UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

 

FORM 10-Q

 

(Mark One)

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2020

 

OR

¨

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)
N/A
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class:	Trading Symbol:	Name of exchange on which registered:
Class A Common Stock ($0.01 par value per share)	OTEL	The Nasdaq Stock Market LLC

 

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            ¨ 

 

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files).

Yes            x            No            ¨ 

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨

Accelerated filer ¨

Non-accelerated filer x

Smaller reporting company x

Emerging growth company ¨

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes            ¨            No            x 

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class		Outstanding at November 3, 2020
Class A Common Stock ($0.01 par value per share)		3,421,794
Class B Common Stock ($0.01 par value per share)		0

 

 

 

OTELCO INC.
FORM 10-Q
For the three-month and nine-month periods ended September 30, 2020

 

TABLE OF CONTENTS

 

		Page
PART I FINANCIAL INFORMATION		2
Item 1.	Financial Statements	2
	Condensed Consolidated Balance Sheets as of September 30, 2020 (unaudited) and December 31, 2019 (audited)	2
	Condensed Consolidated Statements of Operations for the Three Months and Nine Months Ended September 30, 2020 and 2019 (unaudited)	3
	Condensed Consolidated Statements of Stockholders’ Equity for the Three Months and Nine Months Ended September 30, 2020 and 2019 (unaudited)	4
	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2020 and 2019 (unaudited)	5
	Notes to Condensed Consolidated Financial Statements (unaudited)	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	27
Item 4.	Controls and Procedures	27
PART II OTHER INFORMATION		28
Item 1A.	Risk Factors	28
Item 6.	Exhibits	30

 

 

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 September 30, 2020.

 

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 or cause our actual results to differ materially from those in the forward-looking statements, including the factors under “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2019 and in Part II, Item 1A of this Quarterly Report on Form 10-Q.

 

 

PART I FINANCIAL INFORMATION

 

Item 1.

Financial Statements

 

OTELCO INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share par value and share amounts)
(unaudited with the exception of December 31, 2019 being audited)

 

		September 30, 2020				December 31, 2019
Assets
Current assets
Cash and cash equivalents		$	8,086			$	3,113
Accounts receivable:
Due from subscribers, net of allowance for doubtful accounts of $253 and $209, respectively			3,985				3,908
Other			1,946				1,905
Materials and supplies			3,731				3,954
Prepaid expenses			1,310				1,624
Other assets			207				251
Total current assets			19,265				14,755
Property and equipment, net			59,465				57,284
Goodwill			44,976				44,976
Intangible assets, net			249				530
Operating lease right-of-use asset			1,636				1,146
Investments			1,458				1,477
Other assets			120				577
Total assets		$	127,169			$	120,745
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable		$	1,779			$	1,525
Accrued expenses			5,835				4,861
Advance billings and payments			1,606				1,618
Customer deposits			27				44
Current operating lease liability			398				296
Current maturity of long-term notes payable, net of debt issuance cost			3,872				3,929
Total current liabilities			13,517				12,273
Deferred income taxes			21,521				21,521
Advance billings and payments			2,011				2,157
Other liabilities			1				12
Long-term operating lease liability			1,238				850
PPP notes payable			2,975				–
Long-term notes payable, less current maturities and debt issuance cost			62,133				65,172
Total liabilities			103,396				101,985
Stockholders’ equity
Class A Common Stock, $.01 par value-authorized 10,000,000 shares; issued and outstanding 3,421,794 and 3,412,805 shares, respectively			34				34
Additional paid in capital			4,411				4,275
Retained earnings			19,328				14,451
Total stockholders’ equity			23,773				18,760
Total liabilities and stockholders’ equity		$	127,169			$	120,745

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

 

OTELCO INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share amounts)
(unaudited)

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2020				2019				2020				2019
Revenues		$	15,574			$	15,762			$	46,464			$	47,175
Operating expenses
Cost of services			7,422				7,542				22,235				22,630
Selling, general and administrative expenses			3,459				2,506				9,326				7,535
Depreciation and amortization			2,088				1,873				6,163				5,698
Total operating expenses			12,969				11,921				37,724				35,863
Income from operations			2,605				3,841				8,740				11,312
Other income (expense)
Interest expense			(931	)			(1,315	)			(3,100	)			(4,044	)
Other income			6				5				813				604
Total other expense			(925	)			(1,310	)			(2,287	)			(3,440	)
Income before income tax expense			1,680				2,531				6,453				7,872
Income tax expense			(452	)			(712	)			(1,576	)			(2,056	)
Net income		$	1,228			$	1,819			$	4,877			$	5,816
Weighted average number of common shares outstanding:
Basic			3,421,794				3,410,936				3,421,794				3,410,936
Diluted			3,440,772				3,431,229				3,440,772				3,431,229
Basic net income per common share		$	0.36			$	0.53			$	1.43			$	1.71
Diluted net income per common share		$	0.36			$	0.53			$	1.42			$	1.70

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

 

OTELCO INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(in thousands, except share amounts)

(unaudited)

 

		Class A Common Stock								Additional				Retained				Total Stockholders’
		Shares				Amount				Paid-In Capital				Earnings				Equity
Balance, December 31, 2019			3,412,805			$	34			$	4,275			$	14,451			$	18,760
Net income															2,218				2,218
Stock-based compensation expense											52								52
Tax withholdings paid on behalf of employees for restricted stock units											(20	)							(20	)
Issuance of Class A Stock			8,989				-												-
Balance, March 31, 2020			3,421,794			$	34			$	4,307			$	16,669			$	21,010
Net income															1,431				1,431
Stock-based compensation expense											52								52
Balance, June 30, 2020			3,421,794			$	34			$	4,359			$	18,100			$	22,493
Net income															1,228				1,228
Stock-based compensation expense											52								52
Balance, September 30, 2020			3,421,794			$	34			$	4,411			$	19,328			$	23,773

 

		Class A Common Stock								Additional Paid-In				Retained				Total Stockholders’
		Shares				Amount				Capital				Earnings				Equity
Balance, December 31, 2018			3,388,624			$	34			$	4,213			$	6,655			$	10,902
Net income															2,281				2,281
Stock-based compensation expense											71								71
Tax withholdings paid on behalf of  employees for restricted stock  units											(183	)							(183	)
Issuance of Class A Stock			22,312				-												-
Balance, March 31, 2019			3,410,936			$	34			$	4,101			$	8,936			$	13,071
Net income															1,716				1,716
Stock-based compensation expenses							-				43								43
Balance, June 30, 2019			3,410,936			$	34			$	4,144			$	10,652			$	14,830
Net income															1,819				1,819
Stock-based compensation expense											59								59
Balance, September 30, 2019			3,410,936			$	34			$	4,203			$	12,471			$	16,708

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

 

OTELCO INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)
(unaudited)

 

		Nine Months Ended September 30,
		2020				2019
Cash flows from operating activities:
Net income		$	4,877			$	5,816
Adjustments to reconcile net income to cash flows provided by operating activities:
Depreciation			5,939				5,465
Amortization			224				233
Amortization of loan costs			379				342
Non-cash lease amortization			311				166
Provision for uncollectible accounts receivable			283				163
Stock-based compensation			156				173
Gain on the sale of property			(211	)			-
Changes in operating assets and liabilities
Accounts receivable			(358	)			(198	)
Materials and supplies			223				(1,448	)
Prepaid expenses and other assets			771				(337	)
Accounts payable and accrued expenses			1,228				1,743
Advance billings and payments			(158	)			(248	)
Other liabilities			(339	)			(182	)
Net cash from operating activities			13,325				11,688
Cash flows used in investing activities:
Acquisition and construction of property and equipment			(8,066	)			(7,594	)
Proceeds from the sale of property			234				-
Net cash used in investing activities			(7,832	)			(7,594	)
Cash flows used in financing activities:
Loan origination costs			(213	)			(12	)
Principal repayment of long-term notes payable			(3,263	)			(3,262	)
Interest rate cap			-				4
Tax withholdings paid on behalf of employees for restricted stock units			(20	)			(183	)
Proceeds from PPP loan			2,975				-
Net cash from (used) in financing activities			(520	)			(3,453	)
Net increase in cash and cash equivalents			4,973				641
Cash and cash equivalents, beginning of period			3,113				4,657
Cash and cash equivalents, end of period		$	8,086			$	5,298
Supplemental disclosures of cash flow information:
Interest paid		$	2,707			$	3,717
Income taxes paid		$	788			$	1,243

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2020
(unaudited)

 

1.

Organization and Basis of Financial Reporting

 

Basis of Presentation and Principles of Consolidation

 

The condensed consolidated financial statements include the accounts of Otelco Inc. (the “Company”) and its subsidiaries, all of which are either directly or indirectly wholly owned. These include: Blountsville Telephone LLC; Brindlee Mountain Telephone LLC; CRC Communications LLC; Granby Telephone LLC; Hopper Telecommunications LLC; Mid-Maine Telecom LLC; Mid-Maine TelPlus LLC; Otelco Mid-Missouri LLC and its wholly owned subsidiary I-Land Internet Services LLC; Otelco Telecommunications LLC; Otelco Telephone LLC; Pine Tree Telephone LLC; Saco River Telephone LLC; Shoreham Telephone LLC; and War Telephone LLC.

 

The accompanying condensed consolidated financial statements include the accounts of the Company and all of the aforesaid subsidiaries after elimination of all material intercompany balances and transactions. The unaudited operating results for the nine months ended September 30, 2020, are not necessarily indicative of the results that may be expected for the year ending December 31, 2020, or any other period.

 

The condensed consolidated financial statements and notes included in this Quarterly Report on Form 10-Q should be read in conjunction with the audited consolidated financial statements and notes thereto in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019. The interim condensed consolidated financial information herein is unaudited, with the condensed consolidated balance sheet as of December 31, 2019 being derived from the Company’s audited consolidated financial statements. The information reflects all adjustments which are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations for the periods included in this report.

 

Certain items in prior year’s condensed consolidated financial statements have been reclassified to conform with 2020 presentation.

 

COVID-19

 

A novel strain of coronavirus (COVID-19) was first identified in December 2019, and subsequently declared a global pandemic by the World Health Organization on March 11, 2020. As a result of the outbreak, companies have experienced disruptions in their operations and in markets served.  The Company instituted numerous precautionary measures intended to help ensure the well-being of its employees, continue providing essential telecommunications services to its customers and minimize business disruption. As COVID-19 restrictions had been eased in some states, the Company began having employees who had been working from home since March 2020 return to their normal work locations while continuing to empower the technicians to reschedule any in-person installation or repair if they determine that circumstances at the location present a health risk. During third quarter 2020, the Company saw customer calls for new and changed service, payment arrangements and service troubles begin to trend toward pre-COVID-19 levels. As a result of the measures implemented, no significant adverse impact on results of operations through and financial position at September 30, 2020, has occurred as a result of the pandemic. The full extent of the future impacts of the COVID-19 pandemic on its operations is uncertain. An increase of COVID-19 cases in the Company's service areas could have a material adverse impact on its financial results and business, including the timing and ability of the Company to collect accounts receivable and procure materials and services from its suppliers.

 

CARES Act

 

The Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”) was enacted on March 27, 2020.  There are several different provisions with the CARES Act that impact income taxes for corporations. The Company has evaluated the tax implications and believes these provisions did not have a material impact to the financial statements.

 

Additionally, the Company applied for and received funds under the Paycheck Protection Program (the “PPP Loan”) in the amount of $2,975,000. The receipt of these funds, and the forgiveness of the loan attendant to these funds, is dependent on the Company having initially qualified for the loan and qualifying for the forgiveness of such loan based on its adherence to the updated forgiveness criteria included in the Paycheck Protection Program Flexibility Act (“PPP Flexibility”). The Company submitted its application for loan forgiveness on October 1, 2020. Approval of loan forgiveness by the lender and the Small Business Administration (“SBA”) has not been received.

 

The PPP Loan received by the Company has a two-year term and bears interest at a rate of 1.0% per annum. Under PPP Flexibility, monthly principal and interest payments are deferred until the date the lender receives the applicable forgiven amount from the SBA. The PPP Loan may be prepaid at any time prior to maturity with no prepayment penalties. The promissory note contains events of default and other provisions customary for a loan of this type.

 

 

The PPP Loan was used to retain Otelco’s employees and allow them to be able to continue to provide essential telecommunications and data services for its customers during the initial peak of the COVID-19 pandemic. These services were and remain critical to customers as they work and live under physical separation and quarantine requirements. Given direction from the Federal Communications Commission (the “FCC”) and state public utilities commissions, the Company made available free or discounted services to families who receive other governmental assistance and delayed for four months service disconnection for non-payment where families and businesses were experiencing COVID-19 financial impacts. Consent of the agent and Required Lenders (as defined in the Credit Facility) under the Credit Facility was obtained in connection with the incurrence of the PPP Loan. The Company will continue to work with federal, state and local governmental bodies to be responsive to COVID-19 guidance and CARES Act requirements.

 

Recently Adopted Accounting Pronouncements

 

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) (“ASU 2016-02”). This ASU requires lessees to recognize most leases on the balance sheet. The provisions of this guidance are effective for annual periods beginning after December 15, 2018, and interim periods within those years, with early adoption permitted. In January 2017, the FASB issued ASU 2017-03, which requires registrants to evaluate the impact ASU 2016-02 will have on financial statements and adequately disclose this information to assist the reader in assessing the significance of ASU 2016-02 on the financial statements when adopted. In January 2018, the FASB issued ASU 2018-01, Leases (Topic 842): Land Easement Practical Expedient for Transition to Topic 842. This ASU provides an optional transition practical expedient to not evaluate under ASU 2016-02 existing or expired land easements that were not previously accounted for as leases under ASC Topic 840, Leases. An entity that elects this practical expedient should evaluate new or modified land easements under ASU 2016-02 beginning at the date that the entity adopts ASU 2016-02. In July 2018, the FASB issued ASU 2018-10, Codification Improvements to Topic 842, Leases, which provides improvements and clarifications for ASU 2016-02. In July 2018, the FASB issued ASU 2018-11, Leases (Topic 842): Targeted Improvements (“ASU 2018-11”). This ASU provides an additional transition method by allowing entities to initially apply the new lease standard at the date of adoption with a cumulative effect adjustment to the opening balances of retained earnings in the period of adoption. This ASU also gives lessors the option of electing, as a practical expedient by class of underlying asset, not to separate the lease and non-lease components of a contract when those lease contracts meet certain criteria. In December 2018, the FASB issued ASU 2018-20, Narrow-Scope Improvements for Lessors. This ASU clarifies lessor treatment for sales taxes and other similar taxes collected from lessees, certain lessor costs, and recognition of variable payments for contracts with lease and non-lease components. In March 2019, the FASB issued ASU 2019-01, Codification Improvements. This ASU clarifies determining the fair value of the underlying asset by lessors that are not manufacturers or dealers, presentation on the statement of cash flows for sales-type and direct financing leases, and transition disclosures related to Topic 250, Accounting Changes and Error Corrections. The Company has completed its evaluation of the requirements of this guidance and implemented the processes necessary to adopt ASU 2016-02, as amended. The Company has elected certain practical expedients available at adoption. The Company elected the package of practical expedients upon transition not to reassess whether expired or existing contracts contain leases under the new definition of a lease; not to reassess the lease classification for expired or existing leases; and not to reassess whether previously capitalized initial direct costs would qualify for capitalization under ASU 2016-02. In evaluating certain equipment rental arrangements such as cable, internet and security service contracts, the Company considered the practical expedient that allows lessors to elect, by class of underlying asset, to not separate non-lease components from the associated lease components if the non-lease components otherwise would be accounted for in accordance with the new revenue recognition standard. The Company elected this practical expedient as the following two criteria are met; the lease component and the associated non-lease components have the same timing and pattern of transfer; and the lease component, if accounted for separately, would be classified as an operating lease. The Company elected to adopt the new standard using the transition method provided by ASU 2018-11; therefore, prior periods will not be restated. The Company has determined that the impact of adoption is limited to real property leases and is consistent with industry practices. Adoption of the new standard resulted in the Company recognizing an aggregate of $1,073,919 in lease liabilities and corresponding right of use (“ROU”) assets and no impact on the opening retained earnings balances. The adoption of ASU 2016-02 had an immaterial impact on the consolidated statements of operations and consolidated statements of cash flows for the year ended December 31, 2019.

 

In June 2018, the FASB issued ASU 2018-07, Compensation – Stock Compensation (Topic 718) (“ASU 2018-07”). This ASU expands the scope of ASU 2017-09, which currently only includes share-based payments issued to employees, to also include share-based payments issued to nonemployees for goods and services. The amendments in this ASU are effective for public companies for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years.  Early adoption is permitted, but no earlier than the Company’s adoption date of ASU 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). The Company adopted this ASU and that adoption did not have a material impact on the Company’s condensed consolidated financial statements.

 

In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820) (“ASU 2018-13”). This ASU modifies the disclosure requirements on fair value measurements in ASU 2018-13, based on the concepts in the Concepts Statement, including the consideration of costs and benefits. This ASU eliminates, adds and modifies certain disclosure requirements for fair value measurements as part of its disclosure framework project. ASU 2018-13 is effective for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. An entity is permitted to early adopt any removed or modified disclosures upon issuance of this ASU and delay adoption of the additional disclosures until their effective date. The Company adopted this ASU and that adoption did not have a material impact on the Company’s condensed consolidated financial statements.

 

 

In November 2019, the FASB issued ASU 2019-08, Compensation – Stock Compensation (Topic 718) and Revenue from Contracts with Customers (Topic 606); Codification Improvements – Share-Based Consideration Payable to a Customer (“ASU 2019-08”). ASU 2019-08, requires that an entity apply the guidance in ASU 2018-07 to measure and classify share-based payment awards granted to a customer. The amount recorded as a reduction in the transaction price should be based on the grant-date fair value of the share-based payment award. The amendments in ASU 2019-08 are effective for public companies for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years.  Early adoption is permitted, but no earlier than the Company’s adoption of the amendments in ASU 2018-07. The Company does not have any share-based payment awards to customers. The Company adopted this ASU and that adoption did not have a material impact on the Company’s condensed consolidated financial statements.

 

Recent Accounting Pronouncements

 

During 2019, the FASB issued ASUs 2019-01 through 2019-12 and, during 2020, the FASB has issued ASUs 2020-01 through 2020-08. Except for the ASUs discussed above and below, these ASUs provide technical corrections or simplifications to existing guidance and to specialized industries or entities and therefore have minimal, if any, impact on the Company.

 

In November 2018, the FASB issued ASU 2018-19, Codification Improvements to Topic 326, Financial Instruments – Credit Losses (“ASU 2018-19”). This ASU improves the disclosure requirements in ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”) issued in June 2016, to make a cumulative-effect adjustment to opening retained earnings as of the beginning of the first reporting period in which the amendments are effective. The effective date and transition requirements for the amendments in this update are the same as the effective dates and transition requirements in ASU 2016-13, as amended by ASU 2018-19. In April 2019, the FASB issued ASU 2019-04, Codification Improvements to Topic 326, Financial Instruments – Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments. This ASU improves the disclosure requirements in ASU 2016-13 issued in June 2016, to allow the measurement of allowance for credit losses on accrued interest receivable balances separately from other components of the amortized cost basis of associated financial assets. In May 2019, the FASB issued ASU 2019-05, Financial Instruments – Credit Losses (Topic 326). This ASU improves the disclosure requirements in ASU 2016-13 issued in June 2016, to allow companies to irrevocably elect, upon adoption of ASU 2016-13, the fair value option on financial instruments that (1) were previously recorded at amortized cost and (2) are within the scope of ASC 326-20 if the instruments are eligible for the fair value option under ASC 825-10. The effective date and transition requirements for the amendments in this update are the same as the effective dates and transition requirements in ASU 2016-13, as amended by ASU 2018-19. In November 2019, the FASB issued ASU 2019-10, Financial Instruments – Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842) (“ASU 2019-10”). This ASU defers certain major updates not yet effective due to the challenges that private companies, smaller public companies, and not-for-profit organizations are having with implementation. In November 2019, the FASB issued ASU 2019-11, Codification Improvements to Topic 326, Financial Instruments – Credit Losses. The amendments in this ASU clarify and address stakeholders’ specific issues about certain aspects in update 2016-13. In February 2020, the FASB issued ASU 2020-02, Financial Instruments – Credit Losses (Topic 326) and Leases (Topic 842). The amendments in this ASU address the methodology for the allowance for credit losses. ASU 2019-10 has deferred the effective date for credit losses for smaller reporting companies to fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. An entity is still permitted to early adopt as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company does not expect this ASU to have a material impact on its condensed consolidated financial statements.

 

In December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740) (“ASU 2019-12”). This ASU simplifies the accounting for income taxes by removing certain exceptions to the general principles in Topic 740. The amendments in ASU 2019-12 are effective for public companies for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Early adoption of the amendments is permitted, including adoption in any interim period for which financial statements have not yet been issued. An entity that elects to early adopt the amendments in an interim period should reflect any adjustments as of the beginning of the annual period that includes that interim period. Additionally, an entity that elects early adoption must adopt all the amendments in the same period. The Company does not expect this ASU to have a material impact on its condensed consolidated financial statements.

 

 

2.

Notes Payable

 

Notes payable consists of the following (in thousands, except percentages) as of:

 

										September 30,				December 31,
		Current				Long-term				2020				2019
Loan with CoBank, ACB (the “Credit Facility”); variable interest rate of 4.66% at September 30, 2020, interest is monthly, paid in arrears on the last business day of each month.  The Credit Facility is secured by the total assets of the subsidiary guarantors.  The unpaid balance is due November 3, 2022.		$	4,350			$	62,600			$	66,950			$	70,212
Debt issuance cost			(478	)			(467	)			(945	)			(1,111	)
Notes payable, net of debt issuance cost		$	3,872			$	62,133			$	66,005			$	69,101

 

Associated with the Credit Facility, the Company incurred $2.3 million in deferred financing cost including $212 thousand incurred during first quarter 2020. The Company and its lender for the Credit Facility amended the agreement effective December 31, 2019, to change covenant measurements in recognition of the Company’s plans for increased investment in fiber and other network improvements intended to increase broadband speeds for its customers. Amortization expense for the deferred financing cost associated with the Credit Facility was $379 thousand and $342 thousand for the nine months ended September 30, 2020, and 2019, respectively, which is included in interest expense.

 

The revolving credit facility associated with the Company’s Credit Facility had a maximum borrowing capacity of $5.0 million on September 30, 2020. The revolving credit facility is available until November 3, 2022. There was no balance outstanding as of September 30, 2020. The Company pays a commitment fee at an initial rate of 0.50% per annum, payable quarterly in arrears, on the unused portion of the revolver loan under the Credit Facility. The rate declined from 0.50% per annum to 0.38% per annum on October 22, 2018. The rate fluctuated during the nine months ended September 30, 2020 from 0.50% per annum for eighty-eight days, and then declined to 0.38% per annum for one hundred and eighty-five days. The commitment fee expense was $17 thousand and $14 thousand for the nine months ended September 30, 2020, and 2019, respectively.

 

Maturities of notes payable for the next five years, assuming no future annual excess cash flow payments, are as follows (in thousands):

 

2020 (remaining)		$	1,088
2021			4,350
2022			61,512
2023			—
2024			—
Total		$	66,950

 

The Company’s notes payable agreements are subject to certain financial covenants and restrictions on indebtedness, financial guarantees, business combinations and other related items. As of September 30, 2020, the Company was in compliance with all such covenants and restrictions.

 

3.

Income Tax

 

Provision for income tax expense was $1.6 million in the nine months ended September 30, 2020, compared to $2.1 million in the nine months ended September 30, 2019. The effective tax rate varies from the federal corporate tax rate of 21.0% largely due to state income taxes and other permanent differences. The effective income tax rate as of September 30, 2020, and September 30, 2019, was 24.4% and 26.1%, respectively.

 

4.

Net Income per Common Share

 

Basic net income per common share is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted net income per common share reflects the potential dilution that would occur should all of the shares of Class A common stock underlying restricted stock units (“RSUs”) be issued.

 

A reconciliation of the common shares for purposes of the calculation of the Company’s basic and diluted net income per common share is as follows (weighted average number of common shares outstanding in whole numbers and net income in thousands):

 

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2020				2019				2020				2019
Weighted average number of common shares outstanding - basic			3,421,794				3,410,936				3,421,794				3,410,936
Effect of dilutive securities			18,978				20,293				18,978				20,293
Weighted average number of common shares and potential common shares - diluted			3,440,772				3,431,229				3,440,772				3,431,229
Net income		$	1,228			$	1,819			$	4,877			$	5,816
Net income per common share - basic		$	0.36			$	0.53			$	1.43			$	1.71
Net income per common share - diluted		$	0.36			$	0.53			$	1.42			$	1.70

 

 

5.

Revenue Streams and Concentrations

 

Revenue Streams

 

The Company identifies its revenue streams with similar characteristics as follows (in thousands):

 

		Three Months Ended September 30, 2020				Nine Months Ended September 30, 2020
Local services		$	4,594			$	13,899
Network access			4,963				14,936
Internet			4,032				11,671
Transport services			1,087				3,289
Video and security			722				2,151
Managed services			176				518
Total revenues		$	15,574			$	46,464

 

The Company identifies its revenue streams with similar characteristics as follows (in thousands):

 

		Three Months Ended September 30, 2019				Nine Months Ended September 30, 2019
Local services		$	4,717			$	14,585
Network access			5,436				15,970
Internet			3,673				10,996
Transport services			1,091				3,143
Video and security			691				2,028
Managed services			154				453
Total revenues		$	15,762			$	47,175

 

ASU 2014-09 requires that an entity recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The Company has used a five-step process to identify the contract with the customer, identify the performance obligations, determine the transaction price, allocate the transaction price to the performance obligations and recognize revenue when or as the performance obligations are satisfied. The majority of the Company’s revenue is recognized over time as the service is transferred to the customer. For certain other services, such as unlimited long distance, revenue is recognized over the period of time the service is provided.

 

The following table identifies revenue generated from customers (in thousands):

 

		Three Months Ended September 30, 2020				Nine Months Ended September 30, 2020
Local services		$	4,594			$	13,899
Network access			786				2,451
Internet			4,032				11,671
Transport services			1,049				3,176
Video and security			722				2,151
Managed services			176				518
Total revenues generated from customers		$	11,359			$	33,866

 

 

The following table identifies revenue generated from customers (in thousands):

 

		Three Months Ended September 30, 2019				Nine Months Ended September 30, 2019
Local services		$	4,717			$	14,585
Network access			1,086				3,273
Internet			3,673				10,996
Transport services			1,054				3,030
Video and security			691				2,028
Managed services			154				453
Total revenues generated from customers		$	11,375			$	34,365

 

The following table summarizes the revenue generated from contracts with customers among each revenue stream for the three and nine month periods ended September 30, 2020 (in thousands, except percentages):

 

		Three Months Ended
		September 30, 2020				% In-Scope				% Total
Month to month (“MTM”) customers		$	7,239				64.7	%			46.5	%
Competitive local exchange carrier (“CLEC”) business customers			3,158				28.2				20.3
Network access			487				4.4				3.1
Total revenue streams			10,884				97.3				69.9
Global access*			299				2.7				1.9
Total revenue from contracts with customers			11,183				100.0	%			71.8
Managed services**			176				n/a				1.1
Total revenue generated from customers			11,359				n/a				72.9
Indefeasible rights-of-use agreements**			38				n/a				0.3
Network access**			4,177				n/a				26.8
Total revenues		$	15,574								100.0	%

 

*Fixed fees charged to MTM customers and CLEC business customers.

** Revenue generated from sources not within the scope of ASU 2014-09.                        

 

		Nine Months Ended
		September 30, 2020				% In-Scope				% Total
MTM customers		$	21,298				63.9	%			45.8	%
CLEC business customers			9,599				28.8				20.7
Network access			1,534				4.6				3.3
Total revenue streams			32,431				97.3				69.8
Global access*			917				2.7				2.0
Total revenue from contracts with customers			33,348				100.0	%			71.8
Managed services**			518				n/a				1.1
Total revenue generated from customers			33,866				n/a				72.9
Indefeasible rights-of-use agreements**			113				n/a				0.2
Network access**			12,485				n/a				26.9
Total revenues		$	46,464								100.0	%

 

*Fixed fees charged to MTM customers and CLEC business customers.

** Revenue generated from sources not within the scope of ASU 2014-09.

 

 

The following table summarizes the revenue generated from contracts with customers among each revenue stream for the three and nine month periods ended September 30, 2019 (in thousands, except percentages):

 

		Three Months Ended September 30, 2019				% In-Scope				% Total
MTM customers		$	6,847				61.0	%			43.4	%
CLEC business customers			3,288				29.3				20.9
Network access			640				5.7				4.1
Total revenue streams			10,775				96.0				68.4
Global access*			446				4.0				2.8
Total revenue from contracts with customers			11,221				100.0	%			71.2
Managed services**			154				n/a				1.0
Total revenue generated from customers			11,375				n/a				72.2
Indefeasible rights-of-use agreements**			37				n/a				0.2
Network access**			4,350				n/a				27.6
Total revenues		$	15,762								100.0	%

 

*Fixed fees charged to MTM customers and CLEC business customers.

** Revenue generated from sources not within the scope of ASU 2014-09.

 

		Nine Months Ended September 30, 2019				% In-Scope				% Total
MTM customers		$	20,769				61.3	%			44.0	%
CLEC business customers			9,870				29.1				20.9
Network access			1,908				5.6				4.1
Total revenue streams			32,547				96.0				69.0
Global access*			1,365				4.0				2.9
Total revenue from contracts with customers			33,912				100.0	%			71.9
Managed services**			453				n/a				1.0
Total revenue generated from customers			34,365				n/a				72.9
Indefeasible rights-of-use agreements**			113				n/a				0.2
Network access**			12,697				n/a				26.9
Total revenues		$	47,175								100.0	%

 

*Fixed fees charged to MTM customers and CLEC business customers.

** Revenue generated from sources not within the scope of ASU 2014-09.

 

Payment terms vary by customer. The Company typically invoices customers in the month following when the service was provided. The term between invoicing and when payment is due is less than a year and is not considered significant. Certain customers are invoiced in advance of the service being provided. Revenue is deferred until the point in time control of the service is transferred to the customer, or over the term the service is provided.

 

Revenue is recognized net of taxes collected on behalf of third parties.

 

As of September 30, 2020, the Company had approximately $6.6 million of unsatisfied performance obligations. As of September 30, 2020, the Company expected to recognize approximately $944 thousand of revenue within the next year and $5.4 million in the next two to five years related to such unsatisfied performance obligations. The Company does not disclose the value of unsatisfied performance obligations for contracts with an original expected life of one year or less or for contracts for which the Company has a right to invoice for services performed.

 

The deferred revenue balance as of June 30, 2020, was $3.7 million. Approximately $1.4 million of revenue from that balance was recognized as revenue during the three months ended September 30, 2020, offset by payments received as of September 30, 2020, in advance of control of the service being transferred to the customer.

 

Revenue Concentrations

 

Revenues from the FCC Universal Service Fund, Connect America Fund, and Alternative Connect America Cost Model funding are used to improve and upgrade the Company’s network to promote support for the availability and affordability of advanced telecommunications services. Revenues from these sources amounted to 23.9% and 24.3% of the Company’s total revenues for the nine months ended September 30, 2020, and 2019, respectively.

 

 

6.

Commitments and Contingencies

 

From time to time, the Company 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 Alabama Public Service Commission, the Maine Public Utilities Commission, the Massachusetts Department of Telecommunications and Cable, the Missouri Public Service Commission, the New Hampshire Public Utilities Commission, the Vermont Public Utility Commission and the West Virginia Public Service Commission, relating primarily to rate making and customer service requirements. In addition, the Company may be involved in similar proceedings with interconnection carriers and the FCC. Currently, none of the Company’s legal proceedings are expected to have a material adverse effect on the Company’s business.

 

7.

Leases

 

ASU 2016-02 requires lessees to recognize most leases on the balance sheet. As stated above in Note 1, Organization and Basis of Financial Reporting – Recently Adopted Accounting Pronouncements, the Company has elected certain practical expedients available at adoption. The Company elected the package of practical expedients upon transition not to reassess whether expired or existing contracts contain leases under the new definition of a lease; not to reassess the lease classification for expired or existing leases; and not to reassess whether previously capitalized initial direct costs would qualify for capitalization under ASU 2016-02. In evaluating certain equipment rental arrangements such as cable, internet and security service contracts, the Company considered the practical expedient that allows lessors to elect, by class of underlying asset, to not separate non-lease components from the associated lease components if the non-lease components otherwise would be accounted for in accordance with the new revenue recognition standard. The Company elected this practical expedient as the following two criteria are met; the lease component and the associated non-lease components have the same timing and pattern of transfer; and the lease component, if accounted for separately, would be classified as an operating lease. The Company elected to adopt the new standard using the transition method provided by ASU 2018-11; therefore, prior periods will not be restated. The Company has determined that the impact of adoption is limited to real property leases and is consistent with industry practices. This ASU was effective January 1, 2019, when the Company recognized an aggregate of $1,073,919 in lease liabilities and corresponding ROU assets and no impact on the opening retained earnings balances.

 

In consideration of whether an agreement contains a lease as defined under ASU 2016-02, the Company answered these three questions; has an asset been identified, is the asset physically distinct, and does the customer have the right to control the asset. The Company determined based on the three-step questions above, the arrangements pertaining to real property building and office facilities in Alabama, Maine and Massachusetts are within the scope of ASU 2016-02.

 

In calculating the lease liability, the Company considered the lease term in which the Company would include any periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option. The Company evaluated factors that might create an economic incentive to exercise options to extend, including contract, asset, entity and market-based factors. The Company determined that there would be no significant relocation and interruption costs associated with moving to alternative space that would disincentivize a move at renewal; therefore, renewals to extend the lease term are not included in the ROU asset and lease liabilities.

 

A lessee may recognize the lease payments in profit or loss on a straight-line basis over the lease term and variable lease payments in the period in which the obligation for those payments is incurred. The accounting policy election for short-term leases shall be made by class of underlying asset to which the right of use relates. A short-term lease is defined as a lease that, at the commencement date, has a lease term of 12 months or less and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise. The Company elected to exclude short-term leases from the recognition requirements.

 

In discounting the liability, ASU 2016-02 indicates that the incremental rate used must be comparable to a rate attributable to a similar amount, for a similar term, and with similar collateral as the assets in the lease. The Company observed that published commercial borrowing rates were generally between 5.0% to 7.0% for loans collateralized by the real estate for terms ranging from 5-10 years.

 

Maturities of lease liabilities as of September 30, 2020 are as follows (in thousands):

 

		Leased Real Property and
		Office Facilities
2020 (remaining)		$	123
2021			460
2022			302
2023			285
2024			153
Thereafter			691
Total lease payments		$	2,014
Less: Interest			(378	)
Present value of lease liabilities		$	1,636

 

 

Supplemental cash flow information related to operating leases was as follows (in thousands, except years and percentages):

 

		Three Months Ended
		September 30, 2020				September 30, 2019
Cash paid for amounts included in the measurement of lease liabilities:
Operating cash outflow from operating leases		$	(122	)		$	(108	)
Weighted-average remaining lease term – operating leases (in years)			6.5				3.6
Weighted average discount rate – operating leases			6.5	%			6.5	%

 

		Nine Months Ended
		September 30, 2020				September 30, 2019
Cash paid for amounts included in the measurement of lease liabilities:
Operating cash outflow from operating leases		$	(365	)		$	(325	)
Weighted-average remaining lease term – operating leases (in years)			6.5				3.6
Weighted average discount rate – operating leases			6.5	%			6.5	%

 

8.

Stock Plans

 

The Company has previously granted RSUs underlying 401,111 shares of Class A common stock as of December 31, 2018. These RSUs (or a portion thereof) vest with respect to each recipient over a one to five year period from the date of grant, provided the recipient remains in the employment or service of the Company as of the vesting date and, in selected instances, certain performance criteria are attained. Additionally, these RSUs (or a portion thereof) could vest earlier in the event of a change in control of the Company, or upon involuntary termination without cause. Of the 401,111 previously granted RSUs, RSUs underlying 334,799 shares of Class A common stock have vested or were cancelled as of December 31, 2018. The previous RSU grants were made primarily to executive-level personnel at the Company and, as a result, no compensation costs have been capitalized. There were no RSUs granted by the Company during 2019. During the nine months ended September 30, 2020, 14,500 RSUs were granted by the Company to fourteen management level employees.

 

 

The following table summarizes RSU activity for the nine months ended September 30, 2019:

 

		RSUs				Weighted Average Grant Date Fair Value
Outstanding at December 31, 2018			66,312			$	9.06
Granted			—				—
Vested			(34,202	)			5.09
Forfeited or cancelled			(11,817	)			13.30
Outstanding at September 30, 2019			20,293				13.30

 

The following table summarizes RSU activity for the nine months ended September 30, 2020:

 

		RSUs				Weighted Average Grant Date Fair Value
Outstanding at December 31, 2019			17,648			$	13.30
Granted			14,500				9.22
Vested			(12,920	)			13.30
Forfeited or cancelled			(250	)			9.22
Outstanding at September 30, 2020			18,978				10.24

 

Stock-based compensation expense related to RSUs was $49 thousand and $108 thousand for the nine months ended September 30, 2020, and 2019, respectively. Stock-based compensation related to RSUs is recognized over the 60-month vesting schedule. Accounting standards require that the Company estimate forfeitures for RSUs and reduce compensation expense accordingly. The Company has reduced its expense by the assumed forfeiture rate and will evaluate actual experience against the assumed forfeiture rate going forward. The forfeiture rate has been developed using historical performance metrics which could impact the size of the final issuance of Class A common stock.

 

As of September 30, 2020, and 2019, the unrecognized total compensation cost related to unvested RSUs was $131 thousand and $108 thousand, respectively. That cost is expected to be recognized by the end of 2024.

 

On October 15, 2018, the Company granted 29,460 incentive stock options (“ISOs”) and 20,540 non-qualified (“NQ”) stock options to purchase shares of Class A common stock. These options vest with respect to the recipient thereof over a five-year period with 20% becoming exercisable on each anniversary of the vesting commencement date of October 15, 2019, provided the recipient remains in the employment or service of the Company as of the vesting date. Additionally, these options (or a portion thereof) could vest earlier in the event of a change in control of the Company. These option grants were made to one executive-level employee of the Company and, as a result, no compensation costs have been capitalized.

 

The following table summarizes ISO and NQ stock option activity for the nine months ended September 30, 2019:

 

		ISOs and NQ Stock Options				Weighted Average Grant Date Fair Value
Outstanding at December 31, 2018			50,000			$	16.97
Granted			—				—
Vested			—				—
Forfeited or cancelled			—				—
Outstanding at September 30, 2019			50,000				16.97

 

On January 2, 2020, the Company granted 34,500 ISOs and 30,000 NQ stock options to purchase shares of Class A common stock. These options vest with respect to the recipients thereof over a five-year period with 20% becoming exercisable on each anniversary of the vesting commencement date of January 1, 2021, provided the recipient remains in the employment or service of the Company as of the vesting date. Additionally, these options (or a portion thereof) could vest earlier in the event of a change in control of the Company. These option grants were made to one executive-level employee and fourteen management-level employees of the Company and, as a result, no compensation costs have been capitalized.

 

 

The following table summarizes ISO and NQ stock option activity for the nine months ended September 30, 2020:

 

		ISOs and NQ Stock Options				Weighted Average Grant Date Fair Value
Outstanding at December 31, 2019			40,000			$	16.97
Granted			64,500				9.22
Vested			—				—
Forfeited or cancelled			(250	)			9.22
Outstanding at September 30, 2020			104,250				12.19

 

Stock-based compensation expense related to ISOs and NQ stock options was $107 thousand and $65 thousand for the nine months ended September 30, 2020, and 2019, respectively.

 

As of September 30, 2020, and 2019, the unrecognized total compensation cost related to unvested ISOs and NQ stock options was $503 thousand and $351 thousand, respectively. That cost is expected to be recognized by the end of 2024.

 

9.

Goodwill

 

The Company evaluated its goodwill for impairment as of September 30, 2020, in light of the COVID-19 pandemic impact on the economy. After evaluating the qualitative and quantitative information, the Company concluded that goodwill was not impaired as of September 30, 2020.

 

10.

Subsequent Events

 

On July 27, 2020, Otelco filed a Current Report on Form 8-K with the Securities and Exchange Commission (the “SEC”) in connection with the proposed acquisition of the Company by Future Fiber FinCo, Inc., a Delaware corporation (“Parent”), pursuant to an Agreement and Plan of Merger, dated as of July 26, 2020 (as may be amended from time to time, the “Merger Agreement”), by and among the Company, Parent and Olympus Merger Sub, Inc., a Delaware corporation and a wholly owned subsidiary of Parent (“Merger Sub”), providing for the merger of Merger Sub with and into the Company (the “Merger”), with the Company continuing as the surviving corporation of the Merger and a wholly owned subsidiary of Parent. On August 20, 2020, the Company filed with the SEC its preliminary proxy statement on Schedule 14A (the “Preliminary Proxy Statement”), and on September 9, 2020, the Company filed with the SEC its definitive proxy statement on Schedule 14A (the “Definitive Proxy Statement”), in each case relating to the special meeting of stockholders of the Company that was held on October 9, 2020 to, among other things, vote on a proposal to adopt the Merger Agreement.

 

On September 1, 2020, a purported stockholder of Otelco filed a putative stockholder class action lawsuit, captioned Patrick Plumley v. Otelco Inc. et. al., No. 1:20-cv-01165-UNA, in the United States District Court for the District of Delaware, on behalf of all public stockholders of Otelco against the Company and the members of its Board of Directors (the “PLUMLEY Action”). Thereafter, on September 21, 2020, another purported stockholder of Otelco filed a separate individual lawsuit, captioned Jacob Scheiner IRA v. Otelco Inc., et al., 1:20-cv-07756-AJN, in the United States District Court for the Southern District of New York (the “IRA Action” and, together with the PLUMLEY Action, the “Actions”). The Actions generally allege that the Preliminary Proxy Statement or the Definitive Proxy Statement omits certain material information in violation of Section 14(a) of the Securities Exchange Act of 1934 and Rule 14a-9 promulgated thereunder, and further that the members of the Company’s Board of Directors are liable for those omissions under Section 20(a) of the Securities Exchange Act of 1934. The relief sought in the Actions includes a preliminary and permanent injunction to prevent the completion of the Merger, rescission or rescissory damages if the Merger is completed, costs and attorneys’ fees.

 

While Otelco believes that the disclosures set forth in the Preliminary Proxy Statement and Definitive Proxy Statement complied fully with applicable law, to resolve the alleged stockholders’ claims and moot the disclosure claims, to avoid nuisance, potential expense, and delay and to provide additional information to our stockholders, the Company voluntarily supplemented the Definitive Proxy Statement with additional disclosures filed with the SEC on October 1, 2020. Nothing in the supplemental disclosures shall be deemed an admission of the legal necessity or materiality under applicable law of any of the disclosures set forth therein or in the Definitive Proxy Statement. To the contrary, the Company denied all allegations that any additional disclosure was, or is, required.

 

On October 9, 2020, Otelco’s stockholders adopted the Merger Agreement and approved the Merger.

 

On November 3, 2020, the Company entered into a contract with Parent under which the Company has agreed to incur capital expenditures in connection with network design and engineering services in existing and new markets. The contract could result in up to $3.5 million in incremental revenue for the Company over the next six months.

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Overview

 

General

 

Since 1999, we have acquired and operate eleven rural local exchange carriers (“RLECs”) serving subscribers in north central Alabama, central Maine, western Massachusetts, central Missouri, western Vermont and southern West Virginia. We also operate a competitive local exchange carrier (“CLEC”) serving subscribers in Maine, Massachusetts and New Hampshire. Our services include a broad suite of communications and information services including local and long distance telephone services; internet and broadband data services; network access to other wireline, long distance and wireless carriers for calls originated or terminated on our network; other telephone related services; cloud hosting and professional engineering services for small and mid-sized companies who rely on mission-critical software applications; digital high-speed transport services (in our New England market); and video and security (in some markets). We view, manage and evaluate the results of operations from the various telecommunications services as one company and therefore have identified one reporting segment as it relates to providing segment information.

 

The Federal Communications Commission (the “FCC”) released its intercarrier compensation order (the “FCC ICC Order”) in November 2011. This order made substantial changes in the way telecommunication carriers are compensated for serving high cost areas and for completing traffic with other carriers. We began seeing the significant impact of the FCC ICC Order to our business in July 2012, with additional impacts beginning in July 2013 and July 2014. The initial consequence to our business was to reduce access revenue from intrastate calling in Maine and other states where intrastate rates were higher than interstate rates. A portion of this revenue loss for our RLEC properties is returned to us through the Connect America Fund (the “CAF”). There is no recovery mechanism for the lost revenue in our CLEC. The impact of the FCC ICC Order is expected to continue reducing our revenue and net income through 2020.

 

A portion of the revenue loss for our RLEC properties is also returned to us through the Alternative Connect America Model (the “A-CAM”). Support under the A-CAM model-based approach is higher than the estimated support which would have been received under legacy rate-of-return regulation. Without the A-CAM model-based support, in 2017, our RLECs would have seen a normal year-over-year funding decrease under Universal Service Fund High Cost Loop (the “USF HCL) and the FCC’s Budget Control mechanism. A-CAM support requires additional investment in plant and equipment to reach target broadband speeds and covered locations. A-CAM support will decline through 2028 as the additional investment is completed.

 

COVID-19

 

A novel strain of coronavirus (COVID-19) was first identified in December 2019, and subsequently declared a global pandemic by the World Health Organization on March 11, 2020. As a result of the outbreak, companies have experienced disruptions in their operations and in markets served.  We instituted numerous precautionary measures intended to help ensure the well-being of our employees to continue providing essential telecommunications services to our customers and minimize business disruption.

 

As COVID-19 restrictions had been eased in some states, our employees who had been working from home since March 2020 began returning to their normal work locations while we continue to empower our technicians to reschedule any in-person installation or repair if they determine that circumstances at the location present a health risk. During third quarter 2020, we saw customer calls for new and changed service, payment arrangements and service troubles begin to trend toward pre-COVID-19 levels.

 

As a result of the measures implemented, no significant adverse impact on results of operations through and financial position at September 30, 2020, has occurred as a result of the pandemic. The full extent of the future impacts of the COVID-19 pandemic on our operations is uncertain. An increase of COVID-19 cases in our service areas could have a material adverse impact on our financial results and business, including our timing and ability to collect accounts receivable and procure materials and services from our suppliers.

 

CARES Act

        

The Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”) was enacted on March 27, 2020.  There are several different provisions with the CARES Act that impact income taxes for corporations. We have evaluated the tax implications and believe these provisions did not have a material impact on our financial statements.

 

Additionally, we applied for and received funds under the Paycheck Protection Program (the “PPP Loan”) in the amount of $2,975,000. The receipt of these funds, and the forgiveness of the loan attendant to these funds, is dependent on the Company having initially qualified for the loan and qualifying for the forgiveness of such loan based on our adherence to the updated forgiveness criteria included in the Paycheck Protection Program Flexibility Act (“PPP Flexibility”). We submitted the application for loan forgiveness of the full loan amount on October 1, 2020. Approval of loan forgiveness by the lender and the Small Business Administration (the “SBA”) has not been received and could take up to six months.

 

 

Our PPP Loan has a two-year term and bears interest at a rate of 1.0% per annum. Under PPP Flexibility, monthly principal and interest payments are deferred until the date the lender receives the applicable forgiven amount from the SBA. The PPP Loan may be prepaid at any time prior to maturity with no prepayment penalties. The promissory note contains events of default and other provisions customary for a loan of this type.

 

The PPP Loan was used to retain our employees and allow them to be able to continue to provide essential telecommunications and data services for our customers during the initial peak of the COVID-19 pandemic. These services were and remain critical to customers as they work and live under physical separation and quarantine requirements. Given direction from the FCC and state public utilities commissions, free or discounted services were made available to families who receive other governmental assistance and service disconnection for non-payment was delayed for four months where families and businesses were experiencing COVID-19 financial impacts. Consent of the agent and Required Lenders (as defined in the Credit Facility) under the Credit Facility was obtained in connection with the incurrence of the PPP Loan. We will continue to work with federal, state and local governmental bodies to be responsive to COVID-19 guidance and CARES Act requirements.

 

The following discussion and analysis should be read in conjunction with our unaudited condensed consolidated financial statements and the related notes included in Item 1 of Part 1, Financial Statements and Supplementary Data, and the other financial information appearing elsewhere in this report. The following discussion and analysis relate to our financial condition and results of operations on a consolidated basis.

 

Revenue Sources

 

We derive our revenues from six sources:

 

·

Local services. We receive revenues from providing local exchange telecommunication services in our eleven rural territories. In addition, we receive revenues on a competitive basis through both wholesale and retail channels throughout Maine, New Hampshire and western Massachusetts. These revenues include monthly subscription charges for basic service, calling beyond the local territory on a fixed price and on a per minute basis, local private line services and enhanced calling features, such as voicemail, caller identification, call waiting and call forwarding. We also receive revenues from directory advertising. A significant 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 customers and switched and special access charges paid by carriers. Switched access charges for long distance services within Alabama, Maine, Massachusetts, Missouri, New Hampshire, Vermont and West Virginia have historically been based on rates approved by the Alabama Public Service Commission, the Maine Public Utilities Commission (the “MPUC”), the Massachusetts Department of Telecommunications and Cable (the “MDTC”), the Missouri Public Service Commission, the New Hampshire Public Utilities Commission (the “NHPUC”), the Vermont Public Utility Commission and the West Virginia Public Service Commission, respectively, where appropriate. The FCC ICC Order preempted the state commissions’ authority to set terminating intrastate access service rates, and required companies 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, which will eliminate access charges between carriers. The FCC ICC Order prescribes a recovery mechanism for the recovery of any decrease in intrastate terminating access revenues through the CAF for RLEC companies. This recovery is limited to 95% of the previous year’s revenue requirement. Interstate access revenue is based on an FCC-regulated rate-of-return on investment and recovery of expenses and taxes. From 1990 through June 2016, the rate-of-return had been authorized up to 11.25%. In March 2016, the FCC reduced the authorized rate-of-return to 9.75% effective July 1, 2021, using a transitional approach to reduce the impact of an immediate reduction. Rate-of-return transition began on July 1, 2016, with the authorized rate reduced to 11.0%, with further 25 basis points reductions each July 1 thereafter until the authorized rate reaches 9.75% on July 1, 2021. Switched and special access charges for interstate and international services are based on rates approved by the FCC. We also receive revenue from the Universal Service Fund (the “USF”) for the deployment of voice and broadband services to end-user customers. Since January 1, 2017, ten of our RLECs receive support payments through A-CAM. One RLEC received support payments through modified legacy rate-of-return support mechanisms for USF HCL and Interstate Common Line Support for 2017 and 2018 and A-CAM support payments for 2019.

 

·

Internet. We receive revenues from monthly recurring charges for digital high-speed data lines 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 telecommunication services in Alabama, Maine and New Hampshire.

 

 

·

Video and security. We offer basic, digital, high-definition, digital video recording and pay-per-view cable television services to a portion of our telephone service territory in Alabama, including internet protocol television (“IPTV”). We offer wireless security systems and system monitoring in Alabama and Missouri.

  

·

Managed services. We provide private/hybrid cloud hosting services, as well as consulting and professional IT engineering services, for mission-critical software applications for small and mid-sized North American companies. Revenues are generated from monthly recurring hosting Infrastructure as a Service fees, monthly maintenance fees, à la carte professional engineering services and pay-as-you-use Software as a Service fees. Services are domiciled in two diverse owned data centers.

 

Customer and Service Trends

 

With the implementation of our consolidated billing system in 2018 supporting all of our customers and services, we have adopted managerial systems that focus on retaining customers and offering them a variety of service options. We offer competitively priced location-specific bundled service packages tailored to the varying telecommunications requirements of our customers.

 

Key Operating Statistics

 

		September 30, 2020				June 30, 2020				Change for the Third Quarter 2020								December 31,  2019				Change for Year to Date 2020								December 31,  2018				Change for the Year 2019
Customers served
Business/Enterprise			5,131				5,192				(61	)			(1.2	)%			5,337				(206	)			(3.9	)%			5,769				(432	)			(7.5	)%
Residential			27,604				27,901				(297	)			(1.1	)%			26,917				687				2.6	%			27,734				(817	)			(2.9	)%
Customers served			32,735				33,093				(358	)			(1.1	)%			32,254				481				1.5	%			33,503				(1,249	)			(3.7	)%
Services provided
Hosted PBX			7,994				8,010				(16	)			(0.2	)%			8,685				(691	)			(8.0	)%			9,008				(323	)			(3.6	)%
Voice			31,957				32,997				(1,040	)			(3.2	)%			34,038				(2,081	)			(6.1	)%			36,899				(2,861	)			(7.8	)%
Data			23,258				23,373				(115	)			(0.5	)%			22,242				1,016				4.6	%			22,514				(272	)			(1.2	)%
Video			2,660				2,683				(23	)			(0.9	)%			2,669				(9	)			(0.3	)%			2,734				(65	)			(2.4	)%
Services provided			65,869				67,063				(1,194	)			(1.8	)%			67,634				(1,765	)			(2.6	)%			71,155				(3,521	)			(4.9	)%

 

One of our key performance measures tracks the number of business and residence customers served and the number of telecommunications services provided to these customers. The table above provides a summary of the change in customers and the change in our four largest telecommunications services.

 

For the three months ended September 30, 2020, customers served decreased 1.1%, or 358 customers, reflecting a decrease in both residential and business customers as we returned to a more traditional treatment process for non-payment of customer bills. For the nine months ended September 30, 2020, customers increased 1.5%, or 481 customers. For the three months ended September 30, 2020, services provided to these customers decreased 1.8%, or 1,194 services, primarily reflecting a decrease in voice services. The continued deployment of fiber-based services, the transition to VDSL in all of our networks and the deployment of DOCSIS 3.1 in our cable network are expected to improve the speed of our service offerings in 2020 and positively impact the level of customer and service churn.

 

Our Rate and Pricing Structure

 

Our CLEC enterprise pricing is based on market requirements. We combine varying services to meet individual customer requirements, including technical support, and provide multi-year contracts that are both market sensitive for the customer and profitable for us. The MPUC, MDTC and NHPUC impose minimum 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 and delivery of services.

  

Our RLECs operate in six states and have limited regulation by the respective state regulatory authorities. The impact on pricing flexibility varies by state. In Maine and Vermont, our wholly owned subsidiaries 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 high-speed internet access, are not price regulated. The market for competitive services, such as wireless, also affects the ability to adjust prices. With the increase of bundled services offerings, including unlimited long distance, pricing for individual services takes on reduced importance to revenue stability. We expect this trend to continue into the immediate future.

 

Alabama RLECs receive state-based support, which was implemented more than a decade ago 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 provided total compensation of $0.3 million for the years ended December 31, 2017 and 2018, and $0.2 million for the year ended December 31, 2019, representing approximately 0.5%, 0.5% and 0.4% of our total revenue for the years ended December 31, 2017, 2018 and 2019, respectively. The revenue we receive from these funds is in the process of being phased out over a five-year period that began in June 2016. Reduction in fund revenue was 5% in each of 2016 and 2017, 10% in 2018, and 15% in each of 2019 and 2020. No revenue will be received after June 2021.

 

 

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 operating margins. As our revenue continues to shift to non-regulated services and CLEC customers, and our access and residential RLEC revenues continue to decline, operating margins decrease due to the lower margins associated with non-regulated services. Reductions in USF and intercarrier compensation payments based on FCC action in 2011 are difficult to fully offset through expense control and pricing action. However, A-CAM began providing support funding to increase capital investment in broadband services in our RLECs in 2017.

 

 

Results of Operations

 

The following table sets forth our results of operations as a percentage of total revenues for the periods indicated:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2020				2019				2020				2019
Revenues
Local services			29.5	%			29.9	%			29.9	%			30.9	%
Network access			31.9				34.5				32.2				33.8
Internet			25.9				23.3				25.1				23.3
Transport services			7.0				6.9				7.1				6.7
Video and security			4.6				4.4				4.6				4.3
Managed services			1.1				1.0				1.1				1.0
Total revenues			100.0	%			100.0	%			100.0	%			100.0	%
Operating expenses
Cost of services			47.7	%			47.8	%			47.8	%			47.9	%
Selling, general and administrative expenses			22.2				15.9				20.1				16.0
Depreciation and amortization			13.4				11.9				13.3				12.1
Total operating expenses			83.3				75.6				81.2				76.0
Income from operations			16.7				24.4				18.8				24.0
Other income (expense)
Interest expense			(5.9	)			(8.3	)			(6.7	)			(8.6	)
Other income			—				—				1.7				1.3
Total other expense			(5.9	)			(8.3	)			(5.0	)			(7.3	)
Income before income tax expense			10.8				16.1				13.8				16.7
Income tax expense			(2.9	)			(4.6	)			(3.3	)			(4.4	)
Net income available to common stockholders			7.9	%			11.5	%			10.5	%			12.3	%

 

Revenues by category for the three and nine months ended September 30, 2019, have been adjusted to be consistent with the revenues by category for the three and nine months ended September 30, 2020.

 

Three Months and Nine Months Ended September 30, 2020, Compared to Three Months and Nine Months Ended September 30, 2019

 

Total revenues. Total revenues decreased 1.2% in the three months ended September 30, 2020, to $15.6 million from $15.8 million in the three months ended September 30, 2019. Total revenues decreased 1.5% in the nine months ended September 30, 2020, to $46.5 million from $47.2 million in the nine months ended September 30, 2019. The decrease was primarily due to the decrease in residential local services and traditional access revenue affected by the FCC ICC Order, partially offset by an increase in internet services. The tables below provide the components of our revenues for the three months and nine months ended September 30, 2020, compared to the same period of 2019.

 

For the three months ended September 30, 2020, and 2019

 

		Three Months Ended September 30,								Change
		2020				2019				Amount				Percent
		(dollars in thousands)
Local services		$	4,594			$	4,717			$	(123	)			(2.6	)%
Network access			4,963				5,436				(473	)			(8.7	)%
Internet			4,032				3,673				359				9.8	%
Transport services			1,087				1,091				(4	)			(0.4	)%
Video and security			722				691				31				4.5	%
Managed services			176				154				22				14.3	%
Total		$	15,574			$	15,762			$	(188	)			(1.2	)%

 

Local services. Local services revenue decreased 2.6% in the three months ended September 30, 2020, to $4.6 million from $4.7 million in the three months ended September 30, 2019. RLEC residential voice line revenue, including long distance and other related services accounted for the decrease.

 

 

Network access. Network access revenue decreased 8.7% in the three months ended September 30, 2020, to $5.0 million from $5.4 million in the three months ended September 30, 2019. End-user and access recovery fees decreased $0.2 million. Switched and special access revenue decreased $0.1 million. A-CAM revenue decreased $0.1 million.

 

Internet. Internet revenue increased 9.8% in the three months ended September 30, 2020, to $4.0 million from $3.7 million in the three months ended September 30, 2019. An increase in customers and data speeds accounted for the increase.

 

Transport services. Transport services revenue was unchanged at $1.1 million in the three months ended September 30, 2020, and in the three months ended September 30, 2019, reflecting a stable market presence.

 

Video and security. Video and security revenue increased 4.5% in the three months ended September 30, 2020, to just over $0.7 million from just under $0.7 million in the three months ended September 30, 2019. An increase in IPTV customers and pricing changes offset a decline in traditional cable customers.

 

Managed services. Managed services revenue increased 14.3% in the three months ended September 30, 2020, to just under $0.2 million from just over $0.1 million in the three months ended September 30, 2019, reflecting modestly higher cloud hosting revenue.

 

For the nine months ended September 30, 2020, and 2019

 

		Nine Months Ended September 30,								Change
		2020				2019				Amount				Percent
		(dollars in thousands)
Local services		$	13,899			$	14,585			$	(686	)			(4.7	)%
Network access			14,936				15,970				(1,034	)			(6.5	)%
Internet			11,671				10,996				675				6.1	%
Transport services			3,289				3,143				146				4.6	%
Video and security			2,151				2,028				123				6.1	%
Managed services			518				453				65				14.3	%
Total		$	46,464			$	47,175			$	(711	)			(1.5	)%

 

Local services. Local services revenue decreased 4.7% in the nine months ended September 30, 2020, to $13.9 million from $14.6 million in the nine months ended September 30, 2019. RLEC residential voice line revenue, including long distance and other related services, decreased $0.4 million. Revenue associated with special line and rental revenue decreased $0.3 million.

 

Network access. Network access revenue decreased 6.5% in the nine months ended September 30, 2020, to $14.9 million from $16.0 million in the nine months ended September 30, 2019. A-CAM revenue increased $0.5 million, reflecting the FCC’s adjustment of funding for our conversion of Vermont to A-CAM which was not reflected in 2019. CAF and other transition support payments decreased $0.5 million. Switched and special access decreased $0.4 million and end-user fees decreased $0.7 million.

 

Internet. Internet revenue increased 6.1% in the nine months ended September 30, 2020, to $11.7 million from $11.0 million in the nine months ended September 30, 2019. An increase in customers and data speeds accounted for the increase.

 

Transport services. Transport services revenue increased 4.6% in the nine months ended September 30, 2020, to $3.3 million from $3.1 million in the nine months ended September 30, 2019, reflecting customer growth.

 

Video and security. Video and security revenue increased 6.1% in the nine months ended September 30, 2020, to $2.2 million from $2.0 million in the nine months ended September 30, 2019. An increase in IPTV customers and pricing changes offset a decline in traditional cable customers.

 

Managed services. Managed services revenue increased 14.3% in the nine months ended September 30, 2020, to just over $0.5 million from just under $0.5 million in the nine months ended September 30, 2019, reflecting modestly higher cloud hosting and professional services revenue.

 

Operating expenses. Operating expenses in the three months ended September 30, 2020, increased 8.8% to $13.0 million from $11.9 million in the three months ended September 30, 2019. Operating expenses in the nine months ended September 30, 2020, increased 5.2% to $37.7 million from $35.9 million in the nine months ended September 30, 2019. Board of directors’ project expenses related to the Oak Hill Capital’s plan to acquire the Company accounted for the majority of the increase. The tables below provide the components of our operating expenses for the three months and nine months ended September 30, 2020, compared to the same periods of 2019.

 

 

For the three months ended September 30, 2020, and 2019

 

		Three Months Ended September 30,								Change
		2020				2019				Amount				Percent
		(dollars in thousands)
Cost of services		$	7,422			$	7,542			$	(120	)			(1.6	)%
Selling, general and administrative expenses			3,459				2,506				953				38.0	%
Depreciation and amortization			2,088				1,873				215				11.5	%
Total		$	12,969			$	11,921			$	1,048				8.8	%

 

Cost of services. Cost of services decreased 1.6% to $7.4 million in the three months ended September 30, 2020, from $7.5 million in the three months ended September 30, 2019. Lower network access, toll and circuit expense accounted for the decrease of $0.1 million and lower sales and product management expense accounted for a decrease of $0.1 million. These decreases were partially offset by an increase in cable programming expense.

 

Selling, general and administrative expenses. Selling, general and administrative expenses increased 38.0% to $3.5 million in the three months ended September 30, 2020, from $2.5 million in the three months ended September 30, 2019. Legal and other costs associated with the announced acquisition of Otelco by Oak Hill Capital accounted for an increase of $0.8 million. Uncollectible revenue, property tax and other administrative expense accounted for an increase of $0.3 million. These increases were partially offset by a decrease in executive and planning expense of $0.1 million.

 

Depreciation and amortization. Depreciation and amortization increased 11.5% to $2.1 million in the three months ended September 30, 2020, from $1.9 million in the three months ended September 30, 2019. An increase in RLEC depreciation reflecting new fiber and VDSL investment placed in service accounted for the increase.

 

For the nine months ended September 30, 2020, and 2019

 

		Nine Months Ended September 30,								Change
		2020				2019				Amount				Percent
		(dollars in thousands)
Cost of services		$	22,235			$	22,630			$	(395	)			(1.7	)%
Selling, general and administrative expenses			9,326				7,535				1,791				23.8	%
Depreciation and amortization			6,163				5,698				465				8.2	%
Total		$	37,724			$	35,863			$	1,861				5.2	%

 

Cost of services. Cost of services decreased 1.7% to $22.2 million in the nine months ended September 30, 2020, from $22.6 million in the nine months ended September 30, 2019. Lower network access, toll and circuit expense accounted for the decrease of $0.4 million and lower sales and product management expense accounted for a decrease of $0.2 million. These decreases were partially offset by an increase in cable programming expense.

 

Selling, general and administrative expenses. Selling, general and administrative expenses increased 23.8% to $9.3 million in the nine months ended September 30, 2020, from $7.5 million in the nine months ended September 30, 2019. Legal and other costs associated with the announced acquisition of Otelco by Oak Hill Capital accounted for an increase of $1.5 million. Uncollectible revenue, property tax and other administrative expense accounted for an increase of $0.5 million. These increases were partially offset by a decrease in executive and planning expense of $0.2 million.

 

Depreciation and amortization. Depreciation and amortization increased 8.2% to $6.2 million in the nine months ended September 30, 2020, from $5.7 million in the nine months ended September 30, 2019. An increase in RLEC depreciation reflecting new fiber and VDSL investment placed in service accounted for the increase.

 

For the three months ended September 30, 2020, and 2019

 

		Three Months Ended September 30,								Change
		2020				2019				Amount				Percent
		(dollars in thousands)
Interest expense		$	(931	)		$	(1,315	)		$	(384	)			(29.2	)%
Other income			6				5				1				NM
Income tax expense			(452	)			(712	)			(260	)			(36.5	)

 

 

Interest expense. Interest expense decreased 29.2% in the three months ended September 30, 2020, to $0.9 million from $1.3 million in the three months ended September 30, 2019. Lower outstanding principal balance and lower LIBOR interest rates accounted for the decrease. Our Credit Facility matures in November 2022. See additional information in the “Liquidity and Capital Resources” section below.

 

Other income. Other income in the three months ended September 30, 2020, was basically unchanged from the three months ended September 30, 2019.

 

Income tax expense. As of September 30, 2020, our effective tax rate is 24.4%, as compared to 26.1% as of September 30, 2019. The effective income tax rate varies from the federal corporate tax rate of 21% largely due to state income taxes and other permanent differences.

 

For the nine months ended September 30, 2020, and 2019

 

		Nine Months Ended September 30,								Change
		2020				2019				Amount				Percent
		(dollars in thousands)
Interest expense		$	(3,100	)		$	(4,044	)		$	(944	)			(23.3	)%
Other income			813				604				209				34.6
Income tax expense			(1,576	)			(2,056	)			(480	)			(23.3	)

 

Interest expense. Interest expense decreased 23.3% in the nine months ended September 30, 2020, to $3.1 million from $4.0 million in the nine months ended September 30, 2019. Lower outstanding principal balance and lower LIBOR interest rates accounted for the decrease. Our Credit Facility matures in November 2022. See additional information in the “Liquidity and Capital Resources” section below.

  

Other income. Other income increased 34.6% in the nine months ended September 30, 2020, to $0.8 million from $0.6 million in the nine months ended September 30, 2019, relating to the one-time gains on the sale of a surplus vacant building and a parcel of property. The annual CoBank dividend is received in first quarter of each year.

 

Income tax expense. As of September 30, 2020, our effective tax rate is 24.4%, as compared to 26.1% as of September 30, 2019. The effective income tax rate varies from the federal corporate tax rate of 21% largely due to state income taxes and other permanent differences.

 

Net income. As a result of the foregoing, there was net income of $1.2 million and $1.8 million in the three months ended September 30, 2020, and 2019, respectively. As a result of the foregoing, there was net income of $4.9 million and $5.8 million in the nine months ended September 30, 2020, and 2019, respectively.

 

Liquidity and Capital Resources

 

Our liquidity needs arise primarily from: (i) interest and principal payments related to our credit facility; (ii) capital expenditures for investment in our business, including A-CAM requirements; and (iii) working capital requirements.

 

For the nine months ended September 30, 2020, we generated cash from our business to invest in additional property and equipment of $8.1 million, pay loan principal of $3.3 million and pay scheduled interest on our debt of $2.7 million. After meeting all of these needs of our business, cash increased to $8.1 million as of September 30, 2020, from $3.1 million as of December 31, 2019.

 

Cash flows from operating activities for the nine months ended September 30, 2020, amounted to $13.3 million compared to $11.7 million for the nine months ended September 30, 2019, primarily reflecting slightly lower net income and improvement in operating assets and liabilities.

 

Cash flows used in investing activities for the nine months ended September 30, 2020, were $7.8 million compared to $7.6 million for the nine months ended September 30, 2019, primarily reflecting continuing RLEC fiber installation, expansion of the VDSL data delivery platform and preparation for the upgrade of the Alabama cable network to DOCSIS 3.1.

 

Cash flows from financing activities for the nine months ended September 30, 2020, including proceeds from the PPP Loan, were $0.5 million, compared to cash flows used in financing activities for the nine months ended September 30, 2019 of $3.5 million. Both periods reflect $3.3 million in scheduled principal payments. Loan origination costs of $0.2 million in first quarter 2020 and tax withholdings paid on behalf of employees for restricted stock units of $0.2 million in in first quarter 2019 account for the other differences.

 

 

We do not invest in financial instruments as part of our business strategy. However, our Credit Facility required that we acquire an interest rate hedge on at least 50% of our outstanding notes payable balance for a period of at least two years. Accordingly, we purchased a two-year 3.0% interest rate cap on one-month LIBOR covering $45.0 million on February 26, 2018. The interest rate cap was accounted for as an asset and marked to market each quarter. The interest rate cap expired on February 26, 2020.

 

On November 2, 2017, we refinanced our prior credit facilities with a new $92.0 million, five-year credit facility from a consortium of banks led by CoBank, ACB. Our Credit Facility includes an $87.0 million term loan and a $5.0 million revolving loan, which is undrawn. Our Credit Facility also includes a $20.0 million accordion feature that could be used to increase the term-loan portion of the credit facility, subject to the satisfaction of certain conditions and lender participation. Proceeds from the term loan and cash on hand were used to pay all amounts due in respect of principal, interest, prepayment premiums and fees under our prior credit facilities, as well as fees associated with the transaction. Our Credit Facility requires annual principal reduction of $4.3 million paid equally on a quarterly basis and, beginning in 2019, an annual principal payment equal to 50% of our excess cash flow for the year. During the nine months ended September 30, 2020, we made our scheduled principal payment of $3.3 million. We made no voluntary principal prepayments.

 

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. We continue to monitor the effects that the COVID-19 pandemic could have on our operations and liquidity including our ability to collect account receivable in a timely fashion from our customers due to the economic impacts that the COVID-19 pandemic could have on the general economy.

  

Non-GAAP Measures

 

We use consolidated earnings before interest, taxes, depreciation and amortization (“Consolidated EBITDA”) and the ratio of our debt, net of cash, to Consolidated EBITDA for the last twelve months (the “Leverage Ratio”) as operational performance measurements. Consolidated EBITDA, as presented in this Quarterly Report on Form 10-Q, corresponds to the definition of Consolidated EBITDA in our credit facility. Consolidated EBITDA and the Leverage Ratio, as presented in this Quarterly Report on Form 10-Q, are supplemental measures of our performance that are not required by, or presented in accordance with, accounting principles generally accepted in the United States (“U.S. GAAP”). The lenders under our credit facility use Consolidated EBITDA to determine compliance with credit facility requirements. We report Consolidated EBITDA and the Leverage Ratio in our quarterly earnings press release to allow current and potential investors to understand these performance metrics and because we believe that they provide current and potential investors with helpful information with respect to our operating performance, including our ability to generate earnings sufficient to service our debt, and enhance understanding of our financial performance and highlight operational trends. However, Consolidated EBITDA and the Leverage Ratio should not be considered as an alternative to net income or any other performance measures derived in accordance with U.S. GAAP. Our presentation of Consolidated EBITDA and the Leverage Ratio may not be comparable to similarly titled measures used by other companies. Consolidated EBITDA for the three and nine months ended September 30, 2020, and 2019, and the twelve months ended September 30, 2020, and the reconciliation to net income, are reflected in the table below (dollar amounts in thousands):

  

		Three Months Ended September 30, 2020				Three Months Ended September 30, 2019				Nine Months Ended September 30, 2020				Nine Months Ended September 30, 2019				Twelve Months Ended September 30, 2020
Net income		$	1,228			$	1,819			$	4,877			$	5,816			$	6,856
Add:   Depreciation			1,997				1,798				5,939				5,465				7,817
Interest expense less interest income			802				1,198				2,706				3,691				3,817
Interest expense – amortized loan cost			125				112				379				342				489
Income tax expense			452				712				1,576				2,056				1,913
Amortization - intangibles			91				75				224				233				291
Loan fees			19				17				55				52				72
Stock-based compensation (senior management)			52				59				156				173				238
Consolidated EBITDA		$	4,766			$	5,790			$	15,912			$	17,828			$	21,493

 

The table below provides the calculation of the Leverage Ratio as of September 30, 2020 (dollar amounts in thousands).

 

Notes payable		$	66,005
Debt issuance costs			945
Notes outstanding		$	66,950
Less cash (excluding PPP loan)			(5,111	)
Notes outstanding, net of cash		$	61,839
Consolidated EBITDA for the last twelve months		$	21,493
Leverage Ratio			2.88

 

 

As we reduce our debt, our Leverage Ratio will vary based on changes in Consolidated EBITDA.

 

Off-Balance Sheet Arrangements

 

We have no material off-balance sheet arrangements.

 

Recently Adopted Accounting Pronouncements

 

See Note 1, Organization and Basis of Financial Reporting, to our unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for a description of the recently adopted accounting pronouncements that are applicable to us, including details relating to our adoption of ASU 2016-02, Leases (Topic 842), at the beginning of 2019, which adoption did not have a material impact on our unaudited condensed consolidated financial statements.

  

Recent Accounting Pronouncements

 

See Note 1, Organization and Basis of Financial Reporting, to our unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for a description of the recent accounting pronouncements that are applicable to us.

 

Subsequent Events

 

See Note 10, Subsequent Events, to our unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for a description of subsequent events that occurred after September 30, 2020.

 

Item 3.

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. Accordingly, we are subject to minimal market risk on our investments.

 

Interest rates applicable to the term loans (including any incremental term loans incurred under the accordion feature) and the revolving loans under our credit facility are set at a margin over an adjusted LIBOR rate (which is defined as the higher of (1) LIBOR multiplied by the statutory reserve rate and (2) 0.0% per annum) or a base rate (which is defined as the highest of (1) the prime rate, (2) the federal funds effective rate plus 0.50% per annum, (3) the adjusted LIBOR rate for an interest period of one month plus 1.0% per annum and (4) 0.0% per annum). Accordingly, we are exposed to interest rate risk. A one percentage point change in one-month LIBOR interest rates from the interest rates actually applicable to the loans under our credit facility during the period would have resulted in an increase of $0.5 million in our interest expense for the nine months ended September 30, 2020.

 

Item 4.

Controls and Procedures

 

With the participation of the Chief Executive Officer and the Chief Financial Officer, management has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934). Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that our disclosure controls and procedures were effective as of September 30, 2020.

 

There were no changes in our internal control over financial reporting during the three months ended September 30, 2020, that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

 

PART II OTHER INFORMATION

 

Item 1A.

Risk Factors

 

The following risk factors are added to those disclosed in Item 1A. Risk Factors in Part I of our 2019 Annual Report on Form 10-K.

 

Public health threats or outbreaks of communicable diseases could have a material adverse effect on the Company’s operations and overall financial performance.

 

The Company may face risks related to public health threats or outbreaks of communicable diseases. A global health crisis, such as the current outbreak of coronavirus or COVID-19, could adversely affect the United States and global economies and limit the ability of enterprises to conduct business for an indefinite period of time. The current outbreak of COVID-19 has negatively impacted the global economy, disrupted financial markets and international trade, resulted in increased unemployment levels and significantly impacted global supply chains, all of which have the potential to impact the Company’s business.

 

In addition, government authorities have implemented various mitigation measures, including travel restrictions, limitations on business operations, stay-at-home orders and social distancing protocols. While the Company has been deemed critical infrastructure by the United States Department of Homeland Security, the economic impact of the aforementioned actions may impair our ability to sustain sufficient financial liquidity and impact our financial results. Specifically, the continued spread of COVID-19 and efforts to contain the virus could: (i) result in an increase in costs related to delayed payments from customers and uncollectable accounts, (ii) cause a reduction in revenue related to late fees and other charges related to governmental regulations, (iii) cause delays and disruptions in the supply chain related to obtaining necessary materials for our network infrastructure or customer premise equipment, (iv) cause workforce disruptions, including the availability of qualified personnel; and (v) cause other unpredictable events.

 

As we cannot predict the duration or scope of the global health crisis, the anticipated negative financial impact to our operating results cannot be reasonably estimated, but could be material and last for an extended period of time.

 

Risks Relating to the Proposed Merger

 

There are material uncertainties and risks associated with the Merger Agreement and proposed Merger.

 

 On July 26, 2020, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) pursuant to which we will be acquired by an affiliate (the “Oak Hill Buyer”) formed by Oak Hill Capital (the “Merger”). The announcement and pendency of the Merger, as well as any delays in the expected timeframe, could cause disruption and create uncertainties, which could have an adverse effect on our business, results of operations and financial condition, regardless of whether the Merger is completed. These risks include:

 

·

an adverse effect on our relationships with vendors, customers, and employees;

 

·

a diversion of a significant amount of management time and resources towards the completion of the Merger;

 

·

being subject to certain restrictions on the conduct of our business before the closing of the Merger;

 

·

possibly foregoing certain business opportunities that we might otherwise pursue absent the Merger; and

 

·

difficulties attracting and retaining key employees.

 

The proposed Merger may not be completed in a timely manner or at all.

 

Completion of the proposed Merger is subject to customary closing conditions, including (1) the adoption of the Merger Agreement by the affirmative vote of the holders of at least a majority of the outstanding shares of Class A common stock entitled to vote on the proposed Merger, (2) absence of any law or injunction (whether temporary, preliminary or permanent) enacted or issued by any governmental authority of competent jurisdiction prohibiting or otherwise making illegal the consummation of the proposed Merger, (3) accuracy of representations and warranties, subject to specified materiality thresholds, (4) compliance with covenants, obligations and conditions in the Merger Agreement in all material respects, and (5) the absence of a material adverse effect on the Company.

 

 

On April 4, 2020, the President of the United States issued Executive Order No. 13913 Establishing the Committee for the Assessment of Foreign Participation in the United States Telecommunications Services Sector (the “Committee”), which formalized the ad-hoc foreign investment review process (formerly referred to as “Team Telecom”) applicable to FCC licenses and transactions. The Executive Order empowers the Committee to review FCC license and transfer applications involving foreign participation to determine whether grant of the requested license or transfer approval may pose a risk to the national security or law enforcement interests of the United States, and to review existing licenses to identify any additional or new risks to national security or law enforcement interests that did not exist when a license was first granted. Following an investigation, the Committee may recommend that the FCC revoke or modify of existing licenses, or deny or condition approval of new licenses and license transfers. It is likely that the proposed Merger will be reviewed by the Committee. At this time, it is not possible for us to predict the outcome of a review of the proposed Merger by this new Committee and whether the Committee may condition approval of the Merger to any specific mitigation arrangement or other conditions. Any such arrangement may result in additional compliance obligations that may affect our expenses and business operations in the future.

 

In addition, the Merger Agreement may require the Company and the Oak Hill Buyer to comply with conditions imposed by regulatory entities and neither party is required to take any action with respect to obtaining any regulatory approval that, individually or in the aggregate, would be reasonably likely to have a material adverse effect on the Oak Hill Buyer and its affiliates (taken as a whole) or the Company and its subsidiaries (taken as a whole). There can be no assurance that regulators will not impose conditions, terms, obligations or restrictions and that such conditions, terms, obligations or restrictions will not result in the delay or abandonment of the Merger. There can be no assurance that all of these required approvals and clearances will be obtained or will be obtained on a timely basis. The COVID-19 outbreak may also result in delays to the receipt of certain regulatory approvals required to consummate the Merger.

 

Lawsuits have been, and may be, filed against the Company relating to the Merger and an adverse ruling in any such lawsuit may prevent the Merger from being completed in the time frame expected or at all. Each of the Company and the Oak Hill Buyer has the right to terminate the Merger Agreement under certain circumstances, as described in the Merger Agreement.

 

Failure to complete the Merger could negatively impact our business, financial results and stock price.

 

If the Merger is delayed or not completed, our ongoing businesses may be adversely affected and will be subject to several risks and consequences, including the following:

 

·

decline in share price to the extent that the current price of Class A common stock reflects an assumption that the Merger will be completed;

 

·

negative publicity and a negative impression of the Company in the investment community;

 

·

loss of business opportunities and the ability to effectively respond to competitive pressures; and

 

·

we may be required, under certain circumstances, to pay the Oak Hill Buyer a termination fee and additional expenses.

 

We have incurred, and will incur, substantial direct and indirect costs as a result of the proposed Merger.

 

We have incurred, and will continue to incur, significant costs, expenses and fees for professional advisors, printing and other transaction costs in connection with the Merger, and some of these fees and costs are payable by us regardless of whether the Merger is consummated.

 

 

Item 6.

Exhibits

 

EXHIBIT INDEX

 

Exhibit No.		Description
2.1		Agreement and Plan of Merger, dated as of July 26, 2020 by and among Future Fiber FinCo., Inc., Olympus Merger Sub, Inc. and Otelco Inc. (incorporated by reference to Exhibit 2.1 of Otelco Inc.’s Current Report on Form 8-K filed with the SEC on July 27, 2020)
10.1		Voting Agreement, dated as of July 26, 2020, by and among Future Fiber FinCo., Inc. and each person identified on Schedule I thereto (incorporated by reference to Exhibit 99.1 of Otelco Inc.’s Current Report on Form 8-K filed with the SEC on July 27, 2020)
31.1		Certificate pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934 of the Chief Executive Officer
31.2		Certificate pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934 of the Chief Financial Officer
32.1		Certificate pursuant to 18 U.S.C. §1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of the Chief Executive Officer
32.2		Certificate pursuant to 18 U.S.C. §1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of the Chief Financial Officer
101		The following information from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2020, formatted in Extensible Business Reporting Language (XBRL): (i) Condensed Consolidated Balance Sheets; (ii) Condensed Consolidated Statements of Operations; (iii) Condensed Consolidated Statements of Cash Flows; and (iv) Notes to Condensed Consolidated Financial Statements

 

 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

Date: November 3, 2020	OTELCO INC.
	By:	/s/ Curtis L. Garner, Jr.
		Curtis L. Garner, Jr.
		Chief Financial Officer