividend policy.
 
As described more fully below, holders of our common stock may not receive any dividends as a result of the following factors:
 
 
nothing requires us to pay dividends;
 
 
while our current dividend policy contemplates the distribution of our available cash, this policy could be modified or revoked at any time;
 
 
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even if our dividend policy were not modified or revoked, the actual amount of dividends distributed under the policy and the decision to make any distribution is entirely at the discretion of our board of directors;
 
 
the amount of dividends distributed is subject to covenant restrictions in our indenture and our credit facility, and may also be impacted by our decision to repay indebtedness;
 
 
the amount of dividends distributed is subject to state law restrictions;
 
 
our stockholders have no contractual or other legal right to dividends; and
 
 
we may not have enough cash to pay dividends due to changes to our operating earnings, working capital requirements, debt leverage and amortization requirements and anticipated cash needs.
 
Dividends on our common stock will not be cumulative. Consequently, if dividends on our common stock are not declared and/or paid at the current level, our stockholders will not be entitled to receive such payments in the future.
 
Our board of directors will, in its sole discretion, decide to use cash generated to fund capital expenditures or acquisitions, repay indebtedness, pay dividends or for general corporate purposes.
 
Restrictions on Payment of Dividends
 
The indenture governing our senior subordinated notes restricts our ability to declare and pay dividends on our common stock as follows:
 
 
we may only pay dividends in any given fiscal quarter that are less than 100% of our excess cash for the period from and including the first fiscal quarter beginning after the date of the indenture to the end of our most recently ended fiscal quarter for which internal financial statements are available at the time of such payment. “Excess Cash” means with respect to any period, Adjusted EBITDA, as defined in the indenture, minus the sum of (i) cash interest expense, (ii) capital expenditures and (iii) cash income tax expense, in each case, for such period;
 
 
we may not pay dividends if our interest coverage ratio, which is defined as Adjusted EBITDA divided by consolidated interest expense, is below 1.4 times;
 
 
we may not pay any dividends if not permitted under any of our senior indebtedness;
 
 
we may not pay any dividends while interest on the senior subordinated notes is being deferred or, after the end of any interest deferral, so long as any deferred interest has not been paid in full; and
 
 
we may not pay any dividends if a default or event of default under the indenture governing the senior subordinated notes has occurred and is continuing.
 
Our credit facility does not allow us to pay dividends on our common stock unless we maintain:
 
 
a “fixed charge coverage ratio” (defined as our Consolidated EBITDA, as defined in the credit facility, for any period of four consecutive fiscal quarters divided by the sum of certain capital expenditures, cash income taxes, the aggregate amount of cash interest expense and scheduled principal payments for such period) of not less than 1.14 times; and
 
 
a “senior leverage ratio” (defined as senior secured debt as of the last day of any period divided by our Consolidated EBITDA, as defined in the credit facility, for any period of four consecutive fiscal quarters) of not more than 3.85 times.
 
In addition, our credit facility does not allow us to pay dividends on our common stock if and for as long as (a) interest payments on our senior subordinated notes are required to be deferred pursuant to the terms of the credit facility, (b) any default or event of default exists under the credit facility, (c) deferred interest or interest on deferred interest is outstanding under our senior subordinated notes, (d) a compliance certificate for the prior fiscal quarter has not been timely delivered or (e) there is insufficient excess cash, as defined in the credit facility.
 
 
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Securities Authorized for Issuance under Equity Compensation Plans
 
No securities have been issued under any equity compensation plan and no such plan is currently in place.
 
Recent Sales of Unregistered Securities
 
During the fiscal year ended December 31, 2011, we did not issue any unregistered securities.
 
Performance Graph
 
The following graph compares the cumulative total stockholder return (stock price appreciation plus reinvested dividends) for our shares of common stock (represented by IDSs) with the cumulative total return (including reinvested dividends) of the Russell 2000 Index, or Russell 2000, and the Standard & Poor’s — Telecommunications Services Index, or S&P Telecommunications Services, assuming a $100 investment on December 31, 2006 through December 31, 2011:
 
 (LINE GRAPH)
 
 
17

 
 
Cumulative Stockholder Returns on $100 Invested:
 
      12/06       12/07       12/08       12/09       12/10       12/11  
                                                 
Otelco Inc.
  $ 100.00     $ 68.56     $ 42.52     $ 96.71     $ 130.00     $ 109.11  
Russell 2000
  $ 100.00     $ 98.43     $ 65.18     $ 82.89     $ 105.14     $ 100.75  
S&P Telecommunication Services
  $ 100.00     $ 111.94     $ 77.81     $ 84.76     $ 100.83     $ 107.15  
 
Selected Financial Data
 
The following table sets forth our selected consolidated financial and other information. The consolidated financial information as of December 31, 2010 and 2011 and for each of the three years in the period ended December 31, 2011 has been derived from, and should be read together with, our audited consolidated financial statements and the accompanying notes included in Item 8 of this report. The consolidated financial information as of December 31, 2007, 2008 and 2009 and for each of the two years in the period ended December 31, 2008 has been derived from our audited consolidated financial statements not included in this report. The consolidated financial information set forth should be read in conjunction with, and is qualified in its entirety by reference to, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 and our audited consolidated financial statements and related notes in Item 8 of this report.
 
   
At and For The Year Ended December 31,
   
2007
   
2008(1)
   
2009
   
2010
 
2011(1)
   
(In Thousands Except Per Share Amounts)
Income Statement Data
                         
Revenues:
                         
Local services
  $  26,102     $   30,014     $   48,441     $ 49,014     $  47,463  
Network access
     25,671         27,281         33,297       32,982        32,128  
Cable television
       2,184           2,389           2,489       2,799       2,981  
Internet
     11,517         12,449         14,027        14,015        13,946  
Transport services
    4,275           4,982           5,501       5,590       5,326  
Total
  $  69,749     $ 77,115     $ 103,755     $ 104,400     $ 101,844  
Income from operations
  $  19,265     $ 21,087     $  21,927     $ 26,369     $  24,630  
Income (loss) before income tax
  $ (195   $ 243     $    (4,484   $ 1,301     $    2,447  
Net income (loss) available to common stockholders
  $ 179     $ 214     $    (3,118   $ 691     $ 2,197  
Net income (loss) per common share
                                       
Basic
  $ 0.02     $ 0.02     $     (0.25   $ 0.05     $ 0.17  
Diluted
  $ (0.10   $ (0.03   $     (0.25   $ 0.05     $ 0.17  
Dividends declared per share
  $ 0.71     $ 0.71     $      0.71     $ 0.71     $ 0.71  
Balance Sheet Data
                                     
Cash and cash equivalents
  $ 12,810     $ 13,542     $  17,731     $   18,226     $  12,394  
Property and equipment, net
    54,610       75,407         69,029         63,887        65,882  
Total assets
    232,486       355,541       337,528       322,136       317,724  
Long-term notes payable (including current portion)
    170,020       278,800       273,717       271,596       271,106  
 
(1)
During fiscal 2008 and 2011, we acquired the CR Companies and Shoreham, respectively. More information about each acquisition can be found in Item 1 of this report.
 
 
18

 
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Overview
 
General
 
Since 1999, we have acquired and operate eleven 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 seven of the rural communities we serve. We also operate a CLEC serving subscribers in 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 products and services as one company and therefore have identified one reporting segment as it relates to providing segment information. As of December 31, 2011, we operated 102,378 voice and data access lines, or access line equivalents, and supplied an additional 157,144 wholesale network connections.
 
Our core business is providing 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 business generated approximately 78.2% of our total revenues in 2011. 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 consolidated financial statements and the related notes, included in Item 8, and the other financial information appearing elsewhere in this report. The following discussion and analysis relates to our financial condition and results of operations on a consolidated basis, including the acquisition of Shoreham as of October 14, 2011 and through December 31, 2011.
 
Impact of Indebtedness Levels on our Results of Operations and Liquidity
 
As a result of the significant amount of debt we have outstanding through our senior credit facility, the senior subordinated note portion of the outstanding IDSs, and the senior subordinated notes held separately (not in the form of IDSs), our interest expense remains at a significantly high level. We entered into interest rate swap agreements to cover the majority of borrowings under the senior credit facility to protect against interest rate swings through February 8, 2012. The senior credit facility does not require scheduled principal payments. In August 2009, November 2010 and May 2011, we made voluntary prepayments totaling $11.5 million to reduce our senior credit facility. Our senior credit facility matures on October 31, 2013.
 
Our board of directors has adopted a dividend policy for our common stock pursuant to which, in the event and to the extent we have any available cash for distribution to the holders of shares of our common stock and subject to applicable law and terms of our then existing indebtedness, our board of directors will declare cash dividends on our common stock. The cash available for dividend payments may be impacted by our high levels of indebtedness and related debt service requirements discussed above. The cash requirements of our business are funded through cash flow generated from the operations of our business. We also have access to a $15.0 million revolving credit facility to supplement our liquidity position as needed.
 
There can be no assurance that we will have sufficient cash in the future to pay dividends on our common stock at the historical rate or at all. If we do not generate sufficient cash from our operating activities in the future to pay dividends, we may have to reduce or eliminate dividends. However, if we use working capital to fund dividends, we would have less cash available to pursue growth opportunities such as the introduction of new services and the acquisition of other telecommunications companies, or to respond to unanticipated events such as the failure of a portion of our switching or network facilities. If we do not have sufficient cash to finance growth opportunities or capital expenditures that would otherwise be necessary or desirable, and cannot find alternative sources of financing, our financial condition and our business will suffer.
 
Our high indebtedness levels and related debt service requirements, our current dividend policy and our capital expenditure requirements will significantly limit any cash available from operations for other uses for the foreseeable future.
 
Revenue Sources
 
We derive our revenues 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
 
 
19

 
 
 
 
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, wireless 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, Massachusetts, Maine, Missouri, New Hampshire, Vermont and West Virginia are based on rates approved by the APSC, MDTC, MPUC, MPSC, NHPUC, VPSB and WVPSC, respectively, where appropriate. Switched and special access charges for interstate and international services are based on rates approved by the FCC.
 
 
Cable television. We offer basic, digital, high-definition, digital video recording, VOD and pay per view cable television services to a portion of our telephone service territory in Alabama, including IPTV. We are a reseller of satellite services for DirecTV.
 
 
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 Services. We receive monthly recurring revenues for the rental of fiber to transport data and other telecommunications services in Maine and New Hampshire.
 
Access Line and Customer Trends
 
The number of voice and data 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 when normalized for territory acquisitions. We expect that this trend will continue, and may be further impacted by the continuing effect of the economy on our customers and the availability of alternative wireless data products. These trends will be partially offset by the growth of data access lines, also called digital high-speed internet access service. Our ability to grow CLEC voice and data lines 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 new IP technology services to our competitive customer base.
 
Key Operating Statistics
 
 
                           
Quarterly
       
                            % Change        
                September     December    
September 30-
    Annual  
   
December 31,
     30,      31,     December 31,     % Change  
   
2009
   
2010
     2011      2011(2)      2011      2010-2011  
Otelco access line equivalents(1)
    100,356       99,639       97,958       102,378       4.5 %     2.7 %
                                                 
RLEC and other services:
                                               
Voice access lines
    48,215       45,461       43,444       46,202       6.3 %     1.6 %
Data access lines
    20,066       20,852       21,162       22,904       8.2 %     9.8 %
Access line equivalents(1)
    68,281       66,313       64,606       69,106       7.0 %     4.2 %
Cable television customers
    4,195       4,227       4,156       4,201       1.1 %     (0.6 )%
Satellite television customers
    100       125       224       226       0.9 %     1.5 %
Additional internet customers
    9,116       6,975       5,654       5,414       (4.2 )%     (22.4 )%
RLEC dial-up
    786       393       274       301       9.9 %     (23.4 )%
Other dial-up
    6,439       4,300       3,085       2,797       (9.3 )%     (35.0 )%
Other data lines
    1,891       2,282       2,295       2,316       0.9 %     1.5 %
                                                 
CLEC:
                                               
Voice access lines
    28,647       29,944       30,145       30,189       0.1 %     0.8 %
Data access lines
    3,428       3,382       3,207       3,083       (3.9 )%     (8.8 )%
Access line equivalents(1)
    32,075       33,326       33,352       33,272       (0.2 )%     (0.2 )%
Wholesale network connections
    132,324       149,043       155,691       157,144       0.9 %     5.5 %
 
 
20

 
 
    For the Years Ended
December 31,
 
Annual Change 
2010-2011
 
      2009     2010     2011  
Amount
 
Percent
 
Total revenues (in millions):
  $ 103.8     $ 104.4     $ 101.8     $ 2.6       (2.5 )%  
RLEC
  $ 60.8     $ 58.1     $ 57.4     $ (0.7 )     (1.2 )%  
CLEC
  $ 43.0     $ 46.3     $ 44.4     $ (1.9 )     (4.1 )%  
 
(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 Shoreham 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 as of December 31, 2011.
 
For 2011, RLEC access line equivalents grew 4.2%, reflecting the acquisition of Shoreham. CLEC access line equivalents declined 0.2%, although we installed more than 2,100 seats of our new IP based Hosted PBX offering. We are the primary long distance provider for our customers, serving approximately 63% of our RLEC customer base and virtually all of our CLEC customers. The expansion of IPTV in our Alabama markets and the addition of VOD services contributed to an increase of 243 television customers in Alabama. We converted our cable customers in Missouri to DirecTV, more than offsetting this subscriber growth in Alabama.
 
We continued our strategy of growing our penetration of the competitive markets in Maine and New Hampshire, adding eight new collocation sites during 2011. At the same time, we expect to maintain RLEC revenues by cross-selling to our existing customer base, using bundled service packages including unlimited long distance and adding new services as they become available. Our growth in data access lines to provide digital high-speed internet access will continue as customers increase the use of available content and new services.
 
We provide dial-up internet on a statewide basis in Maine and Missouri. We expect that our dial-up internet customers will continue to migrate to data access lines as growth in broadband services continues. In Missouri, we provide data access lines for digital high-speed internet in selected areas outside of our telephone service territory. This data service offering had 1,891, 2,282 and 2,295 customers in 2009, 2010 and 2011, respectively, of the additional internet customers noted in the table above.
 
The following is a discussion of the major factors affecting our access line count:
 
Cyclical Economic and Industry Factors. We believe that changes in global economic conditions have and will continue to have an impact on voice access line count. The rural nature of much of the territory we serve delayed the economy’s impact on our customer base and we expect any national recovery to also lag in its impact on our business.
 
Competition. There are currently no wireline telephone competitors operating within the majority of our RLEC territories. Where wireline competition exists, it comes from the incumbent cable company and has a negative impact on voice access lines. We have also experienced access line losses to wireless carrier substitution, though the impact is reduced due in part to the topography of a portion of our telephone territories and inconsistent wireless coverage. We have responded to competition by offering bundled service packages which include unlimited domestic calling; features like voice mail and caller identification; data access lines; and, where possible, television services. These service bundles are designed to meet the broader communications needs of our customers at industry competitive prices. There are a number of established competitive providers in our Maine and New Hampshire CLEC markets. The effectiveness of our sales force and the pricing of our products are critical to our success in these markets.
 
Acquisition. In 2011, we purchased Shoreham, an RLEC that serves portions of Addison county in western Vermont.
 
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 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 and Vermont, three of our wholly owned subsidiaries, Saco River, Shoreham and Pine Tree, 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 the ability to adjust prices. With the increase of bundled
 
 
21

 
 
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.
 
Alabama and Maine have state service funds which were implemented over the last 15 years as part of balancing local service pricing and long distance access rates. These funds were intended to neutralize the revenue impact on state RLECs from pricing shifts implemented to reduce access rates over time. The Alabama Transition Service Fund and the MUSF provided total compensation of $3.1 million, representing 3.1% of our total revenue for the year ended December 31, 2011. The revenue we receive from these funds could be affected by the FCC’s efforts to make changes in their Intercarrier Compensation regulations or by the states’ regulatory authorities in response to federal changes.
 
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 (for example, legal fees) 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. Reductions over time in Universal Service Fund and Intercarrier Compensation payments based on FCC action in 2011 may not be fully offset by expense control.
 
Results of Operations
 
The following table sets forth our results of operations as a percentage of total revenues for the periods indicated. All results include acquisitions as of the date acquired.
 
 
22

 
 
   
Year Ended December 31,
 
   
2009
   
2010
   
2011
 
Revenues
                 
Local services
    46.7 %     46.9 %     46.6 %
Network access
    32.1       31.6       31.6  
Cable television
    2.4       2.7       2.9  
Internet
    13.5       13.4       13.7  
Transport services
    5.3       5.4       5.2  
Total revenues
    100.0 %     100.0 %     100.0 %
Operating expenses
                       
Cost of services
    39.7 %     39.5 %      43.2 %
Selling, general and administrative expenses
    13.7       12.5       12.7  
Depreciation and amortization
    25.5       22.7       19.9  
Total operating expenses
    78.9       74.7       75.8  
Income from operations
    21.1       25.3       24.2  
Other income (expense)
                       
Interest expense
    (24.5 )     (23.7 )     (24.3 )
Change in fair value of derivatives
    (1.3 )     (0.8 )     2.2  
Other income
    0.4       0.5       0.3  
Total other expenses
    (25.4 )     (24.0 )     (21.8 )
Income (loss) before income taxes
    (4.3 )     1.3       2.4  
Income tax (expense) benefit
    1.3       (0.6 )     (0.2 )
Net income (loss) available to common stockholders
    (3.0 )%     0.7 %     2.2 %
 
Year Ended December 31, 2011 Compared to Year Ended December 31, 2010
 
Total Revenues. Total revenues decreased 2.4% in 2011 to $101.8 million from $104.4 million in 2010. The table below provides the components of our revenues for 2011 compared to 2010.
 
   
Year Ended December 31,
 
Change
 
   
2010
 
2011
 
Amount
 
Percent
 
   
(Dollars in Thousands)
   
Local services
  $ 49,014     $ 47,463     $ (1,551 )     (3.2 )%  
Network access
    32,982       32,128       (854 )     (2.6 )  
Cable television
    2,799       2,981       182       6.5    
Internet
    14,015       13,946       (69 )     (0.5 )  
Transport services
    5,590       5,326       (264 )     (4.7 )  
Total
  $ 104,400     $ 101,844     $ (2,556 )     (2.4 )  
 
Local services. Local services revenue in 2011 decreased 3.2% to $47.5 million from $49.0 million in 2010. Shoreham accounted for an increase of $0.2 million. One-time recoveries during 2010 associated with the settlement of bankruptcy and intrastate traffic claims accounted for an increase of $0.5 million when compared with 2011. RLEC revenue, including bundled services such as long distance, decreased $1.0 million, reflecting the decline in voice access lines. Billing and collecting and directory advertising revenue declined $0.2 million.
 
Network access. Network access revenue in 2011 decreased 2.6% to $32.1 million from $33.0 million in 2010. Shoreham accounted for an increase of $0.3 million. One-time recoveries during 2010 associated with the settlement of bankruptcy and toll claims accounted for an increase of $0.4 million when compared with 2011. Interchange carrier compensation declined $0.7 million.
 
 
23

 
 
Cable television. Cable television revenue in 2011 increased 6.5% to $3.0 million from $2.8 million in 2010. The growth in IPTV and the conversion of basic services to high definition television, including digital video recording and VOD services in Alabama, accounted for an increase of $0.3 million. The conversion of our Missouri cable subscribers to satellite television reduced revenue by $0.1 million.
 
Internet. Internet revenue in 2011 decreased 0.5% to $13.9 million from $14.0 million in 2010. Shoreham accounted for an increase of $0.2 million. Fiber rental accounted for an increase of $0.1 million. These increases were more than offset by a decrease of $0.4 million associated with the loss of dial-up internet customers we serve outside of our territory, primarily in Maine where we are not able to offer them a high-speed data line alternative.
 
Transport services. Transport services revenue in 2011 decreased 2.4% to $5.3 million from $5.6 million in 2010. Changes in industry pricing for services over our fiber backbone network in Maine and New Hampshire accounted for the decline.
 
Operating expenses. Operating expenses for 2011 decreased 1.0% to $77.2 million from $78.0 million in 2010. This decrease was primarily attributable to the decrease in depreciation and amortization partially offset by higher service costs.
 
   
Year Ended December 31,
 
Change
 
   
2010
 
2011
 
Amount
 
Percent
 
   
(Dollars in Thousands)
   
Cost of services
  $ 41,286     $ 43,996     $ 2,710       6.6 %  
Selling, general and administrative expenses
    13,075       12,985       (90 )     (0.7 )  
Depreciation and amortization
    23,670       20,232       (3,438 )     (14.5 )  
Total
  $ 78,031     $ 77,213     $ (818 )     (1.0 )  
 
Cost of services. Cost of services increased 6.6% to $44.0 million in 2011 from $41.3 million in 2010. Shoreham accounted for an increase of $0.3 million. Expense reductions during 2010 associated with the settlement of bankruptcy and toll claims accounted for an increase of $1.7 million as they did not recur in 2011. Other increases included higher employee salaries of $0.9 million, including augmentation of the CLEC sales and services functions; increased cable expense for programming and growth of $0.2 million; and higher pole attachment costs of $0.2 million. The increase was partially offset by reductions in toll costs of $0.6 million.
 
Selling, general and administrative expenses. Selling, general and administrative expenses decreased 0.7% to $13.0 million in 2011 from $13.1 million in 2010. Shoreham accounted for an increase of $0.1 million. Recoveries during 2010 associated with the settlement of bankruptcy and toll claims accounted for an increase of $0.8 million as they did not recur in 2011. These increases were more than offset by lower employee costs of $0.5 million; property taxes of $0.2 million; sales commissions of $0.2 million; and insurance costs of $0.1 million.
 
Depreciation and amortization. Depreciation and amortization decreased 14.5% to $20.2 million in 2011 from $23.7 million in 2010. Shoreham accounted for an increase of $0.2 million. Amortization of the intangible assets associated with the acquisition of the CR Companies, including a covenant not to compete and the value of a large multi-year contract, accounted for a decrease of $1.2 million. The plant and equipment adjustment associated with the Mid-Maine acquisition was fully amortized in June 2011, reflecting a decrease of $0.4 million. The balance consisted of decreased depreciation of $2.0 million associated with the investment in our RLECs.
 
   
Year Ended December 31,
 
Change
 
   
2010
 
2011
 
Amount
 
Percent
 
   
(Dollars in Thousands)
   
Interest expense
  $ (24,747 )   $ (24,776 )   $ 29       0.1 %  
Change in fair value of derivatives
    (878 )     2,230       3,108      
NM
   
Other income
    557       363       (194     (34.8  
Income tax expense
    (610 )     (250     360       NM    
 
Interest expense. Interest expense in 2011 and 2010 was $24.7 million. Interest on senior debt for 2011 decreased $0.2 million on lower outstanding senior debt associated with the voluntary principal prepayments in 2010 and 2011. The interest on the
 
 
24

 
 
senior subordinated notes associated with the IDSs increased $0.2 million in 2011, reflecting the conversion of the outstanding Class B common stock to IDSs on June 8, 2010.
 
Change in fair value of derivatives. We had two interest rate swap agreements to hedge our exposure to changes in interest rate costs associated with our senior credit facility. From an accounting perspective, the documentation for both swaps did not meet the technical requirements to allow the swaps to be considered highly effective as hedging instruments and therefore the swaps did not qualify for hedge accounting. These swap agreements were required to be considered as investments and the change in value was reflected as a change in fair value of derivatives. During 2011, these swaps increased in value $2.2 million compared to a decrease in value of $0.9 million during 2010. Over the life of the swaps, the cumulative change in value was zero. Both swaps expired on February 8, 2012. See —Liquidity and Capital Resources below for additional explanation.
 
Other income. Other income in 2011 decreased 34.8% to $0.4 million from $0.6 million in 2010. This decrease was primarily attributable to a one-time heating system settlement in 2010 in Missouri of $0.1 million and lower interest income on our invested cash and lower dividends from CoBank of $0.1 million.
 
Income taxes. Provision for income tax expense in 2011 was $0.3 million compared to $0.6 million for 2010. In calculating the effective tax rate, the change in fair value of the derivatives associated with our two interest rate swaps is excluded as a permanent difference. This can cause the effective rate to vary between periods. The effective income tax rate was 46.9% and 10.2% for 2010 and 2011, respectively.
 
Net income. As a result of the foregoing, there was net income in 2011 of $2.2 million compared to net income in 2010 of $0.7 million.
 
Year Ended December 31, 2010 Compared to Year Ended December 31, 2009
 
Total Revenues. Total revenues grew 0.6% in 2010 to $104.4 million from $103.8 million in 2009. The table below provides the components of our revenues for 2010 compared to 2009.
 
   
Year Ended December 31,
   
Change
 
   
2009
   
2010
   
Amount
   
Percent
 
   
(Dollars in Thousands)
 
Local services
  $   48,441     $  49,014     $   573          1.2%  
Network access
      33,297        32,982         (315)       (0.9)  
Cable television
        2,489          2,799         310       12.5  
Internet
      14,027        14,015           (12)        (0.1)  
Transport services
        5,501          5,590           89        1.6  
Total
  $ 103,755     $ 104,400     $   645        0.6  
 
Local services. Local services revenue in 2010 grew 1.2% to $49.0 million from $48.4 million in 2009. This increase was attributable to an increase of $2.1 million from growth in our CLEC business in New England. RLEC revenue, including bundled services such as long distance, decreased $1.5 million, reflecting the decline in RLEC voice access lines and related services.
 
Network access. Network access revenue in 2010 decreased 0.9% to $33.0 million from $33.3 million in 2009. Increases in CLEC switched access of $1.3 million were more than offset by decreases of $1.4 million in RLEC access and $0.2 million in RLEC end user associated fees.
 
Cable television. Cable television revenue in 2010 increased 12.5% to $2.8 million from $2.5 million in 2009. The growth in high definition television, VOD and digital video recording services; IPTV subscribers; and basic service price increases in Alabama accounted for the increase.
 
Internet. Internet revenue was $14.0 million in both 2010 and 2009, although such revenue decreased by 0.1% in 2010. Increases of $0.6 million attributable to the addition of new high-speed internet data lines were offset by comparable decreases associated with the loss of dial-up internet customers, including those we serve outside of our territory, primarily in Maine where we are not able to offer a high-speed data line alternative.
 
 
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Transport services. Transport services revenue in 2010 increased 1.6% to $5.6 million from $5.5 million in 2009. The continued growth in wholesale transport revenue from CLEC customers in Maine and New Hampshire drove this increase.
 
Operating expenses. Operating expenses for 2010 decreased 4.6% to $78.0 million from $81.8 million in 2009. This decrease was primarily attributable to a reduction in amortization expense for intangibles and lower uncollectible revenue.
 
   
Year Ended December 31,
   
Change
 
   
2009
   
2010
   
Amount
   
Percent
 
   
(Dollars in Thousands)
 
Cost of services
  $ 41,179     $ 41,286     $     107             0.3%  
Selling, general and administrative expenses
    14,164       13,075       (1,089)         (7.7)  
Depreciation and amortization
    26,486       23,670       (2,816)       (10.6)  
Total
  $ 81,829     $ 78,031     $ (3,798)         (4.6)  
 
Cost of services. Cost of services increased 0.3% to $41.3 million in 2010 from $41.2 million in 2009. CLEC cost increases of $0.6 million in long distance and $0.2 million in customer service reflect the growth in CLEC revenue for the period. RLEC costs increased by $0.1 million for cable services but declined by an aggregate of $0.8 million in other expense categories, including pole rental, access costs and other operational synergies.
 
Selling, general and administrative expenses. Selling, general and administrative expenses decreased 7.7% to $13.1 million in 2010 from $14.2 million in 2009. Decreases in uncollectible billing of $0.6 million and provision for bad debt of $0.2 million; general and administrative expenses of $0.7 million; insurance premiums of $0.2 million; legal expenses of $0.2 million; and postage of $0.1 million were partially offset by increases in CLEC sales positions and commissions of $0.9 million.
 
Depreciation and amortization. Depreciation and amortization decreased 10.6% to $23.7 million in 2010 from $26.5 million in 2009. Amortization of the intangible assets associated with the acquisition of the CR Companies, including a covenant not to compete and the value of a large multi-year contract, accounted for a decrease of $2.2 million. The balance consisted of decreased depreciation of $0.8 million associated with the investment in our RLECs and an increase of $0.2 million associated with increased investment in our CLEC.
 
   
Year Ended December 31,
   
Change
 
   
2009
   
2010
   
Amount
   
Percent
 
   
(Dollars in Thousands)
 
Interest expense
  $ (25,416)     $ (24,747)     $     (669)          (2.6)%  
Change in fair value of derivatives
       (1,354)             (878)           476      
NM
 
Other income
         359            557           198       55.2  
Income tax (expense) benefit
      1,367             (610)        (1,977)      
NM
 
 
Interest expense. Interest expense in 2010 decreased 2.6% to $24.7 million from $25.4 million in 2009. Non-cash interest caplet expense associated with the recognition of the cost of the five year interest rate cap purchased at the time of the initial public offering was $1.2 million in 2009. The interest rate cap expired at the end of 2009, resulting in no comparable expense in 2010, or a decrease of $1.2 million. Interest on senior debt increased by $0.2 million as interest rate swap costs increased, partially offset by the lower outstanding principal balance under our senior credit facility resulting from the two voluntary prepayments made in 2009 and 2010. The interest on the senior subordinated notes associated with the IDSs increased $0.3 million, reflecting the conversion of the outstanding Class B common stock to IDSs on June 8, 2010.
 
Change in fair value of derivatives. We had two interest rate swap agreements to hedge our exposure to changes in interest rate costs associated with our senior credit facility. From an accounting perspective, the documentation for both swaps did not meet the technical requirements to allow the swaps to be considered highly effective as hedging instruments and therefore the swaps did not qualify for hedge accounting. The value of the swap liability increased in 2010, as interest rates remained at historic lows, but the increase in liability was $0.5 million lower than was experienced in 2009. Over the life of the swaps, the cumulative change in value was zero. Both swaps expired on February 8, 2012. See —Liquidity and Capital Resources below for additional explanation
 
 
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Other income. Other income in 2010 increased 55.2% to $0.6 million from $0.4 million in 2009. An increase in dividends from CoBank accounted for $0.1 million and an increase in interest income on our invested cash accounted for the balance.
 
Income taxes. Provision for income taxes in 2010 was an expense of $0.6 million compared to a benefit of $1.4 million for 2009. In calculating the effective tax rate, the change in fair value of the derivatives associated with our two interest rate swaps are excluded as permanent differences. This can cause the effective rate to vary between periods. The effective income tax rate was 30.5% and 46.9% for 2009 and 2010, respectively.
 
Net income (loss). As a result of the foregoing, there was net income in 2010 of $0.7 million compared to a net loss in 2009 of $3.1 million.
 
Liquidity and Capital Resources
 
Our liquidity needs arise primarily from: (i) interest payments related to our credit facility and our senior subordinated notes; (ii) capital expenditures for investment in our business; (iii) working capital requirements; (iv) dividend payments on our common stock, when declared by our board of directors; and (v) potential acquisitions.
 
Cash flows from operating activities for 2011 were $19.5 million compared to $26.4 million for 2010. See the table below regarding cash generation and cash utilization.
 
Cash flows used in investing activities for 2011 were $15.6 million compared to $10.2 million for 2010. The acquisition and construction of property and equipment reflected cash used in investing activities of $10.5 million in 2011 compared to $10.2 million in 2010. The Company also used $5.1 million to acquire Shoreham in October 2011.
 
Cash flows used in financing activities for 2011 were $9.8 million compared to $15.7 million for 2010. In 2010 and 2011, the Company declared and paid dividends amounting to $9.2 million and $9.3 million, respectively, to the holders of its common stock. The increase reflects the conversion of Class B common stock to IDS units. In addition, the Company made voluntary prepayments of $6.1 million in 2010 and $0.4 million in 2011 on its senior debt due in October 2013.
 
Total capital expenditures in 2011 were $10.6 million, up $0.4 million from $10.2 million in 2010, reflecting the expansion of the Maine and New Hampshire CLEC footprint; continued upgrade to our RLEC data network; and the IPTV system in Alabama. Our business continues to invest approximately 9% to 10% of revenue each year in business infrastructure.
 
We currently have outstanding $162.0 million under the term loan portion of our second amended and restated credit facility that matures in October 2013, reflecting a $0.4 million voluntary prepayment made by the Company in May 2011. Borrowings under the term loan bear interest at LIBOR plus a margin that can range from 3.5% to 4.25% (at December 31, 2011, the rate was 0.2763% LIBOR plus 4.0% margin). In February 2009, the Company executed two interest rate swap agreements as the fixed rate counterparty to hedge its exposure to changes in interest rate costs associated with its senior credit facility. Both swap agreements hedged the 3 month LIBOR rate. The first agreement was effective February 9, 2009 for three years with a notional amount of $90 million and a fixed interest rate of 1.85%. The second agreement was effective February 9, 2010 for two years with a notional amount of $60 million and a fixed interest rate of 2.0475%. From an accounting perspective, the documentation for both swaps did not meet the technical requirements of Accounting Standards Codification, or ASC, 815, Derivatives and Hedging, or ASC 815, to allow the swaps to be considered highly effective as hedging instruments. Both swaps expired on February 8, 2012.
 
We also have outstanding an aggregate of $107.7 million senior subordinated notes due in 2019 which bear interest at a rate of 13%, payable quarterly. On June 8, 2010, our outstanding shares of Class B common stock were exchanged for IDSs on a one-for-one basis.
 
In addition, we currently have a $15.0 million revolving credit facility, which bears interest at a variable rate. No borrowings were outstanding under this facility at December 31, 2011 or at any time since its inception. We are charged a 0.5% fee on the unused balance, payable quarterly.
 
Our credit facility has material covenants based upon Consolidated EBITDA, as defined in the credit facility, and our senior subordinated notes have material covenants based upon Adjusted EBITDA, as defined in the indenture for the senior subordinated notes. In our credit facility, covenants relating to our senior leverage and fixed charge ratios are calculated based upon Consolidated EBITDA. In the indenture for the senior subordinated notes, our ability to pay dividends on our common stock is dependent in large part on our Adjusted EBITDA. In addition, our ability to incur debt under the indenture for the senior subordinated notes and the credit facility is based on our ability to meet a specified leverage ratio. If we are unable to meet the leverage ratio, our liquidity would be adversely affected to the extent that we intend to rely on additional debt to enhance our liquidity.
 
 
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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 2009, 2010 and 2011. The voluntary prepayments of our senior debt of $0.4 million in 2011, $6.1 million in 2010 and $5.0 million in 2009 are not included.
 
   
Year Ended December 31,
 
   
2009
   
2010
   
2011
 
   
(Dollars in Thousands)
 
Cash generation
                 
Revenue
  $ 103,755     $ 104,400     $ 101,844  
Other income
          359              557              363  
Cash received from operations
    104,114       104,957       102,207  
Cost of services
       41,179        41,286        43,996  
Selling, general and administrative expenses
       14,164         13,075        12,985  
Cash consumed by operations
        55,343         54,361        56,981  
Cash generated from operations
  $     48,771     $   50,596     $ 45,226  
                         
Cash utilization
                       
Capital investment in operations
  $      9,596     $  10,225     $ 10,548  
Senior debt interest and fees
         9,589          9,791          9,577  
Interest on senior subordinated notes
       13,465        13,763       13,996  
Dividends
         8,937          9,225          9,321  
Cash utilized by the Company
  $    41,587     $  43,004     $  43,442  
                         
Percentage of cash utilized of cash generated
              85.3               85.0              96.1
 
We anticipate that operating cash flow, together with borrowings under our credit facility, will be adequate to meet our currently anticipated operating and capital expenditure requirements for at least the next 12 months. However, our current dividend policy, our indebtedness levels and related debt service requirements and our capital expenditure requirements will significantly limit any cash available from operations for other uses for the foreseeable future. We may not retain a sufficient amount of cash to finance growth opportunities or unanticipated capital expenditure needs or to fund our operations in the event of a significant business downturn. We may have to forego growth opportunities or capital expenditures that would otherwise be necessary or desirable or adjust our current dividend policy if we do not find alternative sources of financing. If we do not have sufficient cash for these purposes, our financial condition and our business will suffer.
 
Obligations and Commitments
 
The following table discloses aggregate information about our contractual obligations as of December 31, 2011, including scheduled interest and principal for the periods in which payments are due:
 
 
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Total
 
Less Than
1 Year
 
1-3 Years
 
3-5 Years
 
More Than 5 Years
 
Second amended and restated credit facility
   
Term
  $ 162,000,000     $     $ 162,000,000     $     $    
Revolver(1)
                      –                            
Senior subordinated notes
    107,660,531                         107,660,531    
Expected interest expense (2)
    125,983,187       21,661,849       34,341,994       27,991,738       41,987,607    
Total contractual cash obligations
  $ 395,643,718     $ 21,661,849     $ 196,341,994     $ 27,991,738     $ 149,648,138    
     
 
  (1) We have a $15.0 million revolving credit facility with an October 2013 maturity available. No amounts were drawn on this facility on December 31, 2011 or during 2011. The Company pays a commitment fee of 0.50% per annum, payable quarterly in arrears, on the unused portion of the revolver loan.
  (2) Expected interest payments to be made in future periods reflect anticipated interest payments related to our $162.0 million senior credit facility and our $107.7 million senior subordinated notes at 13.0%, including those associated with our IDSs and those held separately. Interest on the senior credit facility reflects a LIBOR rate of from 0.5% to 1.0% plus a margin of 4.0%. Interest rate hedging ran through February 8, 2012 and is not currently expected to be replaced. We have assumed in the presentation above that we will hold the senior credit facility until maturity in 2013 and the senior subordinated notes until maturity in 2019. No interest payment is included for the revolving credit facility because of the variability and timing of advances and repayments thereunder.
 
Off-Balance Sheet Arrangements
 
The Company has no off-balance sheet arrangements.
 
Critical Accounting Policies and Accounting Estimates
 
The process of preparing financial statements requires the use of estimates on the part of management. These estimates are based on our historical experience combined with management’s understanding of current facts and circumstances. Certain of our accounting policies are considered critical as they are both important to the portrayal of our financial statements and require significant or complex judgment on the part of management. The following is a summary of certain policies considered critical by management.
 
Regulatory Accounting. The Company follows the accounting for regulated enterprises, which is now part of Accounting Standards Codification 980, Regulated Operations, or ASC 980. This accounting practice recognizes the economic effects of rate regulation by recording costs and a return on investment as such amounts are recovered through rates authorized by regulatory authorities. Accordingly, ASC 980 requires the Company to depreciate telecommunications property and equipment over the useful lives approved by regulators, which could be different than the useful lives that would otherwise be determined by management. ASC 980 also requires deferral of certain costs and obligations based upon approvals received from regulators to permit recovery of such amounts in future years. Criteria that would give rise to the discontinuance of accounting in accordance with ASC 980 include (1) increasing competition restricting the ability of the Company to establish prices that allow it to recover specific costs and (2) significant changes in the manner in which rates are set by regulators from cost-based regulation to another form of regulation. The Company periodically reviews the criteria to determine whether the continuing application of ASC 980 is appropriate for its rural local exchange carriers. As of December 31, 2010 and 2011, 65.7% and 68.3%, respectively, of the Company’s net property, plant and equipment was accounted for under ASC 980.
 
The Company is subject to reviews and audits by regulatory agencies. The effect of these reviews and audits, if any, will be recorded in the period in which they become known and determinable.
 
Intangible Assets and Goodwill. Intangible assets consist primarily of the fair value of customer related intangibles, non-compete agreements and long-term customer contracts. Goodwill represents the excess of total acquisition cost over the assigned value of net identifiable tangible and intangible assets acquired through various business combinations. Due to the regulatory accounting required by ASC 980, the Company did not record acquired regulated telecommunications property and equipment at fair value as required by ASC 805, Business Combinations, or ASC 805, through 2004. In accordance with 47 CFR 32.2000, the federal regulation governing acquired telecommunications property and equipment, such property and equipment is accounted for at original cost, and depreciation and amortization of property and equipment acquired is credited to accumulated depreciation.
 
For the acquisition of Shoreham, property has been recorded at fair value in accordance with ASC 805, resulting in a plant acquisition adjustment in 2011. The Company has acquired identifiable intangible assets associated with the territories it serves, including a non-compete agreement with one of the former owners of Shoreham, and the customer lists of Shoreham. Any excess of the total purchase price over the amounts assigned to tangible and identifiable assets is recorded as goodwill.
 
 
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The Company performs a quarterly review of its identified intangible assets to determine if facts and circumstances exist which indicate that the useful life is shorter than originally estimated or that the carrying amount of assets may not be recoverable. If such facts and circumstances do exist, the Company assesses the recoverability of identified intangible assets by comparing the projected undiscounted net cash flows associated with the related asset or group of assets over their remaining lives against their respective carrying amounts. Impairment, if any, is based on the excess of the carrying amount over the fair value of those assets.
 
Revenue Recognition. Local services revenue for monthly recurring local services is billed in advance to a portion of the Company’s customers and in arrears to the balance of the customers. The Company records revenue for charges that have not yet been invoiced to its customers as unbilled revenue when services are rendered. The Company records revenue billed in advance as advance billings and defers recognition until such revenue is earned. Long distance service is billed to customers in arrears based on actual usage except when it is included in service bundles. The Company records unbilled long distance revenue as unbilled revenue when services are rendered. In bundles, unlimited usage is billed in arrears at a flat rate.
 
Network access revenue is derived from several sources. Revenue for interstate access services is received through tariffed access charges filed by the NECA with the FCC on behalf of the NECA member companies for our regulated subsidiaries. These access charges are billed by the Company to interstate interexchange carriers and pooled with like-revenues from all NECA member companies. A portion of the pooled access charge revenue received by the Company is based upon its actual cost of providing interstate access service, plus a return on the investment dedicated to providing that service. The balance of the pooled access charge revenue received by the Company is based upon the nationwide average schedule costs of providing interstate access services. Rates for our competitive subsidiaries are set by FCC rule to be no more than the interconnecting interstate rate of the predominant local carrier. Revenue for intrastate access service is received through tariffed access charges billed by the Company to the originating intrastate carrier using access rates filed with the appropriate state regulatory commissions and are retained by the Company. Revenue for the intrastate/interLATA access service is received through tariffed access charges as filed with the APSC, MDTC, MPSC, MPUC, NHPUC, VPSB and WVPSC. These access charges are billed to the intrastate carriers and are retained by the Company. Revenue for terminating and originating long distance service is received through charges for providing usage of the local exchange network. Toll revenues are recognized when services are rendered.
 
Cable television, internet and transport service revenues are recognized when services are rendered. Operating revenues from the lease of dark fiber covered by indefeasible rights-of-use (IRU) agreements are recorded as earned. In some cases, the entire lease payment is received at inception of the lease and recognized ratably over the lease term after recognition of expenses associated with lease inception. The Company has deferred revenue in the consolidated balance sheet as of December 31, 2010 and 2011 of $656,968 and $615,584, respectively, related to transport services.
 
Long-Lived Assets. The Company reviews its long-lived assets for impairment at each balance sheet date and whenever events or changes in circumstances indicate that the carrying amount of an asset should be assessed. To determine if an impairment exists, the Company estimates the future undiscounted cash flows expected to result from the use of the asset being reviewed for impairment. If the sum of these expected future cash flows is less than the carrying amount of the asset, the Company recognizes an impairment loss in accordance with guidance included in ASC 360, Property, Plant, and Equipment. The amount of the impairment recognized is determined by estimating the fair value of the assets and recording a loss for the excess of the carrying value over the fair value.
 
Income Taxes. The Company accounts for income taxes using the asset and liability approach in accordance with guidance included in ASC 740, Income Taxes. The asset and liability approach requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of assets and liabilities. A valuation allowance is provided when it is more likely than not that some portion or all of the deferred tax assets will not be realized.
 
The provision for income taxes consists of an amount for the taxes currently payable and a provision for the tax consequences deferred to future periods.
 
Recently Adopted Accounting Pronouncements
 
In October 2009, the Financial Accounting Standards Board, or the FASB, issued Accounting Standards Update, or ASU, 2009-13, Multiple-Deliverable Revenue Arrangements – a consensus of the FASB Emerging Issues Task Force, or ASU 2009-13, an update to ASC 605, Revenue Recognition. ASU 2009-13 provides application guidance on whether multiple deliverables exist, how the deliverables should be separated, and how the consideration should be allocated to one or more units of accounting. ASU 2009-13 establishes a selling price hierarchy for determining the selling price of a deliverable. The selling price used for each deliverable will be based on vendor-specific objective evidence, if available, third-party evidence if vendor-specific evidence is not available, or estimated selling price if neither vendor-specific nor third-party evidence is available. The Company was required to apply this
 
 
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guidance prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010; however, earlier application was permitted and the Company began applying the guidance in July 2010. The early adoption of this update did not have a material impact on our consolidated financial statements.
 
In January 2010, the FASB issued ASU 2010-06, Improving Disclosures about Fair Value Measurements, or ASU 2010-06, an update to ASC 820, Fair Value Measurements and Disclosures, or ASC 820. ASU 2010-06 provides more robust disclosures about (1) the different classes of assets and liabilities measured at fair value, (2) the valuation techniques and inputs used, (3) the activity in Level 3 fair value measurements, and (4) the transfers between Levels 1, 2, and 3. The new disclosures and clarifications of existing disclosures were effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures were effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The adoption of this update did not have a material impact on our consolidated financial statements.
 
In February 2010, the FASB issued ASU 2010-09, Amendments to Certain Recognition and Disclosure Requirements, or ASU 2010-09, an update to ASC 855, Subsequent Events. ASU 2010-09 eliminates the requirement for an SEC filer to disclose a date through which subsequent events have been evaluated in both issued and revised financial statements. Revised financial statements include financial statements revised as a result of either correction of an error or retrospective application of accounting principles generally accepted in the United States. The FASB believes these amendments remove potential conflicts with the SEC’s literature. ASU 2010-09 was effective upon issuance except for the use of the issued date for conduit debt obligors, which was effective for interim or annual periods ending after June 15, 2010. The adoption of this update did not have a material impact on our consolidated financial statements.
 
In July 2010, the FASB issued ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, or ASU 2010-20, an update to ASC 310, Receivables. ASU 2010-20 provides additional information to assist financial statement users in assessing an entity’s credit risk exposures and evaluating the adequacy of its allowance for credit losses. ASU 2010-20 applies to all entities with financing receivables, excluding short-term trade accounts receivable or receivables measured at fair value or the lower of cost or fair value. For public entities, this update was effective for interim and annual reporting periods ending on or after December 15, 2010. The adoption of this update did not have a material impact on our consolidated financial statements.
 
In December 2010, the FASB issued ASU 2010-29, Disclosure of Supplementary Pro Forma Information for Business Combinations, or ASU 2010-29, an update to ASC 805. ASU 2010-29 applies to any public entity that enters into business combinations that are material on an individual or aggregate basis. If comparative financial statements are presented, the entity should disclose revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. This update also expands the supplemental pro forma disclosures to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. ASU 2010-29 was effective prospectively for business combinations for which the acquisition date was on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. Early adoption was permitted and the Company began applying the guidance in December 2010. The adoption of this update did not have a material impact on our consolidated financial statements.
 
Recent Accounting Pronouncements
 
During 2011, the FASB issued ASU 2011-01 through ASU 2011-12. Except for ASU 2011-04, ASU 2011-05, ASU 2011-08, and ASU 2011-09, which are discussed below, these ASUs provide technical corrections to existing guidance related to specialized industries or entities and therefore, have minimal, if any, impact on the Company.
 
In May 2011, the FASB issued ASU 2011-04, Amendments to Achieve Common Fair Value Measurements and Disclosure Requirements in U.S. GAAP and IFRSs, or ASU 2011-04, an update to ASC 820. ASU 2011-04 provides guidance to change the wording used to describe many of the requirements in U.S. generally accepted accounting principles for measuring fair value and for disclosing information about fair value measurements. For public entities, ASU 2011-04 is effective for interim and annual periods beginning after December 15, 2011 and is to be applied prospectively. As ASU 2011-04 impacts presentation only, the adoption of this update will not impact our consolidated financial statements.
 
In June 2011, the FASB issued ASU 2011-05, Presentation of Comprehensive Income, or ASU 2011-05, an update to ASC 220, Comprehensive Income. This ASU requires the components of net income and the components of other comprehensive income to be presented either in a single continuous statement of comprehensive income or in two separate but continuous statements. ASU 2011-05 eliminates the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity. This guidance does not change the items that must be reported in other comprehensive income, when an item of
 
 
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other comprehensive income must be reclassified to net income or how earnings per share is calculated or presented. ASU 2011-05 is effective for public entities for interim and annual periods beginning after December 15, 2011. As ASU 2011-05 impacts presentation only, the adoption of this update will not impact our consolidated financial statements.
 
In September 2011, the FASB issued ASU 2011-08, Testing Goodwill for Impairment, or ASU 2011-08, an update to ASC 350, Intangibles – Goodwill and Other, or ASC 350. This ASU will provide an entity with the option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, an entity determines it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. However, if an entity concludes otherwise, then it is required to perform the first step of the two-step impairment test in accordance with ASC 350. ASU 2011-08 is effective for annual and interim goodwill impairment tests for fiscal years beginning after December 15, 2011. As ASU 2011-08 impacts testing procedures only, the adoption of this update will not impact our consolidated financial statements.
 
In September 2011, the FASB issued ASU 2011-09, Disclosures about an Employer’s Participation in a Multiemployer Plan, or ASU 2011-09, an update to ASC 715, Compensation – Retirement Benefits, subtopic 80, Multiemployer Plans. ASU 2011-09 requires additional disclosures for multiemployer pension plans and multiemployer other postretirement benefit plans. ASU 2011-09 is intended to create greater transparency in financial reporting by disclosing the commitments an employer has made to a multiemployer pension plan and the potential future cash flow implications of an employer’s participation in the plan. ASU 2011-09 is effective for public entities for annual periods with fiscal years ending after December 15, 2011. ASU 2011-09 impacts disclosure only, the adoption of this update did not impact our consolidated financial statements.
 
Subsequent Events
 
Effective as of January 1, 2012, each of the Company’s subsidiaries that was a corporation converted into a limited liability company pursuant to applicable state law, except that one of the Company’s corporate subsidiaries was merged with and into the Company effective as of January 1, 2012. As a result of the conversions and the merger, the Company currently expects to lower its income tax obligation in Missouri, as well as lower its cash income tax obligation in Alabama by utilizing net operating loss carryforwards and deferred tax assets.
 
Quantitative and Qualitative Disclosures about Market Risk
 
Our short-term excess cash balance is invested in short-term commercial paper. We do not invest in any derivative or commodity type instruments, although our two interest rate swap agreements were technically not effective hedges and therefore did not qualify for hedge accounting. The change in fair value of the swaps was charged or credited to income as a change in fair value of derivatives. Over the life of the swaps, the cumulative change in value was zero. Both swaps expired on February 8, 2012. Accordingly, we are subject to minimal market risk on our investments.
 
We have the ability to borrow up to $15.0 million under a revolving loan facility that expires on October 31, 2013. The interest rate is variable and, accordingly, we are exposed to interest rate risk, primarily from a change in LIBOR or a base rate. Currently, we have no loans drawn under this facility.
 
 
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Financial Statements and Supplementary Data
 
OTELCO INC.
 
CONSOLIDATED FINANCIAL STATEMENTS
 
 
33

 
 
 
Board of Directors and Stockholders
Otelco Inc.
Oneonta, Alabama
 
We have audited the accompanying consolidated balance sheets of Otelco Inc. as of December 31, 2011 and 2010 and the related consolidated statements of operations, stockholders’ equity (deficit), and cash flows for each of the three years in the period ended December 31, 2011. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Otelco Inc. at December 31, 2011 and 2010, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2011, in conformity with accounting principles generally accepted in the United States of America.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Otelco Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 5, 2012 expressed an unqualified opinion thereon.
 
/s/ BDO USA, LLP
 
Atlanta, Georgia
March 5, 2012
 
 
34

 
 
Report of Independent Registered Public Accounting Firm
 
Board of Directors and Shareholders
Otelco Inc.
Oneonta, Alabama
 
We have audited Otelco Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Otelco Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying “Item 9A, Management’s Report on Internal Control Over Financial Reporting”. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
 
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
 
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
As indicated in the accompanying “Item 9A, Management’s Report on Internal Control over Financial Reporting”, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of Shoreham Telephone LLC, which was acquired on October 14, 2011, and which is included in the consolidated balance sheets of Otelco Inc. as of December 31, 2011, and the related consolidated statements of operations, stockholders’ deficit and cash flows for the year then ended. Shoreham Telephone LLC constituted 2.4% of total assets as of December 31, 2011, and 0.7% and 4.7% of revenues and net income, respectively, for the year then ended. Management did not assess the effectiveness of internal control over financial reporting of Shoreham Telephone LLC because of the timing of the acquisition which was completed on October 14, 2011. Our audit of internal control over financial reporting of Otelco Inc. also did not include an evaluation of the internal control over financial reporting of Shoreham Telephone LLC.
 
In our opinion, Otelco Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on the COSO criteria.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Otelco Inc. as of December 31, 2011 and 2010, and the related consolidated statements of operations, stockholders’ equity (deficit), and cash flows for each of the three years in the period ended December 31, 2011 and our report dated March 5, 2012 expressed an unqualified opinion thereon.
 
/s/ BDO USA, LLP
 
Atlanta, Georgia
March 5, 2012
 
 
35

 

OTELCO INC.
 
   
As of December 31,
 
   
2010
   
2011
 
Assets
           
Current assets
           
Cash and cash equivalents
  $ 18,226,374     $ 12,393,792  
Accounts receivable:
               
Due from subscribers, net of allowance for doubtful accounts of $230,752 and $260,568, respectively
    4,406,257       4,355,632  
Unbilled receivables
    2,161,277       2,183,465  
Other
    4,299,088       5,449,074  
Materials and supplies
    1,817,311       1,780,820  
Prepaid expenses
    1,305,028       1,328,475  
Deferred income taxes
    626,267       726,310  
Total current assets
    32,841,602       28,217,568  
                 
Property and equipment, net
    63,887,213       65,881,975  
Goodwill
    188,190,078       188,954,840  
Intangible assets, net
    25,934,042       20,545,691  
Investments
    1,967,095       1,943,805  
Deferred financing costs
    5,757,825       4,485,324  
Deferred income taxes
    4,415,097       7,454,443  
Prepaid expenses
    106,685       238,386  
Other assets
    77,261       2,281  
Total assets
  $ 323,176,898     $ 317,724,313  
                 
Liabilities and Stockholders’ Deficit
               
Current liabilities
               
Accounts payable
  $ 768,055     $ 1,490,717  
Accrued expenses
    7,926,954       6,034,104  
Advance billings and payments
    1,595,133       1,590,689  
Deferred income taxes
    353,285       353,285  
Customer deposits
    172,479       143,657  
Total current liabilities
    10,815,906       9,612,452  
Deferred income taxes
    42,512,576       48,112,384  
Interest rate swaps
    2,471,331       241,438  
Advance billings and payments
    656,968       615,584  
Other liabilities
    368,349       403,823  
Long-term notes payable
    271,595,855       271,106,387  
Total liabilities
    328,420,985       330,092,068  
                 
Stockholders’ deficit
               
Class A Common Stock, $.01 par value-authorized 20,000,000 shares; issued and outstanding 13,221,404 shares
    132,214       132,214  
Additional paid in capital
    921,718        
Retained deficit
    (6,298,019 )     (12,499,969 )
Total stockholders’ deficit
    (5,244,087 )     (12,367,755 )
Total liabilities and stockholders’ deficit
  $ 323,176,898     $ 317,724,313  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
36

 
 
OTELCO INC.
 
   
Years Ended December 31,
 
   
2009
 
2010
 
2011
 
                     
Revenues
  $ 103,755,454     $ 104,400,219     $ 101,843,567    
                           
Operating expenses
                         
Cost of services
    41,178,502       41,286,418       43,995,953    
Selling, general and administrative expenses
    14,164,465       13,074,794       12,984,686    
Depreciation and amortization
    26,485,628       23,670,243       20,232,833    
Total operating expenses
    81,828,595       78,031,455       77,213,472    
                           
Income from operations
    21,926,859       26,368,764       24,630,095    
                           
Other income (expense)
                         
Interest expense
    (25,416,024       (24,746,542 )     (24,776,123 )  
Change in fair value of derivatives
    (1,354,759 )     (878,518 )     2,229,893    
Other income
    359,484       556,820       363,482    
Total other expenses
    (26,411,299 )     (25,068,240 )       (22,182,748 )  
                           
Income (loss) before income tax
    (4,484,440 )     1,300,524       2,447,347    
Income tax (expense) benefit
    1,366,629       (609,809 )     (249,929 )  
                           
Net income (loss) available to common stockholders
  $ (3,117,811 )   $ 690,715     $ 2,197,418    
                           
Weighted average common shares outstanding:
                         
Basic
    12,676,733       12,985,629       13,221,404    
Diluted
    13,221,404       13,221,404       13,221,404    
Basic net income (loss) per common share
  $ (0.25 )   $ 0.05     $ 0.17    
Diluted net income (loss) per common share
  $ (0.25 )   $ 0.05     $ 0.17    
                           
Dividends declared per common share
  $ 0.71     $ 0.71     $ 0.71    
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
37

 
 
OTELCO INC.
 
   
Class A
Common Stock
   
Class B
Common Stock
   
Additional Paid-
In
   
Retained
   
Accumulated Other Comprehensive
   
Total Stockholders’
 
   
Shares
   
Amount
   
Shares
   
Amount
   
Capital
   
Deficit
   
Income (Loss)
   
Equity (Deficit)
 
Balance, December 31, 2008
    12,676,733     $ 126,767       544,671     $ 5,447     $ 19,277,959     $ (3,870,923 )   $ (1,160,759 )   $ 14,378,491  
                                                                 
Comprehensive Loss
                                                               
Net loss
                                            (3,117,811 )             (3,117,811 )
Change in fair value of interest rate cap
                                                    1,160,759       1,160,759  
Total comprehensive loss