NPSI North Pittsburgh Systems (MM)

Item 2. Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Amounts in Thousands Except Per Share Data and Operating Statistics)

Cautionary Language Concerning Forward-Looking Statements

In addition to historical information, this Quarterly Report on Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 (Section 27A) and Section 21E of the Securities Exchange Act of 1934 (Section 21E) regarding events, financial trends and critical accounting policies that may affect our future operating results, financial position and cash flows. We intend that such forward-looking statements be subject to the safe harbors within Section 27A and Section 21E as provided by the Private Securities Litigation Act of 1995.

Forward-looking statements are usually accompanied by words such as “believes”, “anticipates”, “expects”, “estimates”, “intends” or similar words or expressions. Such statements are based on our assumptions and estimates and are subject to risks and uncertainties. You should understand that various factors, including (but not limited to) those items discussed below and elsewhere in this document, could cause our actual results to differ materially from the results expressed in or implied by these forward-looking statements. You are cautioned not to place undue reliance on these forward-looking statements, which are current only as of the date of this filing. We disclaim any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

While the following list of risks and uncertainties is not exhaustive, some factors, in addition to those contained throughout this document, that could affect future operating results, financial position and cash flows and could cause actual results to differ materially from those expressed in or implied by the forward-looking statements are:

We also refer you to the section titled “Risk Factors” under Item 1A of our 2006 Form 10-K and the section titled “Legal Proceedings” under Part II, Item 1 of this Form 10-Q for additional discussions concerning items which pose risks and uncertainties that could affect our future results.

Overview

We are a telecommunications company with annualized revenues of approximately $100 million. Our original core business, which dates back to 1906, consisted primarily of providing telecommunications services in our ILEC territory, which today covers approximately 285 square miles and is located north of the City of Pittsburgh, Pennsylvania. In 1995, as the Internet was still in its relatively early stages, we purchased a small Internet Service Provider (ISP) as a segue into that area of the communications marketplace. During 1999, we began to expand our business beyond our ILEC territory via a CLEC edge-out strategy. In addition, from 1997 through 2001, we invested approximately $83 million in our ILEC territory to upgrade the majority of our network and to deploy a Carrier Serving Area (CSA) architecture in order to allow us to offer advanced broadband products. Starting in 2006 we began expanding on this CSA architecture by deploying fiber even deeper into our ILEC network, thereby allowing us to significantly upgrade our data products and services.

Today, the investments that we have made to develop our Internet related products, to expand our business via our edge-out strategy and to modernize our network for advanced

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broadband products have provided the majority of our new sources of revenue. The great majority of our revenues are generated based on services with monthly recurring fees and are therefore not subject to large short-term fluctuations.

In addition to our core businesses described above, we also derive a portion of our net income and cash flow from our limited partner interests in three wireless partnerships, all of which are majority owned and operated by Verizon Wireless. These partnerships, which have their origin in the 1980s with the allocation by the FCC of B licenses, cover territories which overlap the majority of our ILEC and edge-out markets.

General Description of Our Company and Business

The Registrant, organized May 31, 1985, is a holding company. Its predecessor, North Pittsburgh Telephone Company (North Pittsburgh), a telephone public utility incorporated in 1906, became a wholly owned subsidiary of the Registrant on May 31, 1985. Penn Telecom, Inc. (Penn Telecom) became a wholly owned subsidiary of the Registrant on January 30, 1988. Prior to this date, Penn Telecom was a wholly owned subsidiary of North Pittsburgh. Penn Telecom is certificated as a CAP, a CLEC and an Interexchange Carrier (IXC) and has entered into these businesses. Pinnatech, Inc. (Pinnatech), a wholly owned subsidiary of the Registrant, formed in 1995, principally provides Internet and broadband related services. The Registrant, North Pittsburgh, Penn Telecom and Pinnatech operate under the provisions of the Pennsylvania Business Corporation Law.

North Pittsburgh Telephone Company

North Pittsburgh, our ILEC, was founded in 1906 and operates in an approximately 285 square mile territory in Western Pennsylvania, which includes portions of Allegheny, Armstrong, Butler and Westmoreland Counties. As of September 30, 2007, we served 59,311 business and residential access lines in our ILEC territory. Over the past decade, our ILEC territory has experienced very robust population growth due to the continued expansion of suburban communities into our serving area, with the southernmost point of our territory only 12 miles from the City of Pittsburgh. Growth in business activity in our ILEC territory has accompanied the population growth.

Compared to other ILECs, the majority of which serve territories that are very rural, our ILEC benefits from the favorable demographics associated with the population and business growth that has accompanied the continued development of suburban communities north of the City of Pittsburgh. These favorable demographics, however, also put our ILEC in a much more competitive situation than many of its peers due to the fact that our competitors also view these demographics to be an attractive market. The national wireless companies have built robust networks that cover the majority of our ILEC territory. In addition, the two cable companies that overlay the majority of our territory each launched, in 2006, aggressive triple play packages of voice, video and broadband service. In general, these cable companies have very modernized networks, a high percentage of homes passed and a high penetration rate for their video services. The launch of voice offerings by our cable competitors has been the primary cause for the acceleration in our access line attrition from a loss of 1,898 lines, or 2.6%, during 2005 to an access line loss of 7,092, or 10.1%, during 2006. Our most recent access line loss rate in our ILEC territory of 883 lines and 1,352 lines for the second and third quarters of 2007, respectively, have improved from the 1,771 lines lost in the first quarter of 2007 and 3,030 lines lost in the fourth quarter of 2006, which was the first full quarter that number portability was available to our cable competitors. Although our ILEC access line loss rate has shown improvement from the initial period in which number portability became available to some of our main competitors, the loss rate will most likely still be higher than we historically experienced prior to the entrance of our cable competitors into the telephony market in 2006. CLECs are not a significant competitive factor at the present time due to some of the protections still granted to our ILEC as a rural company, but CLECs more likely than not will become a larger competitive force in the future as some of the regulatory barriers to entry will most likely diminish. Even Verizon, which has core properties to the south and west of our ILEC territory, has become a competitive force as a result of its recent acquisition of MCI, which has CLEC authority in many parts of the state of Pennsylvania, including our ILEC territory.

North Pittsburgh operates a 100% digital switching network, comprised of nine central offices and 86 CSAs. The core of the network consists of two main host switches, a Nortel DMS 500 and a Nortel DMS 100. Our CSA architecture, in which nearly all loop lengths are kept to 12,000 feet or less, has enabled us to provide Digital Subscriber Line (DSL) service to 100% of our access lines. In addition, we have deployed fiber optic cable extensively throughout the network, resulting in a 100% Synchronous Optical Network (SONET) that supports all of the inter-office and host-remote links as well as the majority of business parks within our ILEC serving area. In 2006, we embarked on a capital construction project to further deploy fiber closer to the homes and businesses that we serve. We have continued our fiber deployment in 2007 and now have fiber provisioned to within 5,000 feet of approximately 95% of our addressable access lines. This deployment of fiber will allow us to provision DSL connections with speeds ranging between 20 to 25 megabits per second, a substantial increase over our current maximum speed of 3 megabits

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per second. During 2006, we also upgraded our data transmission network to a gigabit Ethernet backbone using a Multiple Protocol Label Switching (MPLS) network that will more efficiently and effectively handle the increased bandwidth demands of our network, especially our next-generation DSL products as well as our business class Ethernet offerings. We believe that these investments will enable us to offer products and services that will satisfy the growing customer demand for broadband and multi-megabit services, which we believe is a key factor for our future success.

Penn Telecom

Penn Telecom furnishes telecommunication and broadband services south of North Pittsburgh’s territory to customers in Pittsburgh and its surrounding suburbs as well as north of North Pittsburgh’s territory in the City of Butler and its surrounding areas. Verizon is the ILEC in the Pittsburgh area, while Embarq (formerly Sprint) is the ILEC in the City of Butler and its surrounding areas. Our CLEC operation follows a true “edge-out” strategy, in which it has leveraged North Pittsburgh’s network, human capital skills and reputation in the surrounding markets.

We operate an extensive SONET optical network with over 300 route miles of fiber optic facilities in the Pittsburgh metropolitan market. We have physical collocation in 27 Verizon central offices and one Embarq central office and primarily serve our customers using unbundled network element (UNE) loops. Twenty-seven of these collocations are connected to our SONET using a combination of leased and owned fiber optic facilities. In the Pittsburgh market, a carrier hotel that we operate serves as the hub for the fiber optic network. In addition, we also offer space in the carrier hotel to ISPs, IXCs, other CLECs and other customers who need a carrier-class location to house voice and data equipment as well as gain access to a number of networks, including ours. In the City of Butler, we have overbuilt a portion of the Embarq distribution plant in the central business district and continue to expand these facilities as we increase our penetration of the Butler area business market.

Our sales strategy in our edge-out markets has been to focus on small to mid-sized business customers (defined as 5 to 500 lines), educational institutions and healthcare facilities, offering local and long distance voice services as well as broadband services including DSL and multi-megabit metro Ethernet. Our fiber-based network, comprised of multiple rings, enables us to compete against Verizon and other CAPs by offering high capacity special access circuits (from DS-1s up to OC-48s) to IXCs, ISPs and even other CLECs. We have also deployed an MPLS network to handle the core routing and transport of our metro Ethernet in the First Mile products, as it provides a much more efficient method of aggregating, transporting and managing our Ethernet offerings. As of September 30, 2007, Penn Telecom served 42,317 access lines and 25,485 access line equivalents ¹ , for a grand total of 67,802 equivalent access lines. ² Over the course of the last twelve months, Penn Telecom has added 494 access lines and 3,585 access line equivalents.

In addition to the CLEC operations, Penn Telecom also provides long distance services. Prior to our CLEC operations, the majority of our long distance customers resided in our ILEC market. However, with the growth of our CLEC customer base and the effective bundling of toll with local dial tone services, we have been able to greatly expand this service offering throughout Western Pennsylvania.

Pinnatech

Pinnatech, an ISP doing business under the Nauticom name, furnishes Internet access and broadband services in Western Pennsylvania. We serve the majority of our DSL and other broadband customers over our ILEC and CLEC networks with Pinnatech serving as the ISP providing a gateway to the Internet. In addition, Pinnatech also provides virtual hosting services, collocation services, web page design and e-commerce enabling technologies to customers.

Employees

At September 30, 2007, the Company, through all of its subsidiaries, employed 298 persons. Approximately 32% of the Company’s employees are covered under collective bargaining agreements. In October 2004, North Pittsburgh’s bargaining employees ratified a new labor contract with the Communications Workers of America (CWA) that was effective through September 30, 2007. In October 2007, that labor contract was extended for a one-year period, to September 30, 2008. Also, in September 2005, Penn Telecom’s bargaining employees ratified a labor contract with the CWA that will remain in effect until August 31, 2008.

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Additional Information

For a more complete understanding of our business, industry, principal services rendered, properties and other interests, we suggest you read our 2006 Form 10-K. There have been no significant changes in the mode of conducting business or the properties owned by the Company or its subsidiaries since the filing of that Form 10-K report. Current updates to the regulatory environment under which our subsidiaries operate can be found below in the “Regulatory Environment” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Industry Dynamics

The overall structure of the telecommunications industry has been rapidly changing. There has been consolidation among the largest companies, with the two largest IXCs (AT&T and MCI) being acquired by SBC (newly renamed AT&T) and Verizon, respectively. The new AT&T subsequently purchased BellSouth, which resulted in consolidation of both wireline and wireless assets. The wireless sector has also been consolidating, spurred by the Sprint-Nextel combination and the subsequent acquisitions of many of the former Sprint and Nextel independent affiliates. The telecommunications industry is also being greatly impacted by the emergence of new entrants into the market, such as cable companies that are offering triple play packages of voice, video and broadband services.

Demand for the traditional voice telecommunications business has been negatively impacted by the proliferation of wireless services and their one-rate bundled pricing plans that include large (if not unlimited) buckets of minutes, by the popularity of alternative communication technologies such as email and instant messaging and by technological advances such as cable modems and DSL that obviate the need for secondary, and in some cases primary, access lines. The numerous sources of new competition for almost all aspects of the voice telecommunications market have resulted in price decreases for many voice products and services.

Broadband growth has been a bright spot in the overall industry during the past several years. However, the broadband market is very competitive, with little differentiation to the end-user customer between products offered by telephone and cable companies and alternative broadband providers. As such, pricing has been the main focus in winning new customers and retaining existing customers. Although the costs to deliver broadband technologies have decreased over the past several years, profit margins have continued to be squeezed by pricing decreases to customers.

The proliferation of broadband access has also resulted in new competition from innovative technologies, such as Voice over Internet Protocol (VoIP), that threaten to further decrease the revenues received from the traditional voice business. Besides potentially displacing the need for a secondary or primary line, the potential regulatory definition and classification of VoIP services (which takes on many forms) may have a significant impact on the current access compensation structure.

Regulation and Competition

The telecommunications industry has been greatly impacted by the passage of the Telecommunications Act of 1996 (the 1996 Act), which was the legislative instrument that opened the industry to significantly greater competition. The degree and pace at which markets have been experiencing competition have varied, with most of the original regulatory barriers to entry removed in the markets served by the country’s largest local exchange carriers, also referred to as the Regional Bell Operating Companies (RBOCs). Smaller rural companies, such as our ILEC, North Pittsburgh, were given regulatory relief in the form of exemptions and temporary suspensions from many of the competitive portions of the 1996 Act in order to allow state regulators sufficient time to examine the public policy implications of allowing competition in rural areas and, if deemed in the public interest, to allow smaller companies to gradually prepare for competition and to restructure rates. Although we still maintain in our ILEC territory some of the regulatory protections against non-facilities based competition, we expect that over time these protections will be reduced or entirely eliminated.

While the 1996 Act has placed a higher degree of uncertainty on our future revenue streams and margins in our ILEC territory, it has given us the opportunity to selectively expand outside of that territory by taking advantage of the pro-competitive aspects of the 1996 Act. We have pursued an edge-out strategy into Pittsburgh and its surrounding communities as well as into the City of Butler and its surrounding areas, leveraging the network, human capital skills and solid reputation of our traditional ILEC business.

The 1996 Act primarily deals with regulations concerning intra-modal competition—that is, competition among traditional wireline companies. At the same time, however, we have begun to experience a great deal of inter-modal competition from wireless carriers and cable companies. We

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view these facilities based competitors to be the most formidable, as these companies totally bypass our existing networks.

Highlights and Outlook

Net income for the nine-month period ended September 30, 2007 was $9,226, or $.61 per share, as compared to $26,579, or $1.77 per share, for the comparable prior year period. Significant items that were not routine in nature impacted both periods. As discussed in more detail in Note 9 of the Notes to Condensed Consolidated Financial Statements included in Part 1, Item 1 in this Form 10-Q, we recorded $6,468 in curtailment and special termination benefit expenses during the first quarter of 2007 that were associated with the election by 40 employees to retire under the voluntary early retirement incentive program that was in place through March 31, 2007 at our North Pittsburgh subsidiary. On an after tax basis, the curtailment and special termination benefit expenses resulted in a $3,784 decrease in net income recorded for the nine-month period ended September 30, 2007. Also, in connection with activities that resulted in or were pursuant to the Merger Agreement with Consolidated, we incurred strategic alternatives expenses of $2,189 related to financial advisory, legal and other fees during the second and third quarters of 2007; on an after tax basis, these expenses reduced net income recorded for the nine-month period ended September 30, 2007 by $1,281. With respect to the prior year comparable period, as discussed in more detail in Note 11 of the Notes to Condensed Consolidated Financial Statements included in Part 1, Item 1 in this Form 10-Q, our North Pittsburgh subsidiary received its redemption payment of $19,622 from the RTB during the second quarter of 2006. We recognized a gain in the full amount of the proceeds received, which, on an after tax basis, contributed $11,479 to the net income recorded for the nine-month period ended September 30, 2006. The remainder of the decrease in net income was primarily attributable to the decline in revenues discussed below.

Revenues for the nine-month period ended September 30, 2007 decreased $5,444, or 7.0%, from the prior year comparable period. Revenues continue to be negatively affected by the competition experienced in our ILEC territory, as the two main cable companies whose service areas overlap the majority of our ILEC territory launched their own proprietary voice services in the beginning of 2006. Over the past twelve-month period, we experienced a 7,036, or 10.6%, access line decrease in our ILEC territory. The addition of 494 access lines in our CLEC edge-out markets over that same twelve-month period was not enough to offset the loss of access lines in our ILEC market, resulting in a $1,238 decrease in local dial tone revenues during the nine-months ended September 30, 2007. The effect of competition, however, has been more pronounced on our toll revenues. We experienced a $1,591 decrease in such revenues in the nine-months ended September 30, 2007 as compared to the prior year comparable period. We have been aggressive in promoting newer calling plans with either unlimited or flat rate toll at different tiered MOU levels in order to match competitive offerings. By doing so, we have actually been very successful in winning customers in our ILEC territory from the traditional IXCs, although this is detrimental in the short-term to our originating access revenues. In addition, we have been aggressive in marketing these newer plans to our existing toll customers, who may have been on higher rated calling plans. As a result of the combination of winning toll customers away from the traditional IXCs and the conversion of existing customers on higher rated plans, we have experienced an approximate 3,800 subscriber line increase to our unlimited packaged plan, 1000 anytime minutes plan and 250 anytime minutes plan in our ILEC territory over the past twelve-month period. These plans, however, have been aggressively priced to compete with plans marketed by our competitors, such as wireless carriers, VoIP providers and the two main cable companies in our ILEC territory. For instance, in 2005, we charged over $55.00 on average for the individual services that now comprise our unlimited calling plan (local dial tone, toll and enhanced features). Today, we have priced our unlimited calling plan at $39.95, with a six-month promotional price of $29.95 (as a stand-alone service) or $19.95 (when combined with DSL). Although our proactive approach to signing up customers to these newer priced plans most likely has resulted in an acceleration of our revenue decrease in the short-term, we believe that these customers will have less incentive to switch to one of our competitors’ offerings in the future and that our strategy will ultimately prove beneficial to our long-term results, especially when considering the other revenue sources (such as local dial tone revenues, access revenues and Universal Service Fund (USF) revenues) that we lose if a customer switches to a competitor.

In addition, access revenues have decreased from the prior year comparable period, mostly due to a decrease in overall access MOUs on our network and from a decrease in revenues recognized from the National Exchange Carrier Association (NECA) pool in which our ILEC, North Pittsburgh, participates. Broadband growth has been a bright spot, although the $213 increase in broadband revenues for the first nine months of 2007 over the prior year comparable period was not enough to offset the impact of the above-mentioned effects of the decreases in local dial tone, toll and access revenues.

For the remainder of 2007, we believe that revenues will continue to trail those amounts earned during the comparable 2006 period due to multiple factors. First, as discussed in more detail in the “Regulatory Environment” section below in this Item 2 of this Form 10-Q, interstate revenues for our ILEC will be negatively impacted by both the normal modifications to the NECA average schedule formulas as well as the structural changes to those formulas that were made by the NECA tariff filing for the July 1, 2006 through June 30, 2007 period as well as from the modifications to the average schedule formulas made by the NECA filing for the July 1, 2007

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through June 30, 2008 period. Second, as noted above, we have seen intense competition in our ILEC market over the last fifteen months as the two cable companies that overlap the majority of our incumbent market have launched and are heavily promoting their proprietary telecommunications offerings. Our ILEC continues to enjoy several forms of regulatory protection regarding non-facilities based competition, and the entry into our market by the cable companies marks the first main thrust of competition from non-wireless service providers, other than the competition we have experienced in the past and continue to experience from facilities based CAPs competing for larger business customers. We have also begun to experience some competition from CLECs, as several have recently negotiated interconnection agreements and have begun to offer services to customers within our ILEC’s territory. Our most recent access line loss rate in our ILEC territory of 883 lines and 1,352 lines for the second and third quarters of 2007, respectively, improved from the 1,771 lines lost in the first quarter of 2007 and 3,030 lines lost in the fourth quarter of 2006, which was the first full quarter in which number portability was available to our cable competitors. Although our ILEC access line loss rate has shown improvement from the initial period that number portability became available to some of our main competitors, the loss rate will most likely still be higher than we historically experienced prior to the entrance of our cable competitors into the telephony market in 2006. In addition, pricing pressures are anticipated to continue for the majority of the products and services that we provide.

We expect that new revenue generation will continue to be driven by the addition of new customers in our edge-out markets, by the introduction of new products and services and by further broadband penetration. The capital investments that we have made in 2006 and continue to make in 2007 to push fiber deeper into our ILEC network will allow us to commercially deploy our next generation DSL product during the fourth quarter of 2007. We have been achieving speeds ranging from 20 to 25 megabits per second in our current trials and we anticipate launching enhanced broadband services on a broader base in the fourth quarter of 2007, with additional deployments throughout 2008. In addition, we have seen robust growth in our multi-megabit metro Ethernet product, which we expect will continue throughout the remainder 2007. We will continue to focus to an even greater extent on bundled product offerings, which we anticipate will continue to drive value to our customers and serve as a tool for retention of our existing customer base. We have also introduced a business grade VoIP product, which we anticipate will enable us to further penetrate our existing edge-out markets as well as allow us to expand into adjacent new markets that previously were less attractive from a full facilities based edge-out approach.

With the backdrop of the decreases in revenues resulting from the loss of access lines in our ILEC territory and the negative developments we have been experiencing with respect to our access revenues, we have been working diligently on expense reduction initiatives. First, during 2006, we restructured our healthcare plans, which, once restructured, were put through a competitive bidding process with various healthcare providers. As a result, our overall costs associated with our healthcare plans for active employees decreased by approximately $900 on an annualized basis, effective with the plans’ years beginning January 1, 2007. Second, we restructured the postretirement benefit plans at our North Pittsburgh subsidiary by amending North Pittsburgh’s Pension Plan to freeze the future pension benefit accrual effective December 31, 2006 for those employees not covered by the collective bargaining agreement. The freezing of the benefit accrual was partially offset by an enhanced formula for employer contributions into the North Pittsburgh 401(k) plan. As a result of the net effects of the amendments to the Pension Plan and 401(k) plan, the positive impact of the Pension Plan’s 14% return on plan assets experienced in 2006, and the positive impact experienced in our postretirement healthcare plan from the aforementioned decrease in healthcare costs effective January 1, 2007, our costs associated with postretirement benefits decreased by approximately $1,040 in the first nine months of 2007 over the prior year comparable period (exclusive of the one-time charges associated with the early retirement incentive program discussed immediately below). Finally, as discussed in more detail in Note 9 to the Condensed Consolidated Financial Statements included in Part 1, Item 1 in this Form 10-Q, we implemented a voluntary early retirement incentive program for certain eligible non-union employees of North Pittsburgh through March 31, 2007. There were 40 employees who elected to retire under the voluntary early retirement incentive program, and we recorded $6,468 in curtailment and special termination benefit expenses associated with those retirements and a corresponding re-measurement of the North Pittsburgh Pension Plan and postretirement healthcare and life insurance plans. Cash flows from operations were not impacted by these charges during the first nine months of 2007 because there were no cash severance or lump sum benefit options or enhancements associated with the voluntary early retirement incentive program. We have realized immediate ongoing annual cost savings of approximately $2,600 as a result of this program and corresponding reduction in personnel, and we estimate an ultimate annual cost savings of approximately $3,300 once fully phased-in.

We have also benefited from investments we made in the last two decades in three wireless partnerships, all of which today are majority owned and operated by Verizon Wireless. Instead of deploying the majority of our investment capital into forming and operating our own wireless business, in which we would have been at a tremendous disadvantage competing in a market dominated by national carriers with billions of dollars in capital resources, we alternatively invested in three wireless partnerships serving Pittsburgh and other portions of Western Pennsylvania. Total equity income recorded from our investments in the wireless partnerships increased $1,022 in the first nine months of 2007 over the comparable prior year period.

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Results of Operations

The following discussion should be read in conjunction with our condensed consolidated financial statements, and the notes thereto, included in this quarterly report and with our audited financial statements, and notes thereto, included in our 2006 Form 10-K.

Nine Months Ended September 30, 2007 and 2006

Net income for the nine-month period ended September 30, 2007 was $9,226, or $.61 per share, compared to net income of $26,579, or $1.77 per share, for the comparable prior year period. The decrease in net income was attributable to the following factors:

Operating Revenues

For the nine-month period ended September 30, 2007, total operating revenues decreased $5,444, or 7.0%, from the comparable period in 2006. This decrease was the result of decreases in local network services revenues of $1,691 (7.5%), long distance and access services revenues of $3,818 (8.5%) and directory advertising, billing and other services revenues of $132 (12.4%), offset partially by an increase in other operating revenues of $197 (2.2%).

Decreases in local network services revenues of $1,691, or 7.5%, were primarily attributable to the following factors:

The decrease in long distance and access services revenues ³ of $3,818, or 8.5%, was primarily attributable to the following factors:

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Partially offset by:

The decrease in directory advertising, billing and other services revenues of $132 was mostly a result of the prior year period including a positive $74 true-up of North Pittsburgh’s revenue earned from its 2005 directory book upon final settlement with its directory partner. In addition, revenues earned from carrier billing and collection services decreased $35.

The increase in other operating revenues of $197, or 2.2%, was primarily due to a $213 increase in DSL and multi-megabit metro Ethernet revenues. Combined DSL lines (both wholesale and retail) sold increased from 15,389 as of September 30, 2006 to 16,860 as of September 30, 2007. Also, our multi-megabit metro Ethernet product, which is currently geared mostly for business applications and can deliver speeds from 1 to 100 megabits, has experienced growth. Other operating revenues for the nine-month period ended September 30, 2007 was also positively impacted by a $124 increase in structured wiring revenues. These increases were partially offset by a $123 decrease in dial-up Internet revenues.

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Operating Expenses and Net Operating Income

For the nine-month period ended September 30, 2007, total operating expenses increased $6,208, or 10.5%, from the comparable period in 2006. The change was the result of strategic alternatives expenses of $2,189 and curtailment and special termination benefit expenses of $6,468 recognized during the first nine months of 2007 and an increase in depreciation and amortization expenses of $986 (10.2%), offset partially by decreases in network and other operating expenses of $3,184 (6.8%) and operating taxes of $251 (9.3%).

The $2,189 of strategic alternatives expenses was incurred in connection with the activities that have resulted in or were pursuant to the Merger Agreement with Consolidated and relate to financial advisory, legal and other fees for services rendered during the second and third quarters of 2007.

The $6,468 of curtailment and special termination benefit expenses was a direct result of the election of 40 employees to retire under the voluntary early retirement incentive program that was in place through March 31, 2007 at our North Pittsburgh subsidiary, as discussed in more detail in Note 9 of the Notes to Condensed Consolidated Financial Statements included in Part 1, Item 1 in this Form 10-Q.

The increase in consolidated depreciation and amortization expenses of $986, or 10.2%, was predominately due to the growth in our depreciable asset base (gross property, plant and equipment), which grew by $12,149 over the course of the past twelve months. Furthermore, a higher ratio of new additions to our depreciable asset base consisted of data-centric equipment, which has shorter useful lives than our average depreciable base.

The decrease in network and other operating expenses of $3,184, or 6.8%, was primarily due to the following factors:

Partially offset by:

The decrease in operating taxes of $251 was mainly due to a $143 decrease in Pennsylvania gross receipts tax expense as a result of the decline in revenues described above as well as a $101 decrease in Pennsylvania capital stock tax as a result of a decrease in the millage rate for 2007.

Overall, the decrease in total operating revenues of $5,444 coupled with the increase in total operating expenses of $6,208 resulted in an $11,652 decrease in net operating income for the nine-month period ended September 30, 2007 over the comparable prior year period. As discussed above, two primary contributing factors to the decrease in net operating income were

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the $2,189 of strategic alternatives expenses and the $6,468 of curtailment and special termination benefit expenses recorded in connection with the retirements under the voluntary early retirement incentive program. Operating income from all other sources for the nine-month period ended September 30, 2007 declined $2,995, or 15.9%, over the comparable prior year period.

Other Items

Interest expense decreased for the nine-month period ended September 30, 2007 by $179 from the comparable prior year period due to the continued scheduled pay-down of our Federal Financing Bank (FFB) notes and capital lease obligations.

Interest income decreased by $122 for the nine-month period ended September 30, 2007 from the comparable prior year period due to a decline in the average invested cash balance during the first nine months of 2007. The decrease in the average invested cash balance was partially offset by increases in the average interest rate received on our temporary investments. Our average interest rate earned on temporary investments was 5.2% during the nine-month period ended September 30, 2007 as compared to 4.8% during the comparable prior year period.

Equity income of affiliated companies increased $996 in the nine-month period ended September 30, 2007 over the comparable prior year period, due mainly to a $1,022, or 16.1%, increase in the amount of income generated from the Company’s limited partner interests in three wireless partnerships. These partnerships, all of which are majority owned and operated by Verizon Wireless, have continued to show strong growth in number of customers and operating results. Customer growth for the Pittsburgh SMSA, RSA 6 I and RSA 6 II partnerships over the last twelve months was 11%, 21% and 11%, respectively. In addition, equity income was positively impacted by $111 as a result of the additional 2.3825% interest in the RSA 6 I partnership that North Pittsburgh purchased in December of 2006.

Gain on redemption of investment, which totaled $19,622, reflects the gain recognized in the second quarter of 2006 from the redemption of our North Pittsburgh subsidiary’s RTB stock (as discussed in more detail in Note 11 of the Notes to Condensed Consolidated Financial Statements included in Part 1, Item 1 in this Form 10-Q).

The changes in sundry expense (net) were not material.

Income Taxes

Federal and state income tax expense from continuing operations was $6,101 for the nine-month period ended September 30, 2007 as compared to $18,975 for the prior year comparable period. The effective tax rate on income from continuing operations was 39.8% for the nine-month period ended September 30, 2007 as compared to 41.7% for the prior year comparable period. The decrease in the effective tax rate was predominately due to decreases in the liability for unrecognized tax benefits and related accrued interest and penalties that reduced our tax expense by $254 for the nine-month period ended September 30, 2007, as described in more detail in Note 7 of the Notes to Condensed Consolidated Financial Statements included in Part 1, Item 1 of this Form 10-Q.

Three Months Ended September 30, 2007 and 2006

Fluctuations in revenue, operating expenses and other income (expenses) for the three-month period ended September 30, 2007, as compared to the same quarterly period in 2006, were generally attributable to the same reasons discussed in the nine-month comparison above, with the exception of the following:

The effective tax rate on income from continuing operations was 36.8% for the three-month period ended September 30, 2007 as compared to 41.8% for the same quarterly period in 2006 and as compared to 39.8% for the nine-month period ended September 30, 2007. The lower effective tax rate for the quarterly period as compared to the 2007 year-to-date period was due to the fact that decreases in the liability for unrecognized tax benefits and related accrued interest and penalties that reduced our tax expense by $254 for the nine-month period ended September 30, 2007 consisted of a $42 increase in such liabilities during the first two quarters of 2007 and a $296 decrease in such liabilities recorded during the third quarter of 2007.

Liquidity and Capital Resources

Cash and temporary investments were $46,629 at September 30, 2007 as compared to $49,518 at December 31, 2006. The decrease was a result of cash flows used for investing and

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financing activities exceeding the cash flows provided by operating activities. Cash flows from operating activities from continuing operations were $11,729 for the nine-month period ended September 30, 2007, a $3,903 increase from the comparable prior year period. The increase in cash flows from operating activities from continuing operations was partially due to the fact that we made $2,700 of contributions into the North Pittsburgh Pension Plan in the first nine months of 2006. Because of the elective tax-deductible contributions made by North Pittsburgh from 2003 through 2006, the above average returns of the Pension Plan’s assets over the course of the past several years and the freezing of Pension Plan benefit accruals for non-bargaining unit employees effective December 31, 2006, no minimum contribution to the Pension Plan is required for 2007 because North Pittsburgh has a $6,900 funding credit. Second, SFAS 95, “Statement of Cash Flows”, prescribes that all income taxes paid be classified as operating cash outflows, regardless of whether the underlying transactions or events which produced the taxable income were operating, investing or financing in nature. Although the $19,622 in cash received by North Pittsburgh in conjunction with the redemption of its RTB stock in the second quarter of 2006 is classified as cash provided by investing activities, the approximate $4,640 in taxes paid through September 30, 2006 in association with this transaction, therefore, are classified in operating activities. Similarly, we made a payment in the amount of approximately $1,960 during the second quarter of 2007 associated with our final tax obligation from the RTB stock redemption. As such, cash flows from operating activities from continuing operations for the nine-months ended September 30, 2007 benefited from approximately $2,680 less in income taxes paid relating to the RTB stock redemption. Third, cash flows from operating activities from continuing operations for the nine-month period ended September 30, 2007 also benefited from approximately $1,128 less in non-RTB related federal and state income tax extension and return payments as compared to the prior year nine-month period. The three specific factors mentioned above were partially offset by the fact that cash expenditures, constituting $1,616 of the $2,189 in strategic alternatives expenses recorded during 2007, were made as of September 30, 2007. In addition, cash flows from all other operating activities from continuing operations decreased $989 as a result of a decrease in cash operating income during the first nine months of 2007.

Cash flows used for investing activities from continuing operations were $2,593 for the nine-month period ended September 30, 2007, a $15,077 change from the $12,484 of cash flows provided by investing activities from continuing operations for the comparable prior year period. The decrease was primarily the result of the $19,622 in proceeds received from the redemption of North Pittsburgh’s RTB stock in the second quarter of 2006, partially offset by a $4,372 reduction in expenditures for capital additions. The majority of the decrease in expenditures for capital additions is due to the fact that the nine-month period ended September 30, 2006 included higher levels of OSS expenditures associated with a billing system conversion made during 2006 as well as expenditures related to the installation of a gigabit Ethernet core transmission backbone. In addition, only nominal expenditures associated with our routing and server capacity additions were made during the first nine months of 2007, because we purchased new core routers and additional server capacity in 2006. Distributions received from affiliated companies increased $25 due to a $225 increase in the distributions received from our investments in three wireless partnerships as they experienced a continued improvement in their income and cash flows generated, offset partially by a $200 decrease in distributions from our investment in Boulevard. The total amount of distributions received for the nine-month period ended September 30, 2007 was impacted by the fact that the quarterly distribution we normally receive from the Pittsburgh SMSA partnership during the third quarter was not received until October 1, 2007; such distribution amounted to $1,260.

We expended $12,025 during the nine-month period ended September 30, 2007 for financing activities from continuing operations, which included cash dividends and the scheduled repayments of debt and capital lease obligations. The amount was $14,660 lower than the prior year period, mostly as a result of a $14,705 decrease in dividends paid by reason of a $15,005 ($1.00 per share) special dividend we paid in the second quarter of 2006, offset partially by a $300 increase in regular quarterly dividends paid during the first nine months of 2007 over the regular quarterly dividends paid during the prior year comparable period.

Temporary excess funds were invested in short-term cash equivalents that provide immediate liquidity for scheduled tax payment due dates, debt principal payments, dividend payment dates and other predictable cash needs.

Working capital levels at September 30, 2007 decreased $948 from December 31, 2006. Although we experienced a $2,889 decrease in cash as described above, a portion of those cash expenditures related to the payment of current liabilities (primarily income tax liabilities) that were outstanding at December 31, 2006 and therefore had a neutral impact on overall working capital levels.

The decrease in long-term debt was a result of scheduled principal repayments of $2,314 during the nine-month period ended September 30, 2007. We funded 100% of our 2007 year-to-date expenditures for property and equipment from operations cash flows and cash reserves. Therefore, no additional advances were requested from our available debt facilities. In 1996, North Pittsburgh was granted approval for a loan from the FFB guaranteed by the Rural Utilities Service (RUS) in the maximum principal amount of $75,000. The total amount outstanding at September 30, 2007 to the FFB under this loan was $16,198, with all advances having a maturity date of

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December 31, 2012. The unadvanced amount of this facility as of September 30, 2007 was $34,764. North Pittsburgh can draw against this facility through June 30, 2012 for qualified capital expenditure projects, as defined in the loan agreement, to furnish and improve telephone service in rural areas. As of September 30, 2007, North Pittsburgh had approximately $5,708 of qualified capital expenditures that were eligible to be drawn against this facility.

The notes payable to the FFB are secured by a supplemental Mortgage Agreement executed by North Pittsburgh, which provides that substantially all of the assets of North Pittsburgh, which approximate a net book value of $84,134, are subject to a lien or a security interest. Such agreement contains restrictions regarding dividends and other distributions by North Pittsburgh. Under these restrictions, unless certain working capital levels, net worth levels and interest expense ratios are maintained, North Pittsburgh is not permitted to pay dividends on its capital stock (other than in shares of capital stock), or make any other distributions to its shareholder, or purchase, redeem or retire any of its capital stock or make any investment in affiliated companies. As a result of these restrictions, approximately $16,253 of North Pittsburgh’s retained earnings were available for dividends and other distributions to the Registrant as of September 30, 2007. The Registrant has no restrictions on the amount of its retained earnings that are available for dividends and other distributions to its shareholders. Based on the respective financial calculations as of September 30, 2007, the aforementioned restrictions on North Pittsburgh’s dividends and distributions to the Registrant would not have caused a restriction in our ability to pay dividends and other distributions to our shareholders in the full amount of the $46,629 of our consolidated cash and temporary investments available as of September 30, 2007. Although as of September 30, 2007, there existed no such restrictions from our debt agreement, the Merger Agreement with Consolidated restricts our ability to pay dividends after the quarterly dividend paid on October 15, 2007 to shareholders of record on October 1, 2007 or to make any other forms of distributions to shareholders in general.

North Pittsburgh also has available through June of 2009 a $10,000 line of credit with the Rural Telephone Finance Cooperative at a rate of prime plus 1-1/2%. No borrowings have been taken against the line of credit and there are no commitment fees associated with it.

Without giving any effect to the proposed merger with Consolidated, we expect cash flows provided by operating activities and cash reserves over the next twelve months to be sufficient to service long-term debt and capital lease obligations, to pay dividends (although the payment of dividends after October 15, 2007, is subject to the aforementioned restrictions imposed by the Merger Agreement with Consolidated through the term of the Merger Agreement) and to finance all capital projects. We initially projected a capital expenditure program for 2007 in the range of $14,000 to $15,000, which would have represented a $1,000 to $2,000 decrease over those amounts expended in 2006. Total capital expenditures through September 30, 2007 were $8,032. The $1,000 to $2,000 decrease in expected expenditures for 2007, as initially projected, was mostly due to the fact that 2006 contained higher levels of OSS expenditures associated with the billing system conversion during 2006 as well as the fact that we expect only nominal expenditures associated with our routing and server capacity additions during 2007 because we purchased new core routers and additional server capacity in 2006. Our capital program for 2007 continues the program we started in 2006 to deploy fiber deeper into our ILEC network, which will enable us to provide more advanced data offerings and potentially other broadband based product offerings throughout the majority of our ILEC territory. Approximately 95% of our addressable ILEC access lines are currently served by loops that have fiber built to within 5,000 feet of the premise, and we expect to complete the build out of the remainder of our ILEC territory by the end of 2007. In addition, our 2007 capital program included the beginning of the deployment of our next generation Digital Subscriber Line Access Multiplexer (DSLAMs), which should be able to deliver speeds of between 20 to 25 megabits per second, a substantial improvement over our current 3 megabit product. However, because of the considerations and activities that have resulted in the Merger Agreement with Consolidated, we delayed our final vendor selection and commencement of DSLAM deployments that we originally projected to occur during the second quarter of 2007. The DSLAM is a critical component of the overall broadband network, which is the fundamental basis for the deployment of services such as video. Consequently, vendor and product alignment of all the multiple elements of a video transmission is essential. We now have finalized vendor selection, and we expect to deploy our next generation DSLAMs in the fourth quarter of 2007. We would expect that our fourth quarter capital expenditures will be higher than those amounts expended in each of the first three quarters of 2007, although depending upon the lead time in which the DSLAMS can be delivered and installation can be accomplished, it is possible that some of the expenditures that we originally projected as part of our 2007 capital plan will be deferred until 2008. In addition, several million dollars of our anticipated 2007 capital expenditure program relate to success-based customer additions in our CLEC edge-out markets that require capital and network capacity additions. Any substantial variations from our underlying customer addition projections could cause the success-based capital expenditures to deviate from those amounts included in our capital expenditure projections above.

We refer you to our Management’s Discussion and Analysis of Financial Condition and Results of Operations section of our 2006 Form 10-K for a disclosure and discussion of our aggregate contractual obligations and purchase commitments as of December 31, 2006. Scheduled payments of $3,035, $1,012, $277 and $1,746 were made to reduce the outstanding long-term debt (principal and interest), capital lease, operating lease and OSS obligations, respectively, during the first nine months of 2007. We refer you to Notes 2 and 3 of the Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Form 10-Q for

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information about contingent obligations under the Merger Agreement, the Company’s engagement letter with its financial advisor and the Company’s Shareholder Approval Bonus Plan.

Critical Accounting Policies

Certain accounting policies are very important to the portrayal of our financial condition and results of operations and require management’s most subjective or complex judgments. These policies are as follows:

Revenue Recognition

Revenues are recognized when local network, long distance, and access services are provided. Local service, intrastate long distance and intrastate access service revenues are subject to the jurisdiction of the PA PUC. Interstate long distance and interstate access service revenues are subject to the jurisdiction of the FCC. Directory advertising revenues are recognized ratably over the period related to the directory publication.

Our North Pittsburgh subsidiary receives a portion of its interstate access revenues from pooling arrangements in which it participates with other telephone companies. Such pools, which are administrated by NECA, are funded by access service charges regulated by the FCC. Revenues earned through these pooling arrangements, which are based on nationwide average costs of the pooling companies applied to certain projected demand quantities, are initially recorded based on estimates and are subject to adjustments that may either increase or decrease the final amount of interstate revenues realized for a given period. Management monitors the activity of the pools and establishes accruals, if deemed necessary, for estimated obligations to the pool. The calculations used to record these revenues are complex and involve a variety of estimates, and it is therefore possible that the ultimate amount realized from the pools could differ materially from our estimates, although historically we usually have not experienced significant out-of-period adjustments to our revenues as a result of participating in these pools.

Valuation of Accounts Receivable

We review accounts receivable to determine which are doubtful of collection. In making the determination of the appropriate allowance for doubtful accounts, we consider our accounts receivable aging schedules, history of write-offs and relationships with our customers and the overall credit worthiness of our customers.

Income Taxes

In assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. We consider the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment.

Pension and Other Postretirement Benefits

We calculate the costs of providing retiree benefits under the provisions of SFAS No. 87 and SFAS No. 106. The key assumptions used in making these calculations are disclosed in Note 6 to our consolidated financial statements included in our 2006 Form 10-K. The most significant of these assumptions are the discount rate used to value the future obligation, expected return on plan assets and health care cost trend rates. We select discount rates commensurate with current market interest rates on high-quality, fixed-rate debt securities. In doing so, we match our estimated benefit plan cash flows to that of the average of two published yield curves, those being the Citigroup Pension Discount Curve and the Mercer Yield Curve. The expected return on assets is based on our current view of the long-term returns on assets held by the plan, which is influenced by the historical performance of plan assets, asset allocation and third-party studies. The medical cost trend rate is based on our actual medical claims and future projections of medical cost trends.

The judgments used in applying the above policies are based on our evaluation of the relevant facts and circumstances as of the date of the financial statements. Actual results may differ from those estimates.

Regulatory Environment

Both North Pittsburgh and Penn Telecom are subject to regulatory oversight by the PA PUC for intrastate services and the FCC for interstate services. The PA PUC and the FCC have broad powers of supervision and regulation over public utilities with respect to service and facilities, rates and charges, securities, the encumbering or disposition of public utility properties, accounting and various other matters.

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Federal Regulatory Matters

The FCC regulates the rates, the system of financial accounts for reporting purposes, rules for interconnection with other carriers, universal service funding, certain aspects of service quality, the use of numbering resources, compliance with the Communications Assistance for Law Enforcement Act (CALEA), and other aspects related to North Pittsburgh’s and Penn Telecom’s provision of interstate services.

Interconnection Rules

In 1996, Congress passed the 1996 Act, which has the goal of opening the telecommunications industry to further competition for all services, including the local exchange market. The 1996 Act prohibits state legislative or regulatory restrictions or barriers to entry regarding the provision of local telephone service. It also requires most ILECs to interconnect with the networks of other telecommunications carriers, unbundle their services into network elements, offer their telecommunications services at wholesale rates in order to permit the resale of such services and allow other telecommunications carriers to locate equipment on their premises. Local exchange telephone carriers are also required to compensate each other for the transport and termination of calls. The FCC has issued a number of Rulemakings that continue to implement the requirements of the 1996 Act and are intended to facilitate the resale of services at wholesale rates and provide for local number portability (LNP), dialing parity, interconnection to any requesting carrier and access to network elements.

North Pittsburgh’s wireline operations are considered Rural under the 1996 Act and therefore are exempt from certain of the above-mentioned obligations unless, in response to a bona fide request for interconnection, the PA PUC removes that exemption. More specifically, pursuant to the rural exemption provision of Section 251(f)(1) of the 1996 Act, North Pittsburgh is currently exempted from offering collocation, UNEs, wholesale discounts and certain other requirements of the 1996 Act which originally pertained only to non-rural ILECs. However, upon a petition by a potential competitor, the PA PUC may remove North Pittsburgh’s rural exemption if it finds that the competitor’s proposal is not unduly economically burdensome to North Pittsburgh, is technically feasible and is consistent with the universal service provisions of the 1996 Act. The burden of proof in such a proceeding rests with the competitor. The rural exemption does not, however, prevent facilities-based competition in North Pittsburgh’s service area.

North Pittsburgh has interconnected with several facilities-based CLECs that offer competitive services to customers within the North Pittsburgh service territory.

Triennial Review Order and Related Matters

On February 20, 2003, the FCC issued its Triennial Review Order (TRO) regarding the 1996 Act. In that Order, the FCC eliminated unbundling requirements for ILECs in regard to broadband services provided over fiber facilities but continued to require unbundled access to mass-market narrowband loops. In addition, ILECs were not required to unbundle packet switching services. The FCC further found that the high frequency portion of the loop, also referred to as line sharing, was no longer required to be provided as a UNE and that requirement would therefore be phased out over three years. As noted below, other aspects of the original TRO filing were later remanded back to the FCC.

On March 2, 2004, the U. S. Court of Appeals for the District of Columbia issued a decision in response to a number of court appeals filed in regard to the FCC’s TRO. In that ruling, the court upheld the FCC’s rules in regard to the FCC’s conclusion that ILECs need not unbundle broadband loops provided through the utilization of new technologies such as hybrid fiber/coaxial cable and fiber-to-the-home. Subsequent FCC orders have also relieved incumbents of the unbundling requirements for fiber-to-the-curb loops, where fiber is extended to within 500 feet of a customer premises. The court also agreed with the FCC that ILECs need not provide line sharing. However, the court vacated and remanded a number of other FCC rules promulgated in the original TRO, including those pertaining to the availability of the local switching UNE (UNE-P).

On February 4, 2005, the FCC in response to the Court of Appeals decision released its Order on Remand, setting forth final rules regarding the unbundling obligations of the ILECs. The FCC’s revised UNE rules now state that CLECs are not impaired without unbundled access to the UNE-P combination comprised of Local Switching and UNE Loop, or Shared Transport, Call Related Databases, or Signaling Networks used in connection with Local Switching. In addition, the FCC found that CLECs are not impaired at certain Wire Center locations in regard to high bandwidth (DS-1 and DS-3) loops, dark fiber loops and interoffice transport facilities based on such criteria as the number of Business Lines and Fiber-Based collocators within the wire center.

On February 14, 2005, a number of parties filed a supplementary petition with the U.S. Court of Appeals for the District of Columbia, again seeking a writ of mandamus to compel the FCC to follow the Court’s previous directive in its earlier remand decision. The parties filing the petition claim that the final FCC rules are still flawed and not in compliance with the Court’s decision. Action by the Court on this petition is still pending.

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The final FCC rules regarding the unbundling of various network elements did not have an impact on our ILEC operations, because we are not required to offer UNEs to competitors as long as we retain our rural exemption. In regard to our CLEC operations, because we do not currently utilize line sharing and utilize our own switching for business customers that are served by high-capacity loops, the elimination of these network elements had no effect on our operations or revenues from our existing customer base.

In July of 2005, we executed a three-year commercial agreement with Verizon that has set the terms of the pricing and provisioning of lines served utilizing UNE-P. We currently provision 8% of our CLEC access lines (or 3% of our consolidated access lines) utilizing UNE-P. Although the costs for UNE-P will increase over time pursuant to the terms of the agreement, our relatively low use of UNE-P and our ability to migrate some of the lines to alternative provisioning methodologies will limit the overall impact on our current cost structure. With respect to the rules concerning access to unbundled high capacity loops, interoffice transport facilities and dark fiber, we have experienced moderate increases in the overall cost to provision such loops and facilities as a result of the FCC’s Order on Remand.

On September 6, 2006, Verizon filed a Petition with the FCC requesting that they forbear from applying a number of regulations to the Verizon operations in six major metropolitan markets, one of which was the Pittsburgh market area. In addition to seeking forbearance from dominant carrier tariffing requirements, price cap regulations, comparably efficient interconnection and open network architecture requirements, Verizon also sought forbearance from applying loop and transport unbundling regulations, claiming that there was sufficient competition in the Pittsburgh market, which no longer necessitated the application of these rules. Should the FCC approve the Verizon petition for forbearance, our CLEC may no longer be eligible to obtain loops and transport on an unbundled basis and may have to convert all existing unbundled loops and transport it orders from Verizon to an alternative pricing arrangement, presumably at rates close to or equal to special access rates for these services. The effect of the grant of the petition would be to greatly increase our CLEC’s costs to purchase these services. A number of parties have filed in opposition to this Petition, because it seeks essentially to deconstruct many of the fundamental principles of the 1996 Act passed by Congress. As a result of the filings in opposition, the proceeding has been extended by the FCC to allow it to solicit more comments from interested parties before making a final ruling on the Petition.

Intercarrier Compensation and Universal Service

On February 10, 2005, the FCC issued a Further Notice of Proposed Rulemaking (FNPRM) in regard to the rules governing intercarrier compensation for the various types of traffic exchanged by telecommunications carriers. Under the current rules, rates charged for traffic vary by the type and/or the jurisdiction of the traffic. The FCC is considering replacing this current system of payments with a uniform regime under which all types of traffic are compensated at a unitary rate. In that proceeding, the FCC is seeking comment on seven comprehensive reform proposals that have been submitted to the FCC from industry participants and other interested parties. The FCC’s goal is to put in place an intercarrier compensation mechanism that encourages the development of efficient competition, that preserves universal service support which ensures affordable rates in rural and high cost areas, that is technologically and competitively neutral and that minimizes regulatory intervention and enforcement and relies on commercially negotiated contracts rather than rules and regulations. Both North Pittsburgh and Penn Telecom receive a large percentage of their revenues from intercarrier compensation payments, and the outcome of this proceeding therefore may have a large impact on their revenue streams. In addition, because universal service funding will be affected by any change in the current intercarrier compensation system, North Pittsburgh’s universal service funding from both the interstate and intrastate jurisdictions may be affected by the outcome of this proceeding.

On February 12, 2004, the FCC issued a Notice of Proposed Rulemaking (NPRM) in regard to examining the regulatory treatment of VoIP. While the FCC indicated its preference for minimal regulation, it also recognized the need to ensure that the provision of VoIP is consistent with social objectives including universal service, emergency 911, law enforcement access, consumer protection and disability access.

Prior to the FCC’s issuance of the NPRM regarding VoIP, several companies had petitioned the FCC for declaratory rulings that their specific service offerings, which utilize Internet Protocol (IP) in some portion of the service, were exempt from access charges. In one case, the FCC ruled that access charges do apply to toll calls that originate or terminate on the Public Switched Telephone Network (PSTN) even if some portion of the call is transported utilizing IP. In the second case, the FCC ruled that voice-calling services utilizing IP between two broadband connections to the Internet and which do not utilize the PSTN at either end were exempt from access charges.

While these two FCC rulings have addressed the applicability of access charges to specific services that utilize IP to provide voice or toll calling services, various questions regarding the full scope of regulations that will apply in general to VoIP services are still unresolved and will be

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addressed in the VoIP NPRM. Certain specific issues regarding the application of access charges to VoIP and enhanced services may also be addressed prior to completion of the VoIP NPRM proceeding as a result of several other petitions that are currently pending before the FCC. The outcome of these petitions and the NPRM proceeding will affect North Pittsburgh and Penn Telecom because: 1) VoIP services compete directly with the local and toll service offerings of North Pittsburgh and Penn Telecom, 2) we are a provider of VoIP services, and 3) both North Pittsburgh and Penn Telecom receive a portion of their revenues from access charges, the applicability of which to various forms of IP and enhanced services traffic is being reviewed in these petitions and the NPRM. Because the outcomes of the petitions and the NPRM proceeding are unknown at this time, we are unable to determine the effect such actions may have on our operations and revenues.

In February of 2002, the FCC issued a FNPRM regarding the possible reformation of the system for assessing and recovering USF monies. In that proceeding, the FCC asked for comment on whether it should assess carrier contributions based on the number and capacity of connections that contributing carriers provide to customers, rather than on the current method, which is based on the interstate revenues they earn. In June of 2006, the FCC released an Order and NPRM in response to the February 2002 FNPRM. In that Order, the FCC made what it characterized as interim modifications to the existing approach for assessing contributions to the federal USF. The key changes to USF funding implemented in the Order were to: 1) raise the interim wireless safe harbor interstate percentage from its then current 28.5 percent level to 37.1 percent; and 2) establish a USF contribution obligation for providers of interconnected VoIP service. The raising of the wireless safe harbor rate and the assessment of interconnected VoIP providers will have the effect of mitigating any potential impact on the assessment rate of the fund caused by the elimination of contributions to the USF by carriers that have chosen to no longer offer their wireline broadband services on a common carrier basis as a result of the FCC’s August 2005 Wireline Broadband Order. However, the FCC declined to make any further changes in the USF contribution assessment methodology at that time, noting that a consensus approach to fundamental reform had not developed yet and that they would continue to address the challenges of fundamental reform. In the Order, the FCC also issued a NPRM and asked for comments from interested parties in regard to any potential further refinements to both the safe harbor rules for wireless and the assessment on VoIP services.

While the record has now closed on the FNPRM, the FCC has not yet taken any further action in regard to universal service funding issues addressed in that proceeding. Consequently, the proposed changes that were the subject of the February 2002 FCC FNPRM regarding fundamental reform of the USF are still pending and unresolved at this time and we are unable to determine the effect the FCC’s actions with respect to these proposals may have on our operations and revenues.

On August 11, 2006, the Federal-State Joint Board on Universal Service issued a Notice seeking comment on the merits of using auctions to determine and distribute universal service support. Effective July 1, 2007, North Pittsburgh’s annual receipts approximate $2,025 of Interstate Common Line Support (ICLS) in the federal jurisdiction, down from approximately $2,750 of annual receipts for the fiscal July 1, 2006 through June 30, 2007 period. As ICLS is processed through the NECA pool for North Pittsburgh, this decrease in ICLS receipts is part of, not in addition to, the decreases in the NECA average schedule formulas discussed in more detail in the “North Pittsburgh’s Interstate Revenue Requirement” section immediately following this paragraph. In the initial round of the Joint Board proceeding, over 60 parties filed comments with the FCC. As expected, there were parties in support of, and parties in opposition to, the use of auctions in regard to USF determination and distribution. Reply comments in the proceeding were due November 8, 2006. The Joint Board has not yet issued any recommendation to the FCC in regard to the proceeding. Should the Joint Board issue a recommendation to the FCC regarding the proceeding and should the FCC take any future action based on that recommendation regarding universal service funding, which might include the use of auctions to determine USF support amounts, North Pittsburgh may be negatively affected because in such an auction another company may underbid the current support amounts North Pittsburgh receives, thereby causing North Pittsburgh to either lower its bid below the current amount it receives or potentially lose its federal USF support.

North Pittsburgh’s Interstate Revenue Requirement

North Pittsburgh participates as an average schedule company in the interstate tariff and settlement pooling process that is administered by NECA, which means North Pittsburgh’s interstate settlements are determined by formulas based on a statistical sampling of the allocation of costs to the interstate jurisdiction of comparable companies that perform cost studies.

With respect to NECA’s average schedule formulas for the July 1, 2006 through June 30, 2007 period, NECA not only made changes to the average schedule formulas based on the normal annual projected changes in cost and demand for the July 1, 2006 through June 30, 2007 period but also implemented some structural changes to the formulas in order to more closely align average schedule company settlements to the companies’ estimated interstate revenue requirements based on statistical sampling. Although settlement rates for average schedule

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companies on an overall basis decreased by about 1.7% (assuming constant demand), some companies with larger study areas (based on access line size), such as North Pittsburgh, experienced a significant decrease in settlements, while many companies with smaller study areas experienced an increase. The formulas also reflected the trend of reduced access minutes.

Due to the significant decrease in interstate settlements that would be experienced by some companies because of these changes, the NECA filing recommended, and the FCC approved, a two-year phase in of the reduction in settlements resulting from the structural changes in the formulas.

As a relatively large average schedule company, North Pittsburgh was affected by these reductions in settlements. The formulas will cause a reduction of approximately $210 per month (or approximately $2.5 million annually) in North Pittsburgh’s interstate settlements when the reductions are fully phased in. The projected $210 per month reduction consists of two elements: an approximately $60 per month decrease related to the normal year-over-year changes in overall average schedule formulas and an approximately $150 per month decrease related to the structural changes to the formulas. The $60 per month decrease that pertains to the normal changes in the formulas resulted in an immediate decrease in settlement revenues effective July 1, 2006. Under the two-year phase-in of the reduction in settlements relating to the structural changes in the formulas approved by the FCC, the $150 per month decrease related to the structural changes has not been recognized in its entirety immediately; rather, that reduction is being phased in ratably over a twenty-four month period of time ending June 30, 2008.

On December 21, 2006, NECA filed with the FCC its most recent annual proposed modifications of the average schedule formulas. In that filing, NECA proposed to revise the formulas for average schedule interstate settlement disbursements for interstate access services provided during the period July 1, 2007 through June 30, 2008. In this filing, NECA again not only proposed changes to the average schedule formulas based on the normal projected changes in cost and demand for the July 1, 2007 through June 30, 2008 period but also proposed additional structural changes to the formulas in order to more closely align average schedule company settlements to the companies’ estimated interstate revenue requirements based on statistical sampling.

In this filing, NECA proposed lowering the settlement rates for all average schedule companies, which resulted in a proposed overall decrease of approximately 7.27%, assuming constant demand; however, the individual impact on each average schedule company would depend on its size and demand characteristics, with the majority of companies experiencing a decrease in settlements in a range between 5% and 15%. According to NECA, the proposed decreases reflect ongoing overall reduced cost levels of average schedule companies as well as decreases associated with structural changes to the Line Haul Distance Sensitive formula, which reimburses companies for the costs of transporting interstate calls.

Due to the significant decrease in interstate settlements that would be experienced by some companies, the NECA filing, similar to the previous year’s filing, also recommended that the FCC consider implementing a two-year phase-in of the reduction in settlements. The filing included a detailed procedure on how that phase-in might be accomplished.

On June 8, 2007, the FCC issued an order approving the NECA-proposed revised average schedule formulas for the July 1, 2007 through June 30, 2008 period, as well as the proposed two-year phase-in. The new formulas will cause a reduction of approximately $100 per month (or approximately $1.2 million annually) in North Pittsburgh’s interstate settlements when the reductions are fully phased in. This estimated reduction is related solely to the proposed changes for the average schedule formulas proposed by NECA in its filing for the July 1, 2007 through June 30, 2008 period and is independent of the reduction in settlements already being experienced by North Pittsburgh from the average schedule formulas being phased in pursuant to NECA’s filing with respect to the July 1, 2006 through June 30, 2007 period (discussed above). The projected $100 per month reduction consists of two elements: an approximately $40 per month decrease related to the normal year-over-year changes in overall average schedule formulas and an approximately $60 per month decrease related to the structural change to the Line Haul Distance Sensitive formula. Similar to the first phase-in plan, the $60 per month decrease related to the structural change will not be recognized in its entirety immediately; rather, the reduction is being phased in ratably over a twenty-four month period of time beginning July 1, 2007.

In summary, we estimate that North Pittsburgh’s annual revenues realized through the NECA average schedule formulas will eventually decrease by approximately $3,700 on an annualized basis (assuming constant demand data) as a result of the changes made to both the July 1, 2006 through June 30, 2007 and July 1, 2007 through June 30, 2008 average schedule formulas. Revenues for the first nine months of 2007 were negatively impacted by approximately $1,030 as compared to the prior year comparable period because of these normal and structural changes to the NECA average schedule formulas. The full impact of the changes in the average schedules will be realized starting July 1, 2009.

We continue to monitor whether or not it is advantageous for North Pittsburgh to participate in the NECA pool as an average schedule company or, alternatively, to become a cost company

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subject to its own individual cost and demand data studies. It is important to note that as an average schedule company, North Pittsburgh’s interstate revenues and earnings can be subject to more volatility than those of comparable cost companies due to the lack of an exact relationship between the actual cost structure and demand data of an average schedule company such as North Pittsburgh and its ultimate settlement pursuant to average schedules.

State Regulatory Matters

The PA PUC regulates the rates, the system of financial accounts for reporting purposes, certain aspects of service quality, billing procedures, universal service funding and other aspects related to North Pittsburgh’s and Penn Telecom’s provision of intrastate services. In addition, the PA PUC sets the rates and terms for interconnection between carriers within the guidelines ordered by the FCC.

Price Regulation

Effective January 22, 2001, under a statutory framework referred to as Chapter 30, North Pittsburgh moved from rate-of-return regulation in the intrastate jurisdiction to an alternative form of regulation, which was a price cap plan. Under North Pittsburgh’s price cap plan, rates for non-competitive intrastate services were allowed to increase based on an index that measures economy-wide price increases less a productivity offset. In return for approval of the alternative form of regulation, North Pittsburgh committed to continue to upgrade its network in the future to ensure that all its customers would have access to broadband services. The original Chapter 30 legislation expired due to legislative sunset provisions on December 31, 2003.

On November 30, 2004, Act 183 was signed into law in Pennsylvania. Act 183 implemented new Chapter 30 legislation, which continued many aspects of the former Chapter 30 provisions (as described above) but also added some options for ILECs in regard to alternative regulation. Under the new Act 183, ILECs may commit to accelerate the deployment of broadband service capability to their entire service area and in exchange receive a reduction in, or elimination of, the productivity offset in their price index formula.

On February 25, 2005, North Pittsburgh filed an Amended Alternative Form of Regulation and Network Modernization Plan with the PA PUC pursuant to Act 183. In that filing, in addition to modifying its prior Chapter 30 Plan to comport with the new statute, North Pittsburgh committed to accelerate its deployment of a ubiquitous broadband network throughout its entire service area from the previous commitment date of December 31, 2015 to December 31, 2008. In return for making this commitment, North Pittsburgh is no longer subject to a productivity offset when calculating the Price Stability Index component of its annual price stability mechanism filing. As a result of this commitment to accelerate its network deployment, North Pittsburgh also does not have to contribute to certain new public policy funding obligations that were instituted as part of Act 183. On June 2, 2005, the PA PUC approved North Pittsburgh’s amended plan with no significant changes. North Pittsburgh is already in the process of upgrading its broadband infrastructure for general business and competitive purposes, and we do not anticipate that the acceleration of our broadband commitment date under our amended Network Modernization Plan will require any material additional amount of capital expenditures from what otherwise is planned to be spent in the normal course of business.

Other State Regulatory Matters

In an order adopted August 26, 1999 and entered September 30, 1999, the PA PUC as part of a proceeding that resolved a number of pending issues ordered ILECs, including North Pittsburgh, to rebalance and lower intrastate toll and switched access rates. In that same order, the PA PUC also created a Pennsylvania Universal Service Fund (PA USF) to help offset the loss of ILEC revenues due to the reduction in toll and access rates. In 2003, the PA PUC ordered ILECs to further rebalance and reduce intrastate access charges and left the PA USF in place pending further review.

On December 16, 2004, the PA PUC adopted an Order instituting an investigation regarding the intrastate access charges and intraLATA toll rates of rural carriers in Pennsylvania and the effect on those charges and rates if the PA PUC were to reduce disbursements from the PA USF to the rural carriers or if it were to broaden the base of contributors to include carriers that do not currently pay into the fund. The proceeding, which is subject to a stay order, will also address the ramifications of changes to the Pennsylvania Public Utility Code set forth in Act 183 that affect access rate setting for both Local Exchange Carriers (LECs) and CLECs. Under the Act 183 changes to the Public Utility Code, the PA PUC may not require a LEC to reduce intrastate access rates except on a revenue neutral basis. The Act 183 changes also set limits on a CLEC’s ability to charge intrastate access rates higher than the rates charged by the ILEC serving the area in which the CLEC is offering service unless such rates are cost justified. The procedures regarding the PA PUC’s implementation of these rate setting limitations will be determined in this access charge and USF proceeding.

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This proceeding may affect both North Pittsburgh’s and Penn Telecom’s ability to set access charge rates. The proceeding also may affect the amount of funding that North Pittsburgh receives from the PA USF and the amounts that North Pittsburgh and Penn Telecom contribute to that fund. Currently, North Pittsburgh’s annual receipts from and contributions to the PA USF total $5,215 and $305, respectively. Penn Telecom receives no funding from the PA USF but currently contributes $170 on an annual basis. In 2005, a number of parties to the proceeding filed a petition asking that the PA PUC delay any action in regard to the PA USF and intrastate access charges until such time as the FCC takes action in regard to intercarrier compensation issues. On August 11, 2005, the PA PUC adopted an Order, which was entered on August 30, 2005, in which it granted a stay of the investigative proceeding for a period not to exceed twelve months, unless further extended by the PA PUC, or until the FCC issues its ruling in its Unified Intercarrier Compensation proceeding, whichever occurs earlier. On August 30, 2006, a number of parties, including North Pittsburgh, filed a joint motion with the PA PUC requesting a further stay of an additional twelve months to allow the FCC to complete its proceeding regarding intercarrier compensation reform because the FCC action may impact intrastate access rates. The motion for stay was opposed by a number of parties. However, on November 15, 2006, the PA PUC entered an order granting the request for stay pending the outcome of the FCC Unified Intercarrier Compensation proceeding or for one year, whichever is earlier. The current PA USF has been continued under the existing regulations during the period of the stay. On October 16, 2007, a number of parties, including North Pittsburgh, filed a joint motion with the PA PUC requesting another further stay of an additional twelve months to allow the FCC to complete its intercarrier compensation proceeding. The motion for stay is still pending before the PA PUC.

As described in more detail in Note 10 of the Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 and also discussed in Part II, Item 1 “Legal Proceedings”, of this Form 10-Q, on October 23, 2006, Verizon Pennsylvania, Inc., along with a number of its affiliated companies, filed a formal complaint with the PA PUC claiming that Penn Telecom’s intrastate switched access rates are higher than those of the ILEC in the corresponding service area and therefore are in violation of Act 183. Verizon’s most recent official claim for refund of Penn Telecom’s intrastate access billings amounted to $1,559, exclusive of interest, through May 2007. Based solely on our interpretation of the Verizon complaint and the underlying methodologies and calculations used by Verizon in arriving at their $1,559 claim, exclusive of interest, through May 2007, we estimate that the amount of such claim would be approximately $1,715 through September 30, 2007, exclusive of interest. For reasons discussed in more detail in the afore-referenced Note 10 of the Notes to Condensed Consolidated Financial Statements included Part I, Item 1 of in this Form 10-Q, we believe that Penn Telecom’s switched access rates are cost justified and permissible, and we are vigorously opposing this complaint. In the event we are not successful in this proceeding, however, Penn Telecom’s operations could be materially adversely impacted by not only the refund sought by Verizon but more importantly by the prospective decreases in access revenues resulting from the change in its intrastate access rates, which would apply not only to Verizon and its affiliated companies that are parties to the complaint filed with the PA PUC but also to all other carriers on a non-discriminatory basis. We preliminarily estimate that the decrease in our annual revenues and pre-tax income would be approximately $1,200 on a static basis (meaning keeping access MOUs constant) if Verizon were to prevail completely in its complaint.

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Recent Accounting Pronouncements

In February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (SFAS No. 159). SFAS No. 159 allows entities the option to measure eligible financial instruments at fair value as of specified dates. Such election, which may be applied on an instrument by instrument basis, is typically irrevocable once elected. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007 and early application is allowed under certain circumstances. The Company is currently evaluating the impact, if any, SFAS No. 159 may have on the Company’s consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS No. 157). SFAS No. 157 defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We are currently evaluating the impact, if any, SFAS No. 157 may have on the Company’s consolidated financial statements.

In June 2006, the FASB ratified the Emerging Issues Task Force (EITF) consensus on EITF Issue No. 06-3 “How Taxes Collected From Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)” (EITF 06-3). The scope of EITF 06-3 includes any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer, and provides that a company may adopt a policy of presenting taxes either on a gross basis – that is, including the taxes within revenue – or on a net basis. For any such taxes that are reported on a gross basis, a company should disclose the amounts of those taxes for each period for which an income statement is presented if those amounts are significant. EITF 06-3 is effective for financial reports for interim periods and annual reporting periods beginning after December 15, 2006. The Company adopted EITF 06-3 on January 1, 2007. The Company collects various taxes that fall under the scope of EITF 06-3 on services provided and is accounting for and reporting them on a net basis.

The Company adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109” (FIN 48) on January 1, 2007. FIN 48 clarifies the accounting and reporting for uncertainties in income taxes recognized in a company’s financial statements. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition issues. In May 2007, the FASB released FASB Staff Position FIN 48-1, “Definition of Settlement in FASB Interpretation No. 48” (FSP FIN 48-1). FSP FIN 48-1 provides guidance on how a company should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. Please refer to Note 7 of the Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 in this Form 10-Q for additional information, including the effects of adoption of FIN 48 on the Company’s consolidated financial statements.

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PART I