OTEL Otelco Inc

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(unaudited)

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 (“MMT”) and its wholly owned subsidiary I-Land Internet Services LLC; Otelco Telecommunications LLC; Otelco Telephone LLC (“OTP”); 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 three months and nine months ended September 30, 2018, are not necessarily indicative of the results that may be expected for the year ending December 31, 2018, 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, 2017. The interim condensed consolidated financial information herein is unaudited, with the condensed consolidated balance sheet as of December 31, 2017, 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.

Recently Adopted Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). This ASU 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. This ASU also provides a more robust framework for revenue issues and improves comparability of revenue recognition practices across industries. This ASU was the product of a joint project between the FASB and the International Accounting Standards Board to clarify the principles for recognizing revenue and to develop a common revenue standard. ASU 2014-09 permits the use of either a retrospective or modified retrospective application. This guidance was to be effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016, with early adoption not permitted. In July 2015, the FASB issued ASU 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date. This ASU confirmed a one-year delay in the effective date of ASU 2014-09, making the effective date for the Company the first quarter of fiscal 2018 instead of the first quarter of fiscal 2017.

In March 2016, the FASB issued ASU 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Consideration (Reporting Revenues Gross versus Net) . This ASU is further guidance to ASU 2014-09, and clarifies principal versus agent considerations. In April 2016, the FASB issued ASU 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing. This ASU is also further guidance to ASU 2014-09, and clarifies the identification of performance obligations. In May 2016, the FASB issued ASU 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients. This ASU is also further guidance to ASU 2014-09, and clarifies assessing the narrow aspects of recognizing revenue. In December 2016, the FASB issued ASU 2016-20, Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers. This ASU is also further guidance to ASU 2014-09, and clarifies technical corrections and improvements for recognizing revenue.

In January 2017, the FASB issued ASU 2017-03, Accounting Changes and Error Corrections (Topic 250) and Investments-Equity Method and Joint Ventures (Topic 323) (“ASU 2017-03”). This ASU requires registrants to evaluate the impact ASU 2014-09 will have on financial statements and adequately disclose this information to assist the reader in assessing the significance of ASU 2014-09 on the financial statements when adopted. The Company commenced its assessment of ASU 2014-09 beginning in June 2016. This assessment included analyzing ASU 2014-09’s impact on the Company’s various revenue streams, comparing the Company’s historical accounting policies and practices to the requirements of ASU 2014-09, and identifying potential differences from applying the requirements of ASU 2014-09 to the Company’s contracts. 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 Company has implemented the appropriate changes to its business processes, systems and controls to support revenue recognition and disclosures under ASU 2014-09.

The Company adopted ASU 2014-09 at the beginning of its 2018 fiscal year using the modified retrospective method applied to those contracts which were not completed as of January 1, 2018. Prior period amounts have not been adjusted and continue to be reported in accordance with historic accounting standards in effect during those periods. The adoption of ASU 2014-09 and related amendments did not have a material impact on the Company’s condensed consolidated financial statements.

In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10) (“ASU 2016-01”). This ASU addresses certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. ASU 2016-01 requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (that is, securities or loans and receivables) on the balance sheet or in the accompanying notes to the financial statements. That presentation provides financial statement users with more decision-useful information about an entity’s involvement in financial instruments. The provisions of this ASU were to be effective for annual periods beginning after December 15, 2017, and interim periods within those years, with early adoption permitted. In February 2018, the FASB issued ASU 2018-03, Technical Corrections and Improvements to Financial Instruments - Overall (Subtopic 825-10), which made targeted improvements to address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. This ASU also confirmed a six-month delay in the effective date of ASU 2016-01, making the effective date for the Company the second quarter of fiscal 2018 instead of the first quarter of fiscal 2018, with early adoption permitted. The Company adopted ASU 2016-01 as of March 31, 2018, and that adoption did not have a material impact on the Company’s condensed consolidated financial statements.

In August 2016, the FASB issued ASU 2016-15 , Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments . This ASU addresses how certain cash receipts and cash payments are presented and classified in the statement of cash flows under Topic 230, Statement of Cash Flows , and other Topics. This ASU is effective for annual reporting periods, and interim periods therein, beginning after December 15, 2017, with early adoption permitted. The Company adopted this ASU and that adoption did not have a material impact on the Company’s condensed consolidated financial statements.

In May 2017, the FASB issued ASU 2017-09, Compensation-Stock Compensation (Topic 718) (“ASU 2017-09”). ASU 2017-09 provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in Accounting Standards Codification (“ASC”) Topic 718, Stock Compensation . ASU 2017-09 is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted for any interim period for which financial statements have not been issued. ASU 2017-09 should be applied prospectively to an award modified on or after the adoption date. The Company adopted this ASU and that adoption did not have a material impact on the Company’s condensed consolidated financial statements.

In May 2017, the FASB issued ASU 2017-10, Service Concession Arrangements (Topic 853) (“ASU 2017-10”). The objective of this ASU is to specify that an operating entity should not account for a service concession arrangement that meets certain criteria as a lease in accordance with ASC Topic 840, Leases . ASU 2017-10 further states that the infrastructure used in a service concession arrangement should not be recognized as property, plant, and equipment of the operating entity. The provisions of this ASU are effective for annual periods beginning after December 15, 2017, and interim periods within those years, with early adoption permitted. The Company adopted this ASU and that adoption did not have a material impact on the Company’s condensed consolidated financial statements.

In March 2018, the FASB issued ASU 2018-05, Income Taxes (Topic 740) . The objective of this ASU is to amend ASC 740, Income Taxes to reflect Staff Accounting Bulletin No. 118, issued by the staff of the Securities and Exchange Commission (“SAB 118”), which addresses the enactment of the Tax Cuts and Jobs Act (the “Tax Act”). SAB 118 outlines the approach companies may take if they determine that the necessary information is not available (in reasonable detail) to evaluate, compute, and prepare accounting entries to recognize the effects of the Tax Act by the time the financial statements are required to be filed. Companies may use this approach when the timely determination of some or all of the income tax effects from the Tax Act are incomplete by the due date of the financial statements. A reporting entity must act in good faith and update provisional amounts as soon as more information becomes available, evaluated and prepared, during a measurement period that cannot exceed one year from the enactment date. Initial reasonable estimates and subsequent changes to provisional amounts should be reported in income tax expense or benefit from continuing operations in the period in which they are determined. As of December 31, 2017, the provisional amount recorded related to the remeasurement of the Company’s deferred tax liability balance was $9.3 million and reflected a one-time reduction in the Company’s income tax provision.

Recent Accounting Pronouncements

During 2017, the FASB issued ASUs 2017-01 through 2017-15 and, during 2018, the FASB has issued ASUs 2018-01 through 2018-15. 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 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 . This ASU provides an additional transition method by allowing entities to initially apply the new lease standard at the date 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 nonlease components of a contract when those lease contracts meet certain criteria. The Company is evaluating the requirements of this guidance and implementing the processes necessary to adopt ASU 2016-02. The Company will adopt ASU 2016-02 on the effective date of January 1, 2019. While the Company continues to assess all of the effects of adoption, the Company currently believes the most significant effects relate to the recognition of new right-of-use assets and lease liabilities on the balance sheet for real estate operating leases, and providing significant new disclosures about the Company’s leasing activities.

In January 2017, the FASB issued ASU 2017-04, Intangibles-Goodwill and Other (Topic 350) (“ASU 2017-04”). The objective of this ASU is to simplify how an entity is required to test goodwill for impairment by eliminating Step 2 from the goodwill impairment test. ASU 2017-04 is effective for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company does not expect this ASU to have a material impact on its condensed consolidated financial statements.

In June 2018, the FASB issued ASU 2018-07, Compensation – Stock Compensation (Topic 718). 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. The Company does not expect this ASU to have a material impact on its 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 does not expect this ASU to have a material impact on its condensed consolidated financial statements.

2017 Refinancing

On November 2, 2017, the Company refinanced its senior loan agreement with Cerberus Business Finance, LLC (the “Senior Loan Agreement”) and its subordinated loan agreement with NewSpring Mezzanine Capital III, L.P. (the “Subordinated Loan Agreement”) with a new $92 million, five-year credit facility from a consortium of banks led by CoBank, ACB (the “New Credit Facility”). The New Credit Facility includes an $87.0 million term loan and a $5.0 million revolving loan, which is undrawn. The New Credit Facility also includes a $20.0 million accordion feature that could be used to increase the term-loan portion of the New Credit Facility. Proceeds from the New Credit Facility and cash on hand were used to pay all amounts due in respect of principal, interest, prepayment premiums and fees under the Senior Loan Agreement and the Subordinated Loan Agreement, as well as fees associated with the transaction. The Company recorded costs of $28 thousand and write-off of loan costs of $3.7 million in connection with this refinancing.

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

The Senior Loan Agreement was fully repaid on November 2, 2017. Associated with the Senior Loan Agreement, the Company had $4.9 million in deferred financing cost. Amortization expense for the deferred financing cost associated with the Senior Loan Agreement was $808 thousand for the nine months ended September 30, 2017, which is included in interest expense.

The Subordinated Loan Agreement was fully repaid on November 2, 2017. Associated with the Subordinated Loan Agreement, the Company had $892 thousand in deferred financing cost. Amortization expense for the deferred financing cost associated with the Subordinated Loan Agreement was $120 thousand for the nine months ended September 30, 2017, which is included in interest expense.

Associated with the New Credit Facility, the Company has $2.1 million in deferred financing cost. Amortization expense for the deferred financing cost associated with the New Credit Facility was $354 thousand for the nine months ended September 30, 2018, which is included in interest expense.

The Company had a revolving credit facility of $5.0 million associated with the Senior Loan Agreement. There was no balance outstanding as of September 30, 2017. The Senior Loan Agreement was terminated on November 2, 2017. The Company paid a monthly fee of 0.75% per annum on the unused portion of the revolver loan under the Senior Loan Agreement, payable in arrears. The fee expense was $28 thousand for the nine months ended September 30, 2017.

The revolving credit facility associated with the Company’s New Credit Facility had a maximum borrowing capacity of $5.0 million on September 30, 2018. The revolving credit facility is available until November 3, 2022. There was no balance outstanding as of September 30, 2018. The Company pays a commitment fee of 0.50% per annum, payable quarterly in arrears, on the unused portion of the revolver loan under the New Credit Facility. The commitment fee expense was $19 thousand for the nine months ended September 30, 2018.

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

A total of $2.1 million of debt issuance cost is amortized over the life of the loan and is recorded net of the notes payable on the condensed consolidated balance sheets.

The Company made voluntary principal prepayments of $1.0 million and $2.0 million under the New Credit Facility on July 31, 2018, and August 31, 2018, respectively, which are reflected in the remaining balance of the notes payable total listed above.

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, 2018, the Company was in compliance with all such covenants and restrictions.

As of September 30, 2018, and December 31, 2017, the Company had no U.S. federal net operating loss carryforwards. As of September 30, 2018, and December 31, 2017, the Company had state net operating loss carryforwards of $43 thousand and $33 thousand, respectively. The Company had no alternative minimum tax credit carryforwards as of September 30, 2018, or December 31, 2017. The Company establishes valuation allowances when necessary to reduce deferred tax assets to amounts expected to be realized. As of September 30, 2018, the Company had no valuation allowance recorded.

The effective income tax rate as of September 30, 2018, and December 31, 2017, was 25.0% and (184.5)%, respectively.

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):

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. As stated above in Note 1, Organization and Basis of Financial Reporting – Recently Adopted Accounting Pronouncements , 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 at the point in time control of 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 Company has implemented the appropriate changes to its business processes, systems and controls to support revenue recognition and disclosures under ASU 2014-09.

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

The following table summarizes the revenue generated from contracts with customers among each revenue stream as of September 30, 2018 (in thousands, except percentages):

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

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

*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, 2018, the Company had approximately $8.0 million of unsatisfied performance obligations. As of September 30, 2018, the Company expected to recognize approximately $0.9 million of revenue within the next year and $7.1 million in the next 2 to 5 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 January 1, 2018, was $4.1 million. Approximately $1.5 million of revenue from that balance was recognized as revenue during the three months ended March 31, 2018, offset by payments received as of March 31, 2018, in advance of control of the service being transferred to the customer.

The deferred revenue balance as of June 30, 2018, was $3.9 million. Approximately $1.4 million of revenue from that balance was recognized as revenue during the three months ended September 30, 2018, offset by payments received as of September 30, 2018, in advance of control of the service being transferred to the customer.

Revenue Concentrations

Revenues for interstate access services are based on reimbursement of costs and allowed rate of return. Revenues of this nature are received from the National Exchange Carrier Association in the form of monthly settlements. Such revenues amounted to 22.6% and 21.8% of the Company’s total revenues for the nine months ended September 30, 2018, and 2017, respectively.

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 Federal Communications Commission (the “FCC”). Currently, none of the Company’s legal proceedings are expected to have a material adverse effect on the Company’s business.

Sprint Communications L.P. (“Sprint”), MCI Communications Services, Inc. (“MCI”) and Verizon Select Services, Inc. (“Verizon”) filed more than 60 lawsuits in federal courts across the United States alleging that over 400 local exchange carriers (“LECs” or “LEC Defendants”) overcharged Sprint, MCI and Verizon for so-called intraMTA traffic (wireless phone calls that originate and terminate in the same metropolitan transit area). The lawsuits seek a refund of previously-paid access charges for intraMTA traffic, as well as a discount related to intraMTA traffic on a going-forward basis. One of the Company’s subsidiaries, MMT, was named as a defendant in two of the lawsuits that are being brought before the District Court for the Western District of Missouri (one filed on May 2, 2014, by Sprint and the other filed on September 5, 2014, by MCI and Verizon). In addition, one of the Company’s other subsidiaries, OTP, was named as a defendant in a lawsuit relating to these issues filed by MCI and Verizon in the District Court for the District of Delaware on September 5, 2014. In addition, MMT filed suit, along with other LECs, against Level 3 Communications LLC (“Level 3”) seeking payment of access charges that Level 3 was refusing to pay because of its position on intraMTA traffic. As all of the lawsuits relating to these issues raise the same fundamental questions of law, the United States Judicial Panel on Multidistrict Litigation has consolidated the lawsuits in the District Court for the Northern District of Texas (the “Court”). On May 5, 2018, the Court granted the LEC Defendants’ request to dismiss all of the claims brought by Sprint, MCI and Verizon. The Court also granted the LECs’ motion for summary judgment against Level 3. Sprint, MCI and Verizon have appealed the Court’s ruling. The Fifth Circuit Court of Appeals (the “Fifth Circuit”) is currently accepting party appearances and corporate disclosures. A briefing schedule from the Fifth Circuit is expected in the near future.

On November 10, 2014, a large coalition of the LEC Defendants, including MMT and OTP, filed a petition for declaratory ruling with the FCC seeking a ruling by the FCC that: (1) any traffic intentionally routed over Interexchange carrier (“IXC”) trunks by IXCs should be subject to access charges; (2) only carriers with specific agreements with an LEC may use alternative billing arrangements; (3) federal tariffing rules require the LECs to assess access charges for switched access traffic routed through Feature Group D trunks; and (4) the IXCs may not engage in self-help by refusing to pay the LEC Defendants’ properly assessed access charges. On March 11, 2015, the LEC Defendants filed their reply brief with the FCC. No timeline has been established for a decision by the FCC.

During the nine months ended September 30, 2018, 34,755 RSUs were granted by the Company. Prior to that time, the Company had previously granted RSUs underlying 366,356 shares of Class A common stock. The RSUs (or a portion thereof) vest with respect to each recipient over a one to three 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, the 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 366,356 RSUs granted prior to the nine months ended September 30, 2018, RSUs underlying 267,413 shares of Class A common stock had vested or were cancelled as of December 31, 2017. The RSU grants were made primarily to executive-level personnel at the Company and, as a result, no compensation costs have been capitalized.

The following table summarizes RSU activity as of September 30, 2018:

Stock-based compensation expense related to RSUs was $207 thousand and $237 thousand for the nine months ended September 30, 2018, and 2017, respectively. 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. The Company has no history before 2014 with RSU forfeiture.

As of September 30, 2018, the unrecognized total compensation cost related to unvested RSUs was $684 thousand. That cost is expected to be recognized by the end of 2022.