PART I - FINANCIAL INFORMATION | Item 1. Financial Statements | | SBC COMMUNICATIONSAT&T INC.
| CONSOLIDATED STATEMENTS OF INCOME | Dollars in millions except per share amounts | (Unaudited) | | | Three months ended | | Six months ended
| | | June 30,
| | June 30,March 31,
| | | 20052006
| | 2004
| | 2005 | | 2004
| Operating Revenues | | | | | | | | | Voice | $ | 4,9748,722
| $ | 5,205
| $
| 10,060
| $
| 10,4185,852
| Data | | 2,9974,442
| | 2,7272,391
| Directory | | 5,821901
| | 5,374
| Long-distance voice
| | 922
| | 815
| | 1,823
| | 1,564
| Directory advertising
| | 949
| | 959
| | 1,895
| | 1,921905
| Other | | 4861,770
| | 490
| | 977
| | 9311,100
| Total operating revenues | | 10,32815,835
| | 10,196
| | 20,576
| | 20,20810,248
| Operating Expenses | | | | | | | | | Cost of sales (exclusive of depreciation and | | | | amortization | | | | | amortization shown separately below)
| | 4,3477,128
| | 4,292
| | 8,744
| | 8,5194,388
| Selling, general and administrative | | 2,6544,024
| | 2,576
| | 5,124
| | 4,9222,479
| Depreciation and amortization | | 1,8092,492
| | 1,888
| | 3,634
| | 3,8111,825
| Total operating expenses | | 8,81013,644
| | 8,756
| | 17,502
| | 17,2528,692
| Operating Income | | 1,5182,191
| | 1,440
| | 3,074
| | 2,9561,556
| Other Income (Expense) | | | | | | | | | Interest expense | | (349)(464)
| | (235)
| | (702)
| | (467)(353)
| Interest income | | 10085
| | 120
| | 209
| | 236109
| Equity in net income (loss) of affiliates | | 181334
| | 369
| | 123
| | 961(58)
| Other income (expense) – net | | 3411
| | (44)
| | 81
| | 81747
| Total other income (expense) | | (34) | | 210
| | (289)
| | 1,547(255)
| Income Before Income Taxes | | 1,4842,157
| | 1,650
| | 2,785
| | 4,5031,301
| Income taxes | | 484712
| | 515
| | 900
| | 1,457
| Income From Continuing Operations
| | 1,000
| | 1,135
| | 1,885
| | 3,046
| Income From Discontinued Operations, net of tax
| | -
| | 33
| | -
| | 59416
| Net Income | $ | 1,0001,445
| $ | 1,168
| $
| 1,885
| $
| 3,105885
| Earnings Per Common Share: | | | | | | | | | Income From Continuing Operations
| $
| 0.30
| $
| 0.34
| $
| 0.57
| $
| 0.92
| Net Income | $ | 0.300.37
| $ | 0.35
| $
| 0.57
| $
| 0.940.27
| Earnings Per Common Share - Assuming Dilution: | | | | | | | | | Income From Continuing Operations
| $
| 0.30
| $
| 0.34
| $
| 0.57
| $
| 0.92
| Net Income | $ | 0.300.37
| $ | 0.35
| $
| 0.57
| $
| 0.940.27
| Weighted Average Number of Common | | | | | | | | | Shares Outstanding– Basic (in millions) | | 3,3023,882
| | 3,312
| | 3,303 | | 3,310
| Dividends Declared Per Common Share | $ | 0.3225
| $
| 0.3125
| $
| 0.6450.3325
| $ | 0.6250.3225
|
See Notes to Consolidated Financial Statements. 2 SBC COMMUNICATIONS INC. | CONSOLIDATED BALANCE SHEETS | Dollars in millions except per share amounts | | | | | | | | June 30, | | | December 31, | | | 2005 | | | 2004 | Assets | | (Unaudited) | | | | Current Assets | | | | | | Cash and cash equivalents | $ | 406 | | $ | 760 | Accounts receivable - net of allowances for | | | | | | uncollectibles of $894 and $881 | | 5,220 | | | 5,480 | Prepaid expenses | | 867 | | | 746 | Deferred income taxes | | 545 | | | 566 | Other current assets | | 784 | | | 989 | Total current assets | | 7,822 | | | 8,541 | Property, plant and equipment - at cost | | 137,498 | | | 136,177 | Less: accumulated depreciation and amortization | | 88,700 | | | 86,131 | Property, Plant and Equipment – Net | | 48,798 | | | 50,046 | Goodwill | | 1,769 | | | 1,625 | Investments in Equity Affiliates | | 1,768 | | | 1,798 | Investments in and Advances to Cingular Wireless | | 32,414 | | | 33,687 | Other Assets | | 13,072 | | | 13,147 | Total Assets | $ | 105,643 | | $ | 108,844 | | | | | | | Liabilities and Stockholders’ Equity | | | | | | Current Liabilities | | | | | | Debt maturing within one year | $ | 6,890 | | $ | 5,734 | Accounts payable and accrued liabilities | | 9,208 | | | 10,038 | Accrued taxes | | 1,762 | | | 1,787 | Dividends payable | | 1,066 | | | 1,065 | Liabilities of discontinued operations | | - | | | 310 | Total current liabilities | | 18,926 | | | 18,934 | Long-Term Debt | | 18,216 | | | 21,231 | Deferred Credits and Other Noncurrent Liabilities | | | | | | Deferred income taxes | | 15,157 | | | 15,621 | Postemployment benefit obligation | | 9,347 | | | 9,076 | Unamortized investment tax credits | | 177 | | | 188 | Other noncurrent liabilities | | 3,334 | | | 3,290 | Total deferred credits and other noncurrent liabilities | | 28,015 | | | 28,175 | | | | | | | Stockholders’ Equity | | | | | | Common shares issued ($1 par value) | | 3,433 | | | 3,433 | Capital in excess of par value | | 12,557 | | | 12,804 | Retained earnings | | 29,105 | | | 29,352 | Treasury shares (at cost) | | (4,034) | | | (4,535) | Additional minimum pension liability adjustment | | (190) | | | (190) | Accumulated other comprehensive income | | (385) | | | (360) | Total stockholders’ equity | | 40,486 | | | 40,504 | Total Liabilities and Stockholders’ Equity | $ | 105,643 | | $ | 108,844 |
AT&T INC. | CONSOLIDATED BALANCE SHEETS | Dollars in millions except per share amounts | | | | | | | | March 31, | | | December 31, | | | 2006 | | | 2005 | Assets | | (Unaudited) | | | | Current Assets | | | | | | Cash and cash equivalents | $ | 1,057 | | $ | 1,224 | Accounts receivable – net of allowances for | | | | | | uncollectibles of $1,131 and $1,176 | | 8,647 | | | 9,351 | Prepaid expenses | | 1,215 | | | 1,029 | Deferred income taxes | | 1,874 | | | 2,011 | Other current assets | | 1,057 | | | 1,039 | Total current assets | | 13,850 | | | 14,654 | Property, plant and equipment | | 150,516 | | | 149,238 | Less: accumulated depreciation and amortization | | 92,149 | | | 90,511 | Property, Plant and Equipment – Net | | 58,367 | | | 58,727 | Goodwill | | 13,402 | | | 14,055 | Intangible Assets – Net | | 8,214 | | | 8,503 | Investments in Equity Affiliates | | 2,090 | | | 2,031 | Investments in and Advances to Cingular Wireless | | 32,316 | | | 31,404 | Other Assets | | 16,198 | | | 16,258 | Total Assets | $ | 144,437 | | $ | 145,632 | | | | | | | Liabilities and Stockholders’ Equity | | | | | | Current Liabilities | | | | | | Debt maturing within one year | $ | 5,712 | | $ | 4,455 | Accounts payable and accrued liabilities | | 15,510 | | | 17,088 | Accrued taxes | | 2,240 | | | 2,586 | Dividends payable | | 1,293 | | | 1,289 | Total current liabilities | | 24,755 | | | 25,418 | Long-Term Debt | | 25,829 | | | 26,115 | Deferred Credits and Other Noncurrent Liabilities | | | | | | Deferred income taxes | | 14,902 | | | 15,713 | Postemployment benefit obligation | | 18,278 | | | 18,133 | Unamortized investment tax credits | | 202 | | | 209 | Other noncurrent liabilities | | 5,382 | | | 5,354 | Total deferred credits and other noncurrent liabilities | | 38,764 | | | 39,409 | | | | | | | Stockholders’ Equity | | | | | | Common shares issued ($1 par value) | | 4,065 | | | 4,065 | Capital in excess of par value | | 27,262 | | | 27,499 | Retained earnings | | 29,257 | | | 29,106 | Treasury shares (at cost) | | (4,927) | | | (5,406) | Additional minimum pension liability adjustment | | (218) | | | (218) | Accumulated other comprehensive income | | (350) | | | (356) | Total stockholders’ equity | | 55,089 | | | 54,690 | Total Liabilities and Stockholders’ Equity | $ | 144,437 | | $ | 145,632 |
See Notes to Consolidated Financial Statements. 3 SBC COMMUNICATIONS INC. | CONSOLIDATED STATEMENTS OF CASH FLOWS | Dollars in millions, increase (decrease) in cash and cash equivalents | (Unaudited) | Six months ended | | June 30, | | | 2005 | | 2004 | Operating Activities | | | | | Net income | $ | 1,885 | $ | 3,105 | Adjustments to reconcile net income to net cash | | | | | provided by operating activities: | | | | | Depreciation and amortization | | 3,634 | | 3,811 | Undistributed earnings from investments in equity affiliates | | (87) | | (671) | Provision for uncollectible accounts | | 413 | | 388 | Amortization of investment tax credits | | (11) | | (15) | Deferred income tax (benefit) expense | | (264) | | 882 | Net gain on sales of investments | | (75) | | (849) | Income from discontinued operations, net of tax | | - | | (59) | Retirement benefit funding | | - | | (232) | Changes in operating assets and liabilities: | | | | | Accounts receivable | | (153) | | 230 | Other current assets | | (14) | | 10 | Accounts payable and accrued liabilities | | (753) | | (1,035) | Other - net | | 465 | | 126 | Total adjustments | | 3,155 | | 2,586 | Net Cash Provided by Operating Activities | | 5,040 | | 5,691 | Investing Activities | | | | | Construction and capital expenditures | | (2,329) | | (2,138) | Receipts from (investments in) affiliates – net | | 1,179 | | - | Purchases of held-to-maturity securities | | - | | (135) | Maturities of held-to-maturity securities | | 98 | | 237 | Dispositions | | 86 | | 5,179 | Acquisitions | | (169) | | (9) | Proceeds from note repayment | | 37 | | 50 | Net Cash (Used in) Provided by Investing Activities | | (1,098) | | 3,184 | Financing Activities | | | | | Net change in short-term borrowings with original | | | | | maturities of three months or less | | (882) | | (35) | Repayment of long-term debt | | (1,037) | | (184) | Purchase of treasury shares | | (235) | | - | Issuance of treasury shares | | 298 | | 93 | Dividends paid | | (2,130) | | (2,069) | Net Cash Used in Financing Activities | | (3,986) | | (2,195) | Net increase (decrease) in cash and cash equivalents from continuing operations | | (44) | | 6,680 | Net increase (decrease) in cash and cash equivalents from discontinued operations | | (310) | | 100 | Net increase (decrease) in cash and cash equivalents | | (354) | | 6,780 | Cash and cash equivalents beginning of year | | 760 | | 4,806 | Cash and Cash Equivalents End of Period | $ | 406 | $ | 11,586 | Cash paid during the six months ended June 30 for: | Interest | $ | 752 | $ | 536 | Income taxes, net of refunds | $ | 1,493 | $ | 144 |
AT&T INC. | CONSOLIDATED STATEMENTS OF CASH FLOWS | Dollars in millions, increase (decrease) in cash and cash equivalents | (Unaudited) | | Three Months Ended | | March 31, | | | 2006 | | 2005 | Operating Activities | | | | | Net income | $ | 1,445 | $ | 885 | Adjustments to reconcile net income to net cash | | | | | provided by operating activities: | | | | | Depreciation and amortization | | 2,492 | | 1,825 | Undistributed earnings from investments in equity affiliates | | (313) | | 74 | Provision for uncollectible accounts | | 193 | | 239 | Amortization of investment tax credits | | (7) | | (6) | Deferred income tax expense (benefit) | | 66 | | (37) | Net gain on sales of investments | | (8) | | (66) | Changes in operating assets and liabilities: | | | | | Accounts receivable | | 509 | | 128 | Other current assets | | (189) | | (97) | Accounts payable and accrued liabilities | | (2,057) | | (1,624) | Stock-based compensation tax benefit | | (8) | | (3) | Other - net | | 335 | | (65) | Total adjustments | | 1,013 | | 368 | Net Cash Provided by Operating Activities | | 2,458 | | 1,253 | Investing Activities | | | | | Construction and capital expenditures | | (1,821) | | (1,050) | Receipts from (investments in) affiliates – net | | (699) | | 596 | Maturities of held-to-maturity securities | | - | | 64 | Dispositions | | 27 | | 73 | Acquisitions | | (62) | | (169) | Proceeds from note repayment | | - | | 37 | Net Cash Used in Investing Activities | | (2,555) | | (449) | Financing Activities | | | | | Net change in short-term borrowings with original | | | | | maturities of three months or less | | 1,271 | | 761 | Repayment of other short-term borrowings | | (2) | | - | Repayment of long-term debt | | (259) | | (572) | Issuance of treasury shares | | 201 | | 47 | Dividends paid | | (1,289) | | (1,066) | Stock-based compensation tax benefit | | 8 | | 3 | Net Cash Used in Financing Activities | | (70) | | (827) | Net increase (decrease) in cash and cash equivalents from continuing operations | | (167) | | (23) | Net Cash Used in Operating Activities from Discontinued Operations | | - | | (310) | Net increase (decrease) in cash and cash equivalents | | (167) | | (333) | Cash and cash equivalents beginning of year | | 1,224 | | 760 | Cash and Cash Equivalents End of Period | $ | 1,057 | $ | 427 | | | | | | Cash paid during the three months ended March 31 for: | | | | | Interest | $ | 449 | $ | 413 | Income taxes, net of refunds | $ | 853 | $ | 1,426 |
See Notes to Consolidated Financial Statements. 4 SBC COMMUNICATIONS INC. | CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY | Dollars and shares in millions, except per share amounts | (Unaudited) | | Six months ended | | June 30, 2005 | | Shares | Amount | Common Stock | | | | Balance at beginning of year | 3,433 | $ | 3,433 | Balance at end of period | 3,433 | $ | 3,433 | Capital in Excess of Par Value | | | | Balance at beginning of year | | $ | 12,804 | Issuance of shares | | | (286) | Stock option expense | | | 11 | Other | | | 28 | Balance at end of period | | $ | 12,557 | Retained Earnings | | | | Balance at beginning of year | | $ | 29,352 | Net income ($0.57 per share) | | | 1,885 | Dividends to stockholders ($0.645 per share) | | | (2,131) | Other | | | (1) | Balance at end of period | | $ | 29,105 | Treasury Shares | | | | Balance at beginning of year | (132) | $ | (4,535) | Purchase of shares | (10) | | (235) | Issuance of shares | 15 | | 736 | Balance at end of period | (127) | $ | (4,034) | Additional Minimum Pension Liability Adjustment | | | | Balance at beginning of year | | $ | (190) | Balance at end of period | | $ | (190) | Accumulated Other Comprehensive Income, net of tax | | | | Balance at beginning of year | | $ | (360) | Other comprehensive income (loss) (see Note 2) | | | (25) | Balance at end of period | | $ | (385) | | See Notes to Consolidated Financial Statements. | | | | | |
AT&T INC. | CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY | Dollars and shares in millions, except per share amounts | (Unaudited) | | Three months ended | | March 31, 2006 | | Shares | Amount | Common Stock | | | | Balance at beginning of year | 4,065 | $ | 4,065 | Balance at end of period | 4,065 | $ | 4,065 | | | | | Capital in Excess of Par Value | | | | Balance at beginning of year | | $ | 27,499 | Issuance of shares | | | (191) | Stock based compensation | | | (46) | Balance at end of period | | $ | 27,262 | | | | | Retained Earnings | | | | Balance at beginning of year | | $ | 29,106 | Net income ($0.37 per share) | | | 1,445 | Dividends to stockholders ($0.3325 per share) | | | (1,292) | Other | | | (2) | Balance at end of period | | $ | 29,257 | | | | | Treasury Shares | | | | Balance at beginning of year | (188) | $ | (5,406) | Issuance of shares | 11 | | 479 | Balance at end of period | (177) | $ | (4,927) | | | | | Additional Minimum Pension Liability Adjustment | | | | Balance at beginning of year | | $ | (218) | Balance at end of period | | $ | (218) | | | | | Accumulated Other Comprehensive Income, net of tax | | | | Balance at beginning of year | | $ | (356) | Other comprehensive income (loss) (see Note 3) | | | 6 | Balance at end of period | | $ | (350) | | See Notes to Consolidated Financial Statements. | | | | | |
5 SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Dollars in millions except per share amounts NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation – Throughout this document, SBC CommunicationsAT&T Inc. is referred to as “AT&T,” “we” or “SBC.the “Company.” The consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) that permit reduced disclosure for interim periods. We believe that these consolidated financial statements include all adjustments (consisting only of normal recurring accruals) necessary to present fairly the results for the interim periods shown. The results for the interim periods are not necessarily indicative of results for the full year. You should read this document in conjunction with the consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended December 31, 2004.2005. The consolidated financial statements include the accounts of the Company and our majority-owned subsidiaries and affiliates. Our subsidiaries and affiliates operate in the communications services industry both domestically and worldwideinternationally providing wireline and wireless telecommunications services and equipment as well as directory advertising and publishing services. The consolidated financial statements include the accounts of SBC and our majority-owned subsidiaries. All significant intercompany transactions are eliminated in the consolidation process. Investments in partnerships, joint ventures, including Cingular Wireless (Cingular), and less than majority-owned subsidiaries where we have significant influence are accounted for under the equity method. We account for our 60% economic interest in Cingular under the equity method since we share control equally (i.e., 50/50) with our 40% economic partner in the joint venture. We have equal voting rights and representation on the boardBoard of directorsDirectors that controls Cingular. Earnings from certain foreign equity investments accounted for using the equity method are included for periods ended within up to three months of the date of our Consolidated Statements of Income.
The preparation of financial statements in conformity with U.S. generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes, including estimates of probable losses and expenses. Actual results could differ from those estimates. Share-Based CompensationReclassifications – On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (revised 2004), “Share-Based Payment” (FAS 123(R)), which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation” (FAS 123). FAS 123(R) supersedes APB Opinion No. 25, “Accounting for Stock IssuedWe have reclassified certain amounts in prior-period financial statements to Employees,” and amends FASB Statement No. 95, “Statement of Cash Flows.” Generally, the approach in FAS 123(R) is similarconform to the approach describedcurrent period’s presentation. In 2006, we revised our segment reporting (see Note 5). In addition, we revised the product categories reported in FAS 123. However, Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognizedoperating revenue as follows: long-distance voice is now reported in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.voice revenue; integration services and customer premises equipment revenue, previously reported as voice and data revenue are now reported in other revenue; and directory revenues now reflect our traditional directory segment revenues.
For companies registered withRevenue RecognitionRevenues derived from local telephone, long-distance and data services are recognized when services are provided. This is based upon either usage (e.g. minutes of traffic processed), period of time (e.g. monthly service fees) or other established fee schedules. Service revenues also include billings to our customers for various regulatory fees imposed on us by governmental authorities. We record an estimated revenue reduction for future adjustments to customer accounts, other than a provision for doubtful accounts, at the SEC, such as SBC, FAS 123(R) must be adopted no later than the fiscal year beginning after June 15, 2005. FAS 123(R) permits public companies to adopt its requirements using the following methods:
The “modified prospective” method in which compensation costtime revenue is recognized beginning with the effective date (a) based on historical experience. Cash incentives given to customers are recorded as a reduction of revenue. When required as part of providing service, revenues and associated expenses related to nonrefundable, upfront service activation and set-up fees are deferred and recognized over the requirements of FAS 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of FAS 123 for all awards granted to employees prior to the effective date of FAS 123(R) that remain unvested on the effective date.associated service contract period. If no service contract exists, those
6 SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts fees are recognized over the average customer relationship period. Associated expenses are deferred only to the extent of such deferred revenue. For contracts that involve the bundling of services, revenue is allocated to the services based on their relative fair value. We record the sale of equipment to customers as gross revenue when we are the primary obligor in the arrangement, when title is passed and the products are accepted by customers. For agreements involving the resale of third party services in which we are not considered the primary obligor of the arrangement, we record the revenue net of the associated costs incurred. For contracts where we provide customers with an indefeasible right to use network capacity, we recognize revenue ratably over the stated life of the agreement. The “modified retrospective”
We recognize revenues and expenses related to publishing directories on the amortization method, which includesrecognizes revenues and expenses ratably over the requirementslife of the modified prospective method described above, but also permits entitiesdirectory title, typically 12 months. Traffic Compensation ExpenseWe use various estimates and assumptions to restatedetermine the amount of traffic compensation expenses recognized during any reporting period. Switched traffic compensation costs are accrued utilizing estimated rates by product, formulated from historical data and adjusted for known rate changes and volume levels, which are estimated for certain products and known for other products. Such estimates are adjusted monthly to reflect newly available information, such as rate changes and new contractual agreements. Bills reflecting actual incurred information are generally not received until three to nine months subsequent to the end of the reporting period, at which point a final adjustment is made to the accrued switched traffic compensation expense. Dedicated traffic compensation costs are estimated based on the amounts previously recognized under FAS 123number of circuits and the average projected circuit costs, based on historical data adjusted for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods ofrate changes. These costs are adjusted to reflect actual expenses over the year of adoption. We are still considering which method to adopt under FAS 123(R). We adopted the fair-value-based method of accounting for share-based payments allowed under FAS 123 effective January 1, 2002, using the retroactive restatement method of adoption described in FASB Statement No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” This included restatement of results from January 1, 2000 forward, as those were the years for which audited income statements were included in the 2002 SBC Annual Report. Upon adoption of FAS 123(R), if we were to adopt the modified retrospective method, we would also restate results for 1995 through 1999 for the effects on our equity. We are currently using the Black-Scholes option pricing model to estimate the fair value of stock options granted to employees and expect to continue to use this acceptable option valuation model upon the required adoption of FAS 123(R).
We anticipate that adoption of FAS 123(R) will not have a material impact on compensation expense. However, our current accounting under FAS 123 and prospective accounting under FAS 123(R) may affect our ability to fully realize the value shown on our balance sheet of deferred tax assets associated with compensation expense. Full realization of these deferred tax assets requires stock options to be exercised at a price equaling or exceeding the sum of the strike price plus the fair value of the option at the grant date. The provisions of FAS 123 and FAS 123(R), however, do not allow a valuation allowance to be recorded unless the company’s future taxable income is expected to be insufficient to recover the asset. Accordingly, there can be no assurance that the current stock price of SBC common shares will rise to levels sufficient to realize the entire tax benefit currently reflected in our balance sheet. However, to the extent that additional tax benefits are generated in excess of the deferred taxes associated with compensation expense previously recognized, the potential future impact on income would be reduced. Adoption of FAS 123(R) under the modified retrospective method would increase the amount of excess benefits we have previously recorded.
Conditional Asset Retirement Obligations – During the first quarter of 2005, the FASB issued FASB Interpretation Number 47, “Accounting for Conditional Asset Retirement Obligations, an Interpretation of FASB Statement 143” (FIN 47). Under the provisions of FIN 47, companies must accrue legally mandated costs to dispose of assets that are triggered by a future conditional action. This modifies FASB Statement 143, “Accounting for Asset Retirement Obligations” (FAS 143) which required accrual of costs only when removal and disposal were legally required. For example, assume there are specific disposal requirements for an asset once it is physically removed from service, but there is no legal requirement to remove the asset from service. Under FAS 143, nothing would have been accrued for disposal at time of purchase. Under FIN 47, only the cost of disposal would be accrued at the time of purchase, but not the cost of removal as it is the removal activity that triggers the required disposal. Any liability accrued would be offset by an increase in the value of the asset. FIN 47 is effective no later thanthree months following the end of fiscal years ending after December 15, 2005. Wethe reporting period as bills are currently studying the effects of FIN 47 on our financial statements and we do not expect it to have a material impact.received.
Reclassifications–Advertising Costs We have reclassified certain amounts in prior-period financial statements to conform to the current period’s presentation, including those related toAdvertising costs for advertising products and services or promoting our discontinued operations (see Note 7).corporate image are expensed as incurred.
7
SBC COMMUNICATIONS INC.
JUNE 30, 2005
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued
Dollars in millions except per share amounts
Income Taxes–Deferred income taxes are provided for temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for tax purposes. WeTo the extent allowed by GAAP, we provide valuation allowances against the deferred tax assets for amounts when the realization is uncertain. Management reviews these items regularly in light of changes in tax laws and court rulings at both the federal and state levels. Our income tax returns are regularly audited and reviewed by the Internal Revenue Service (IRS) and state taxing authorities. The IRS has completed field examinations for all tax years through 1999 and examinations of subsequent years are in progress. The IRS has issued assessments challenging the timing and amounts of various deductions for the 1997-1999 period. We paid the taxes on these assessments and filed refund claims, which the IRS has denied. We are working with the IRS to resolve all the issues related to these claims. The ultimate resolution is not expected to have a material adverse impact on the financial statements. Additionally, the IRS is expected to complete fieldwork for its audit of the 2000-2002 traditional SBC tax returns during 2006. This is not expected to have an adverse impact on the financial statements. The IRS is also reviewing the tax returns for 2002 – 2004 of our subsidiary, AT&T Corp. (ATTC), as well as the ATTC 2005 short period return. Any adjustments resulting from the review of the 2002 – 2005 ATTC tax returns will be subject to the rules under purchase accounting and therefore are not expected to result in an adverse impact to the financial statements. Additionally, during 2005.the first quarter of 2006, we received Joint Committee approval of the IRS audit for ATTC’s 1997 - 2001 federal income tax returns. The closing of this audit resulted in a reduction to goodwill and a corresponding reduction in our net deferred tax liability, as required by the purchase accounting rules, of approximately $385. See Note 2 for additional information about adjustments to ATTC’s deferred tax liability. 7 AT&T INC. MARCH 31, 2006 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts Investment tax credits earned prior to their repeal by the Tax Reform Act of 1986 are amortized as reductions in income tax expense over the lives of the assets, which gave rise to the credits. Cash Equivalents – Cash and cash equivalents include all highly liquid investments with original maturities of three months or less, and the carrying amounts approximate fair value. At June 30, 2005,March 31, 2006, we held $292$611 in cash, $42$335 in money market funds and $72$111 in other cash equivalents. Allowance for UncollectiblesWe maintain an allowance for uncollectibles for estimated losses that result from the failure or inability of our customers to make required payments. When determining the allowance, we consider the probability of recoverability of accounts receivable based on experience, taking into account current collection trends that are expected to continue, as well as general economic factors, including bankruptcy rates. Credit risks are assessed based on historical write-offs, net of recoveries, and future estimated net write-offs as well as an analysis of the aged accounts receivable balances with reserves generally increasing as the receivable ages. Accounts receivable may be fully reserved for when specific collection issues are known to exist, such as pending bankruptcy or catastrophes. The analysis of receivables is performed monthly and the allowance for uncollectibles adjusted accordingly. Investment Securities – Investments in securities principally consist of held-to-maturity or available-for-sale instruments. Short-term and long-term investments in money market securities are carried as held-to-maturity securities. Available-for-sale securities consist of various debt and equity securities that are long-term in nature. Unrealized gains and losses, net of tax, are recorded in accumulated other comprehensive income. Our investment securities maturing within one year are recorded in “Other current assets” and instruments with maturities more than one year are recorded in “Other Assets” on the Consolidated Balance Sheets. Revenue RecognitionProperty, Plant and Equipment – RevenuesProperty, plant and associated expenses relatedequipment is stated at cost, except for assets acquired using purchase accounting, which are recorded at fair value at the time of their acquisition (see Note 2). The cost of additions and substantial improvements to nonrefundable, up-front wireline service activation feesproperty, plant and equipment is capitalized. The cost of maintenance and repairs of property, plant and equipment is charged to operating expenses. Property, plant and equipment are deferreddepreciated using the straight-line method over their estimated economic lives. Certain subsidiaries follow composite group depreciation methodology; accordingly, when a portion of their depreciable property, plant and equipment is retired in the ordinary course of business, the gross book value is reclassified to accumulated depreciation; no gain or loss is recognized overon the average customer lifedisposition of five years. Expenses, though exceeding revenue, are only deferred to the extent of revenue.this plant and equipment.
Certain revenues derived from local telephone, long-distance, dataProperty, plant and wireless services (principally fixed fees) are billed monthlyequipment is reviewed for recoverability whenever events or changes in advancecircumstances indicate that its carrying amount may not be recoverable.An impairment loss shall be recognized only if the carryingamount of a long-lived asset is not recoverable and are recognizedexceeds its fair value. The carrying amount of a long-lived asset is not recoverable if it exceeds the following month when services are provided. Other revenues derived from telecommunications services, principally long-distance and wireless airtime usage (in excess or in lieu of fixed fees) and network access, are recognized monthly as services are provided.
We recognize revenues and expenses related to publishing directories on the amortization method which recognizes revenues and expenses ratably over the lifesum of the directory, which is typically 12 months.
Allowance for Uncollectibles– Our bad debt allowance is estimated primarily based on analysisundiscounted cash flows expected to result from the use and eventual disposition of history and future expectations of our retail and our wholesale customers in each of our operating companies. For retail customers, our estimates are based on our actual historical write-offs, net of recoveries, and the agingasset.
8 SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts The fair value of a liability for an asset retirement obligation is recorded in the period in which it is incurred if a reasonable estimate of fair value can be made. In periods subsequent to initial measurement, period-to-period changes in the liability for an asset retirement obligation resulting from the passage of time and revisions to either the timing or the amount of the original estimate of undiscounted cash flows are recognized. The increase in the carrying value of the associated long-lived asset is depreciated over the corresponding estimated economic life. Software CostsIt is our policy to capitalize certain costs incurred in connection with developing or obtaining internal-use software. Capitalized software costs are included in “Property, Plant and Equipment” on our consolidated Balance Sheets and are amortized over three years. Software costs that do not meet capitalization criteria are expensed immediately. Goodwill and Other Intangible AssetsGoodwill represents the excess of consideration paid over the fair value of net assets acquired in business combinations. Goodwill and other indefinite-lived intangible assets are not amortized but are tested at least annually for impairment. During 2006, the carrying amount of our goodwill decreased $653 as a result of purchase accounting adjustments related to our acquisition of ATTC (see Note 2). Intangible assets that have finite useful lives are amortized over their useful lives, which range from 1.5 to 18 years. Customer relationships are amortized using primarily the “sum of the months digits” method of amortization over the expected period in which those relationships are expected to contribute to our future cash flows, including consideration for demand, competition and other economic factors based in such a way as to allocate it as equitably as possible to periods during which we expect to benefit from those relationships. Foreign Currency TranslationOur foreign investments and foreign subsidiaries generally report their earnings in their local currencies. We translate our share of their foreign assets and liabilities at exchange rates in effect at the balance sheet dates. We translate our share of their revenues and expenses using average rates during the year. The resulting foreign currency translation adjustments are recorded as a separate component of accumulated other comprehensive income in the accompanying Consolidated Balance Sheets. Gains and losses resulting from exchange rate changes on transactions denominated in a currency other than the local currency are included in earnings as incurred. We have also entered into foreign currency contracts to minimize our exposure to risk of adverse changes in currency exchange rates. We are subject to foreign exchange risk for foreign currency-denominated transactions, such as debt issued, recognized payables and receivables and forecasted transactions. At March 31, 2006, our foreign currency exposures were principally Euros, British pound sterling, Danish krone and Japanese Yen. Derivative Financial InstrumentsWe record derivatives on the balance sheet at fair value. We do not invest in derivatives for trading purposes. We use derivatives from time to time as part of our strategy to manage risks associated with our contractual commitments. Some of these derivatives are designated as either a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge), or a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge and net investment hedge). Our derivative financial instruments primarily include interest rate swap agreements and foreign currency exchange contracts. We account for our interest rate swaps using mark-to-market accounting and include gains or losses from interest rate swaps when paid or received in interest expense on our Consolidated Statements of Income. Amounts paid or received on interest rate forward contracts (treasury rate locks) are amortized over the period of the related interest payments. 9 AT&T INC. MARCH 31, 2006 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts All other derivatives are not formally designated for accounting purposes (undesignated). These derivatives, although undesignated for accounting purposes, are entered into to hedge economic risks. On the balance sheet, we record changes in the fair value of accounts receivable balances. Our assumptionsfair value hedges, along with the changes in the fair value of the hedged asset or liability that is attributable to the hedged risk. Gains or losses upon termination of our fair value hedges are reviewed at least quarterlyamortized as interest expense over the term of the interest payments of the related debt issuances. We record changes in the fair value of cash flow and adjustments are madenet investment hedges, along with the changes in the fair value of the hedged asset or liability that is attributable to our bad debt allowance as appropriate. For our wholesale customers, we usethe hedged risk, in “Accumulated other comprehensive income,” which is a statistical model basedcomponent of Stockholders’ Equity. The settlement gains or costs on our agingcash flow hedges are amortized as interest expense over the term of accounts receivable balances. Our risk categories, risk percentages and reserve balance assumptions built into the modelinterest payments of the related debt issuances. Changes in the fair value of undesignated derivatives are reviewed monthly andrecorded in other income (expense) – net, along with the bad debt allowancechange in fair value of the underlying asset or liability, as applicable. Cash flows associated with derivative instruments are presented in the same category on the Consolidated Statements of Cash Flows as the item being hedged. When hedge accounting is discontinued, the derivative is adjusted accordingly.for changes in fair value through other income (expense) – net. For fair value hedges, the underlying asset or liability will no longer be adjusted for changes in fair value and any asset or liability recorded in connection with the hedging relationship (including firm commitments) will be removed from the balance sheet and recorded in current period earnings. For cash flow hedges, gains and losses that were accumulated in other comprehensive income as a component of Stockholders’ Equity in connection with hedged assets or liabilities or forecasted transactions will be recognized in other income (expense) – net, in the same period the hedged item affects earnings. Goodwill–Employee Separations Goodwill representsIn accordance with Statement of Financial Accounting Standards No. 112, “Employers’ Accounting for Postemployment Benefits,” we establish obligations for expected termination benefits provided to former or inactive employees after employment but before retirement. These benefits include severance payments, workers’ compensation, disability, medical continuation coverage and other benefits. At March 31, 2006, we had severance accruals for traditional SBC employees of approximately $383, of which $274 was established as merger-related severance accruals. In accordance with Statement of Financial Accounting Standards No. 141, “Business Combinations” (FAS 141), severance accruals recorded for ATTC employees were included in the excesspurchase price allocation (see Note 2).
Pension and Postretirement BenefitsSee Note 7 for a comprehensive discussion of our pension and postretirement benefit expense. 10 AT&T INC. MARCH 31, 2006 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts NOTE 2. ACQUISITIONS AND DISPOSITIONS AT&T Corp.In November 2005, we acquired ATTC in a transaction accounted for under FAS 141. ATTC was one of the nation’s largest business service communications providers, offering a variety of global communications services, including large domestic and multinational businesses, small and medium-sized businesses and government agencies. ATTC operated one of the largest telecommunications networks in the U.S. ATTC was also a provider of domestic and international long-distance and usage-based-communications services to consumer customers. Under the merger agreement, each share of ATTC common stock was exchanged for 0.77942 of a share of our common stock. We issued approximately 632 million shares to ATTC shareholders, giving them an approximate 16 percent stake in the combined company, based on common shares outstanding. In addition, immediately prior to the closing of the transaction, ATTC paid each ATTC shareholder a special dividend of $1.30 per share. Based on the $24.17 per share closing price of our common stock on the New York Stock Exchange (NYSE) on November 17, 2005, the last trading day before the closing of the merger, combined with the special dividend, consideration paid over netreceived by ATTC shareholders was approximately $16,300. Based on the average closing price of our common stock on the NYSE for the two days prior to, including, and two days subsequent to the public announcement of the merger (January 31, 2005) of $23.87 and capitalized merger-transaction costs, the transaction was valued, for accounting purposes, at $15,517. ATTC is now a wholly owned subsidiary of AT&T and the results of ATTC’s operations have been included in our consolidated financial statements after the November 18, 2005 acquisition date. Under the purchase method of accounting, the assets and liabilities of ATTC were recorded at their respective fair values as of the date of the acquisition. We obtained preliminary third-party valuations of property, plant and equipment, intangible assets (including the AT&T trade name), debt and certain other assets and liabilities. Because of the proximity of this transaction to year-end, the values of certain assets and liabilities were based on preliminary valuations and are subject to adjustment as additional information is obtained. Such additional information includes, but is not limited to: valuations and physical counts of property, plant and equipment, valuation of investments and the involuntary termination of employees. We have 12 months from the closing of the acquisition to finalize our valuations. As these issues are identified, modified or resolved, resulting increases or decreases to the preliminary value of assets and liabilities are offset by a change to goodwill, which may be material. Adjustments to the preliminary valuation will be recorded in the period finalized. Changes to the valuation of property, plant and equipment may result in adjustments to the fair value of certain identifiable intangible assets acquired. Additionally, as part of the final valuation of the acquisition, we will determine to which entities and to what extent the benefit of the acquisition applies, and as required by GAAP, record the appropriate goodwill to each entity. 11 AT&T INC. MARCH 31, 2006 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts The following table summarizes the preliminary estimated fair values of the ATTC assets acquired and liabilities assumed and related deferred income taxes as of the acquisition date and adjustments made thereto during the first quarter of 2006. | | Purchase Price Allocation | | | As of | | | | As of | | | 12/31/05 | | Adjustments | | 3/31/06 | Assets acquired | | | | | | | Current assets | $ | 6,295 | $ | 19 | $ | 6,314 | Property, plant and equipment | | 10,921 | | - | | 10,921 | Intangible assets not subject to amortization | | | | | | | Trade name | | 4,900 | | - | | 4,900 | Licenses | | 40 | | - | | 40 | Intangible assets subject to amortization | | | | | | | Customer lists and relationships | | 3,050 | | - | | 3,050 | Patents | | 150 | | - | | 150 | Brand licensing agreements | | 70 | | - | | 70 | Investments in unconsolidated subsidiaries | | 160 | | - | | 160 | Other assets | | 4,247 | | - | | 4,247 | Goodwill | | 12,343 | | (653) | | 11,690 | Total assets acquired | | 42,176 | | (634) | | 41,542 | | | | | | | | Liabilities assumed | | | | | | | Current liabilities, excluding current portion of long-term debt | | 6,740 | | 39 | | 6,779 | Long-term debt | | 8,293 | | - | | 8,293 | Deferred income taxes | | 531 | | (673) | | (142) | Postemployment benefit obligation | | 8,807 | | - | | 8,807 | Other noncurrent liabilities | | 2,288 | | - | | 2,288 | Total liabilities assumed | | 26,659 | | (634) | | 26,025 | Net assets acquired | $ | 15,517 | $ | - | $ | 15,517 |
Purchase accounting rules require that as certain pre-merger issues are identified, modified or resolved, resulting increases or decreases to tax liabilities are offset by a change in business combinations. Goodwillgoodwill. During the first quarter of 2006, modifications to various pre-merger tax estimates and the resolution of an ATTC Internal Revenue Service audit (for the years 1997-2001) resulted in a reduction in goodwill of $653 and are reflected in the adjustments column above. 12 AT&T INC. MARCH 31, 2006 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts ATTC maintained change-in-control provisions with its employees that required enhanced severance and benefit payments be paid to employees of ATTC when a change-in-control occurred. Included in the liabilities assumed at acquisition, were employee-related accruals of approximately $1,543. Following is not amortized, but is tested annually for impairment. During 2005, our goodwill increased $144 duea summary of the accrual to anbe paid by the Company, from ATTC's pension plans and from ATTC's postemployment benefit plans. | | For the Quarter
Ended
3/31/06 | |
| Balance at
12/31/05 |
Cash Payments
| Balance at
3/31/06 |
| Paid out of: | | | | | | | | | Company funds | | $ 870 | | $ (46 | ) | $ 824 | | | Pension plans | | 636 | | (4 | ) | 632 | | | Postemployment benefit plans | | 37 | | - | | 37 | |
| | Total | | $ 1,543 | | $ (50 | ) | $ 1,493 | |
|
The following unaudited pro forma consolidated results of operations assume that the acquisition by our consolidated subsidiary Sterling Commerce, Inc.of ATTC was completed as of January 1, 2005. | | For the Quarter Ended | | For the
Year
Ended | | | Mar 31, | | Jun 30, | | Sep 30, | | Dec 31, | | 2005 | Revenues | $ | 16,670 | $ | 16,602 | $ | 16,468 | $ | 16,279 | $ | 66,019 | Net Income | | 1,319 | | 1,257 | | 1,729 | | 1,862 | | 6,167 |
13 AT&T INC. MARCH 31, 2006 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts NOTE 2.3. COMPREHENSIVE INCOME The components of our comprehensive income for the three and six months ended June 30,March 31, 2006 and 2005 and 2004 include net income, adjustments to stockholders’ equity for the foreign currency translation adjustment, net unrealized gain (loss) on available-for-sale securities and net unrealized gain (loss) on cash flow hedges. The foreign currency translation adjustment is due to exchange rate changesfluctuations in our foreign affiliates’ local currencies, Mexico in the second quarter and for the first six months of 2005 and primarily Denmark in the second quarter and for the first six months of 2004.currencies. The reclassification adjustment on cash flow hedges was due to the amortization of losses from our interest rate forward contracts. Following is our comprehensive income: | Three months ended | Six months ended | Three months ended | | | June 30, | | June 30, | March 31, | | | 2005 | | 2004 | | | 2005 | | 2004 | 2006 | 2005 | Net income | $ | 1,000 | $ | 1,168 | | $ | 1,885 | $ | 3,105 | $ | 1,445 | $ | 885 | Other comprehensive income, net of tax: | | | | | | | | | | Foreign currency translation adjustment | | 32 | | (198) | | 30 | | (210) | | (20) | | (2) | Net unrealized gains (losses) on securities: | | | | | | | | | | Unrealized gains (losses) | | (7) | | 21 | | (23) | | 98 | | 27 | | (16) | Less reclassification adjustment realized in net income | | (6) | | (140) | | (33) | | (140) | | (6) | | (27) | Reclassification adjustment for losses | | | | | | | on cash flow hedges included in net income | | - | | 10 | | 1 | | 10 | | Reclassification adjustment for losses on cash flow hedges included in net income | | | 4 | | 1 | Other | | | 1 | | - | Other comprehensive income (loss) | | 19 | | (307) | | (25) | | (242) | | 6 | | (44) | Total comprehensive income | $ | 1,019 | $ | 861 | | $ | 1,860 | $ | 2,863 | $ | 1,451 | $ | 841 |
914
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts NOTE 3.4. EARNINGS PER SHARE A reconciliation of the numerators and denominators of basic earnings per share and diluted earnings per share for net income from continuing operations for the three and six months ended June 30,March 31, 2006 and 2005 and 2004 isare shown in the table below.below: | Three months ended | | Six months ended | Three months ended | | June 30, | | June 30, | March 31, | | 2005 | 2004 | | | 2005 | | 2004 | 2006 | 2005 | Numerators | | | | | | | | | | | | | | Numerator for basic earnings per share: | | | | | | | | | | | Income from continuing operations | $ | 1,000 | $ | 1,135 | | $ | 1,885 | $ | 3,046 | | Net income | | $ | 1,445 | $ | 885 | Dilutive potential common shares: | | | | | | | | | | | | | Other stock-based compensation | | 1 | | 2 | | | 3 | | 4 | | 3 | | 2 | Numerator for diluted earnings per share | $ | 1,001 | $ | 1,137 | | $ | 1,888 | $ | 3,050 | $ | 1,448 | $ | 887 | Denominators (000,000) | | | | | | | | | | | | | | Denominator for basic earnings per share: | | | | | | | | | | | | | | Weighted-average number of common | | | | | | | | | | | | | | shares outstanding | | 3,302 | | 3,312 | | | 3,303 | | 3,310 | | 3,882 | | 3,303 | Dilutive potential common shares: | | | | | | | | | | �� | | | | Stock options | | 1 | | 2 | | | 1 | | 2 | | 3 | | 1 | Other stock-based compensation | | 9 | | 9 | | | 10 | | 11 | | 17 | | 11 | Denominator for diluted earnings per share | | 3,312 | | 3,323 | | | 3,314 | | 3,323 | | 3,902 | | 3,315 | Basic earnings per share | | | | | | | | | | | | | | Income from continuing operations | $ | 0.30 | $ | 0.34 | | $ | 0.57 | $ | 0.92 | | Income from discontinued operations | | - | | 0.01 | | | - | | 0.02 | | Net income | $ | 0.30 | $ | 0.35 | | $ | 0.57 | $ | 0.94 | $ | 0.37 | $ | 0.27 | Diluted earnings per share | | | | | | | | | | | | | | Income from continuing operations | $ | 0.30 | $ | 0.34 | | $ | 0.57 | $ | 0.92 | | Income from discontinued operations | | - | | 0.01 | | | - | | 0.02 | | Net income | $ | 0.30 | $ | 0.35 | | $ | 0.57 | $ | 0.94 | $ | 0.37 | $ | 0.27 |
At June 30,March 31, 2006 and 2005, we had issued and outstanding options to purchase approximately 206264 and 209 million shares of SBCAT&T common stock. The exercise prices of options to purchase a weighted average of 199231 and 196 million shares in the second quarter and 198 million shares for the first six months exceeded the average market price of SBC stock.AT&T stock for the three months ended March 31, 2006 and 2005. Accordingly, we did not include these amounts in determining the dilutive potential common shares for the respective periods. At June 30, 2005,March 31, 2006, the exercise pricesprice of 835 million share options were below market price, commonly referred to as “in the money.”price. Of these “in the money” options, almost all5 million will expire by the end of 2007. At June 30, 2004, we had issued and outstanding options to purchase approximately 227 million shares of SBC common stock. The exercise prices of options to purchase a weighted average of 197 million shares in the second quarter and 194 million shares for the first six months exceeded the average market price of SBC stock. Accordingly, we did not include these amounts in determining the dilutive potential common shares for the respective periods. At June 30, 2004, the exercise prices of 30 million share options were below market price, commonly referred to as “in the money.” Of these “in the money” options, 19 million will expire by the end of 2006.15
10
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts NOTE 4.5. SEGMENT INFORMATION Our segments are strategic business units that offer different products and services and are managed accordingly. Under GAAP segment reporting rules, weWe analyze our various operating segments based on segment income. Interest expense, interest income and other income (expense) – net and income tax expense are managed only on a total company basis and are, accordingly, reflected only in consolidated results. Therefore, these items are not included in the calculation of each segment’s percentage of our consolidated results. As a result of our November 18, 2005 acquisition of ATTC we have revised our segment reporting to represent how we now manage our business, restating prior periods to conform to the current segments. We have fivefour reportable segments that reflect the current management of our business: (1) wireline, (2) Cingular, (3) directory (4) international, and (5)(4) other. The wireline segment provides both retail and wholesale landline telecommunications services, including local and long-distance voice, switched access, data and messaging services, managed networking to business customers and satellite television services through our agreement with EchoStar Communications Corp. The Cingular segment reflects 100% of the results reported by Cingular, our wireless joint venture. In February 2005, we announced we were recording a charge against fourth-quarter 2004 results to reflect the correction of an error relating to the lease accounting practices of Cingular. Because Cingular restated previous financial results, we have reflected those adjustments in Cingular’s 2004 results recorded in the following table. However, due to the immateriality of this adjustment to the results of operations, cash flows and financial position of SBC, we did not adjust our presentation of equity in net income of affiliates in the second quarter and for the first six months of 2004, which is reflected in the “Other” segment. This charge does not affect Cingular’s cash flows and is primarily related to the timing of recording rental expense, which would balance out over the life of the affected operating leases. Cingular’s 2004 results have also been restated to conform the presentation of various state gross receipts taxes and other fees to the current year. In the following segment tables we present 100% of Cingular’s revenues and expenses including these adjustments under “Total segment operating revenues” and “Total segment operating expenses.” Although we analyze Cingular’s revenues and expenses under the Cingular segment, we eliminate the Cingular segment in our consolidated financial statements. In our consolidated financial statements, we report our 60% proportionate share of Cingular’s results as equity in net income of affiliates. For segment reporting, we report this equity in net income (loss) of affiliates in our other segment. The directory segment includes our directory operations, including Yellow and White Pages advertising and electronic publishing. Results for this segment are shown under the amortization method, which means that revenues and direct expenses are recognized ratably over the life of a directory title, typically 12 months. Results for 2004 presented in this segment have been restated to reflect the sale of our interest in the directory advertising business in Illinois and northwest Indiana to R.H. Donnelley Corporation (Donnelley) (see Note 7). In November 2004, a subsidiary in our directory segment entered into a joint venture agreement with BellSouth Corporation (BellSouth) and purchased the online directory provider YellowPages.com (YPC). Our portion of the results from YPCYELLOWPAGES.COM (YPC), a joint venture with BellSouth Corporation (BellSouth), is recorded in this segment as equity in net income of affiliates. Our international segment includes all investments with primarily international operations. The other segment includes results from paging services,Sterling Commerce Inc. and all corporate and other operationsoperations. This segment also includes our portion of the results from our international equity investments and from Cingular as well as the Cingular equity in net income of affiliates, as discussed above.
11
SBC COMMUNICATIONS INC.
JUNE 30, 2005
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued
Dollars in millions except per share amounts
In the following tables, we show how our segment results are reconciled to our consolidated results reported in accordance with GAAP. The Wireline, Cingular, Directory International and Other columns represent the segment results of each such operating segment. The Wireline column includes revenues from services sold to Cingular of $205$382 in the secondfirst quarter of 2006 and $387 for$182 in the first six monthsquarter of 2005 and $137 in the second quarter and $285 for the first six months of 2004 (see Note 5)6). Since we account for Cingular using the equity method of accounting, these revenues are not eliminated upon consolidation and as such, remain in consolidated revenue. The Consolidation and Elimination column adds in those line items that we manage on a consolidated basis only: interest expense, interest income and other income (expense) -– net. This column also eliminates any intercompany transactions included in each segment’s results. Since our 60% share of the results from Cingular is already included in the Other column, the Cingular Elimination column removes the results of Cingular shown in the Cingular segment. 1216
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts For the three months ended June 30, 2005 | | | | | | | | | | | | | | | | At March 31, 2006 or for the three months ended | | At March 31, 2006 or for the three months ended | | | | | | | | | | | | | | | | | | | | | | | | | Consolidation | | Cingular | | Consolidated | | | | | | | | | | Consolidation | | Cingular | | Consolidated | | | Wireline | | Cingular | | Directory | | International | | Other | | and Elimination | | Elimination | | Results | | Wireline | | Cingular | | Directory | | Other | | and Elimination | | Elimination | | Results | Revenues from external customers | $ | 9,369 | $ | 8,609 | $ | 901 | $ | 2 | $ | 56 | $ | - | $ | (8,609) | $ | 10,328 | $ | 14,731 | $ | 8,980 | $ | 901 | $ | 203 | $ | - | $ | (8,980) | $ | 15,835 | Intersegment revenues | | 8 | | - | | 24 | | - | | - | | (32) | | - | | - | | 8 | | - | | 22 | | - | | (30) | | - | | - | Total segment operating revenues | | 9,377 | | 8,609 | | 925 | | 2 | | 56 | | (32) | | (8,609) | | 10,328 | | 14,739 | | 8,980 | | 923 | | 203 | | (30) | | (8,980) | | 15,835 | Operations and support expenses | | 6,571 | | 6,476 | | 433 | | 4 | | 26 | | (33) | | (6,476) | | 7,001 | | 10,557 | | 6,493 | | 447 | | 178 | | (30) | | (6,493) | | 11,152 | Depreciation and amortization expenses | | 1,782 | | 1,629 | | 1 | | - | | 26 | | - | | (1,629) | | 1,809 | | 2,430 | | 1,680 | | 1 | | 61 | | - | | (1,680) | | 2,492 | Total segment operating expenses | | 8,353 | | 8,105 | | 434 | | 4 | | 52 | | (33) | | (8,105) | | 8,810 | | 12,987 | | 8,173 | | 448 | | 239 | | (30) | | (8,173) | | 13,644 | Segment operating income | | 1,024 | | 504 | | 491 | | (2) | | 4 | | 1 | | (504) | | 1,518 | | 1,752 | | 807 | | 475 | | (36) | | - | | (807) | | 2,191 | Interest expense | | - | | 326 | | - | | - | | - | | 349 | | (326) | | 349 | | - | | 297 | | - | | - | | 464 | | (297) | | 464 | Interest income | | - | | 18 | | - | | - | | - | | 100 | | (18) | | 100 | | - | | 4 | | - | | - | | 85 | | (4) | | 85 | Equity in net income (loss) of affiliates | | - | | 1 | | - | | 88 | | 94 | | (1) | | (1) | | 181 | | - | | - | | (5) | | 339 | | - | | - | | 334 | Other income (expense) – net | | - | | (26) | | - | | - | | - | | 34 | | 26 | | 34 | | - | | (36) | | - | | - | | 11 | | 36 | | 11 | Segment income before income taxes | $ | 1,024 | $ | 171 | $ | 491 | $ | 86 | $ | 98 | $ | (215) | $ | (171) | $ | 1,484 | $ | 1,752 | $ | 478 | $ | 470 | $ | 303 | $ | (368) | $ | (478) | $ | 2,157 | | | | | | | | | | | | | | | | | Segment Assets | | $ | 104,409 | $ | 79,344 | $ | 3,950 | $ | 130,809 | $ | (94,731) | $ | (79,344) | $ | 144,437 |
For the six months ended June 30, 2005 | | | | | | | | | | | | | | | | For the three months ended March 31, 2005 | | For the three months ended March 31, 2005 | | | | | | | | | | | | | | | | | | | | | | | | | Consolidation | | Cingular | | Consolidated | | | | | | | | | | Consolidation | | Cingular | | Consolidated | | | Wireline | | Cingular | | Directory | | International | | Other | | and Elimination | | Elimination | | Results | | Wireline | | Cingular | | Directory | | Other | | and Elimination | | Elimination | | Results | Revenues from external customers | $ | 18,650 | $ | 16,838 | $ | 1,806 | $ | 5 | $ | 115 | $ | - | $ | (16,838) | $ | 20,576 | $ | 9,174 | $ | 8,229 | $ | 905 | $ | 169 | $ | - | $ | (8,229) | $ | 10,248 | Intersegment revenues | | 16 | | - | | 48 | | - | | - | | (64) | | - | | - | | 8 | | - | | 24 | | - | | (32) | | - | | - | Total segment operating revenues | | 18,666 | | 16,838 | | 1,854 | | 5 | | 115 | | (64) | | (16,838) | | 20,576 | | 9,182 | | 8,229 | | 929 | | 169 | | (32) | | (8,229) | | 10,248 | Operations and support expenses | | 13,036 | | 12,916 | | 876 | | 11 | | 8 | | (63) | | (12,916) | | 13,868 | | 6,293 | | 6,440 | | 444 | | 160 | | (30) | | (6,440) | | 6,867 | Depreciation and amortization expenses | | 3,580 | | 3,304 | | 3 | | - | | 52 | | (1) | | (3,304) | | 3,634 | | 1,773 | | 1,675 | | 2 | | 52 | | (2) | | (1,675) | | 1,825 | Total segment operating expenses | | 16,616 | | 16,220 | | 879 | | 11 | | 60 | | (64) | | (16,220) | | 17,502 | | 8,066 | | 8,115 | | 446 | | 212 | | (32) | | (8,115) | | 8,692 | Segment operating income | | 2,050 | | 618 | | 975 | | (6) | | 55 | | - | | (618) | | 3,074 | | 1,116 | | 114 | | 483 | | (43) | | - | | (114) | | 1,556 | Interest expense | | - | | 664 | | - | | - | | - | | 702 | | (664) | | 702 | | - | | 338 | | - | | - | | 353 | | (338) | | 353 | Interest income | | - | | 36 | | - | | - | | - | | 209 | | (36) | | 209 | | - | | 18 | | - | | - | | 109 | | (18) | | 109 | Equity in net income (loss) of affiliates | | - | | 3 | | (1) | | 162 | | (38) | | - | | (3) | | 123 | | - | | 2 | | (1) | | (58) | | 1 | | (2) | | (58) | Other income (expense) – net | | - | | (40) | | - | | - | | - | | 81 | | 40 | | 81 | | - | | (14) | | - | | - | | 47 | | 14 | | 47 | Segment income before income taxes | $ | 2,050 | $ | (47) | $ | 974 | $ | 156 | $ | 17 | $ | (412) | $ | 47 | $ | 2,785 | $ | 1,116 | $ | (218) | $ | 482 | $ | (101) | $ | (196) | $ | 218 | $ | 1,301 |
1317
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts For the three months ended June 30, 2004 | | | | | | | | | | | | | | | | | | | | | | | | | | | Consolidation | | Cingular | | Consolidated | | | Wireline | | Cingular | | Directory | | International | | Other | | and Elimination | | Elimination | | Results | Revenues from external customers | $ | 9,220 | $ | 4,187 | $ | 913 | $ | 6 | $ | 57 | $ | - | $ | (4,187) | $ | 10,196 | Intersegment revenues | | 7 | | - | | 20 | | - | | - | | (27) | | - | | - | Total segment operating revenues | | 9,227 | | 4,187 | | 933 | | 6 | | 57 | | (27) | | (4,187) | | 10,196 | Operations and support expenses | | 6,409 | | 2,951 | | 420 | | 6 | | 60 | | (27) | | (2,951) | | 6,868 | Depreciation and amortization expenses | | 1,863 | | 565 | | 2 | | - | | 23 | | - | | (565) | | 1,888 | Total segment operating expenses | | 8,272 | | 3,516 | | 422 | | 6 | | 83 | | (27) | | (3,516) | | 8,756 | Segment operating income | | 955 | | 671 | | 511 | | - | | (26) | | - | | (671) | | 1,440 | Interest expense | | - | | 199 | | - | | - | | - | | 235 | | (199) | | 235 | Interest income | | - | | - | | - | | - | | - | | 120 | | - | | 120 | Equity in net income (loss) of affiliates | | - | | (95) | | - | | 149 | | 220 | | - | | 95 | | 369 | Other income (expense) – net | | - | | (40) | | - | | - | | - | | (44) | | 40 | | (44) | Segment income before income taxes | $ | 955 | $ | 337 | $ | 511 | $ | 149 | $ | 194 | $ | (159) | $ | (337) | $ | 1,650 |
For the six months ended June 30, 2004 | | | | | | | | | | | | | | | | | | | | | | | | | | | Consolidation | | Cingular | | Consolidated | | | Wireline | | Cingular | | Directory | | International | | Other | | and Elimination | | Elimination | | Results | Revenues from external customers | $ | 18,252 | $ | 8,154 | $ | 1,828 | $ | 11 | $ | 117 | $ | - | $ | (8,154) | $ | 20,208 | Intersegment revenues | | 15 | | - | | 43 | | - | | - | | (58) | | - | | - | Total segment operating revenues | | 18,267 | | 8,154 | | 1,871 | | 11 | | 117 | | (58) | | (8,154) | | 20,208 | Operations and support expenses | | 12,613 | | 5,815 | | 830 | | 18 | | 38 | | (58) | | (5,815) | | 13,441 | Depreciation and amortization expenses | | 3,761 | | 1,118 | | 5 | | - | | 45 | | - | | (1,118) | | 3,811 | Total segment operating expenses | | 16,374 | | 6,933 | | 835 | | 18 | | 83 | | (58) | | (6,933) | | 17,252 | Segment operating income | | 1,893 | | 1,221 | | 1,036 | | (7) | | 34 | | - | | (1,221) | | 2,956 | Interest expense | | - | | 397 | | - | | - | | - | | 467 | | (397) | | 467 | Interest income | | - | | 2 | | - | | - | | - | | 236 | | (2) | | 236 | Equity in net income (loss) of affiliates | | - | | (203) | | - | | 601 | | 360 | | - | | 203 | | 961 | Other income (expense) – net | | - | | (65) | | - | | - | | - | | 817 | | 65 | | 817 | Segment income before income taxes | $ | 1,893 | $ | 558 | $ | 1,036 | $ | 594 | $ | 394 | $ | 586 | $ | (558) | $ | 4,503 |
14
SBC COMMUNICATIONS INC.
JUNE 30, 2005
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued
Dollars in millions except per share amounts
NOTE 5.6. TRANSACTIONS WITH CINGULAR We and BellSouth, the two owners of Cingular, have each made a subordinated loan to Cingular (shareholder loans). Our shareholder loan to Cingular totaled approximately $5,675$4,108 at June 30, 2005March 31, 2006 and $5,855 at December 31, 2004, reflecting a repayment under the revolving credit agreement discussed below.2005. This loan bears interest at an annual rate of 6.0% and matures in June 2008. We earned interest income on this loan of $61 in the first quarter of 2006 and $87 in the secondfirst quarter and $174 for the first six months of 2005 and $88 in the second quarter and $176 for the first six months of 2004.2005. Effective August 1, 2004, weWe and BellSouth agreed to finance Cingular’s capital and operating cash requirements to the extent Cingular requires funding above the level provided by operations. We and BellSouth also entered into a one-year revolving credit agreement with Cingular to provide short-term financing for operations on a pro rata basis at an interest rate of LIBOR (London Interbank OfferOffered Rate) plus 0.05%, which may be renewed annually upon agreement of the parties.expires July 31, 2007. This agreement includes a provision for the repayment of our and BellSouth’s shareholder loans made to Cingular in the event there are no outstanding amounts due under the revolving credit agreement and to the extent Cingular has excess cash, as defined by the agreement. Effective June 28, 2005, this agreement was amended to extend the termination date of the agreement to July 31, 2007. All other terms of the agreement remain substantially identical.
UnderIn the first quarter of 2006, our net advances to Cingular totaled $699 under the revolving credit agreement we received net repayments from Cingular totaling $586 in the second quarter and $1,182 for the first six months of 2005. Under the terms of the agreement, these amounts were applied first to reduce the outstanding amount of advances (totaling approximately $406) previously made to Cingular under the agreement. After applying the net repayments, ourOur share of advances to Cingular under the revolving credit agreement was $0 at June 30, 2005 and approximately $1,002 at December 31, 2004 and is reflected in “Investments in and Advances to Cingular Wireless” on our Consolidated Balance Sheet. Under the terms of the agreement, the remaining approximately $180 was applied to reduce the balance of our shareholder loan to Cingular.
In May 2005, we transferred wireless properties to Cingular to settle a liability related to the formation of Cingular. This transfer resulted in a decrease of approximately $35 to our “Investment in Cingular” account.Sheets and totaled $1,006 at March 31, 2006 and $307 at December 31, 2005.
We generated revenues of $205$382 in the secondfirst quarter of 2006 and $387 for$182 in the first six monthsquarter of 2005 and $137 in the second quarter and $285 for the first six months of 2004 for services sold to Cingular. These revenues were primarily from access and long-distance services sold to Cingular on a wholesale basis, and commissions revenue related to customers added through SBCAT&T sales sources. The offsetting expense amounts are recorded by Cingular, and 60% of these expenses are included in our “Equity in net income of affiliates” line inon our Consolidated Statements of Income when we report our 60% proportionate share of Cingular’s results. 15
SBC COMMUNICATIONS INC.
JUNE 30, 2005
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued
Dollars in millions except per share amounts
NOTE 6.7. PENSION AND POSTRETIREMENT BENEFITS Substantially all of our employees are covered by one of various noncontributory pension and death benefit plans. We also provide certain medical, dental and life insurance benefits to substantially all retired employees under various plans and accrue actuarially determined postretirement benefit costs as active employees earn these benefits. Our objective in funding these plans, in combination with the standards of the Employee Retirement Income Security Act of 1974, as amended (ERISA), is to accumulate assets sufficient to meet the plans’ obligations to provide benefits to employees upon their retirement. No significant cash contributions are required under ERISA regulations during 2005.2006. 18 AT&T INC. MARCH 31, 2006 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts The following details pension and postretirement benefit costs included in operating expenses (in cost of sales and selling, general and administrative expenses) in the accompanying Consolidated Statements of Income. We account for these costs in accordance with Statement of Financial Accounting Standards No. 87, “Employers’ Accounting for Pensions” and Statement of Financial Accounting Standards No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” In the following table, gains are denoted with parentheses and losses are not. | Three months ended | | Six months ended | Three months ended | | | June 30, | | June 30, | March 31, | | | 2005 | 2004 | | | 2005 | 2004 | 2006 | 2005 | | Pension cost: | | | | | | | | | | | | | | | Service cost – benefits earned during the period | $ | 196 | $ | 205 | | $ | 392 | $ | 412 | $ | 260 | $ | 196 | | Interest cost on projected benefit obligation | | 404 | | 409 | | | 807 | | 821 | | 628 | | 403 | | Expected return on assets | | (636) | | (666) | | | (1,272) | | (1,340) | | (991) | | (636) | | Amortization of prior service cost and transition asset | | 46 | | 48 | | | 93 | | 95 | | 37 | | 47 | | Recognized actuarial loss | | 40 | | 10 | | | 79 | | 22 | | 93 | | 39 | | Net pension cost | $ | 50 | $ | 6 | | $ | 99 | $ | 10 | $ | 27 | $ | 49 | | | | | | | | | | | | | | Postretirement benefit cost: | | | | | | | | | | | | Service cost – benefits earned during the period | $ | 96 | $ | 97 | | $ | 195 | $ | 188 | $ | 109 | $ | 99 | | Interest cost on accumulated postretirement | | | | | | | | | | | | | | | benefit obligation | | 355 | | 378 | | | 722 | | 738 | | 494 | | 367 | | Expected return on assets | | (189) | | (186) | | | (378) | | (379) | | (234) | | (189) | | Amortization of prior service benefit | | (84) | | (79) | | | (164) | | (188) | | (90) | | (80) | | Recognized actuarial loss | | 105 | | 117 | | | 219 | | 236 | | 126 | | 114 | | Postretirement benefit cost | $ | 283 | $ | 327 | | $ | 594 | $ | 595 | $ | 405 | $ | 311 | | | | | | | | | | | | | | | Combined net pension and postretirement cost | $ | 333 | $ | 333 | | $ | 693 | $ | 605 | $ | 432 | $ | 360 | |
Our combined net pension and postretirement cost did not changeincreased $72 in the second quarter and increased approximately $88 for the first six months of 2005. In January 2004, the majority of nonmanagement retirees were informed of medical coverage changes. Concurrent with our second-quarter 2004 bargaining agreement with the Communications Workers of America, we also modified our nonmanagement retiree benefits. Because this modification of nonmanagement retiree medical coverage changes occurred in the second quarter of 2004 it only affected our first-quarter 2005 results on a comparative basis. Our combined2006. Net pension and postretirement costs in 2006 reflect the November 2005 acquisition of ATTC, changes in our actuarial assumptions, which included the reduction of our discount rate from 6.00% to 5.75% (an increase to expense) and net losses on plan assets in prior years. In accordance with GAAP, we recognize actual gains and losses on pension and postretirement plan assets equally over a period of not more than five years. As part of our acquisition of ATTC, we acquired certain non-U.S. operations. Net pension cost increased approximately $50 due to this contract modification for non-U.S. plans was $8 in the first six monthsquarter of 2006. Net supplemental retirement pension benefits cost were $38 in the first quarter of 2006 and $27 in the first quarter of 2005, when compared to the first six months of 2004.which $26 and $17 was interest cost, respectively. 1619
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts During the second quarter of 2005 we made minor changes to our management medical coverage and now expect a combined net pension and postretirement cost of between $1,350 and $1,450 in 2005.
Included in “Postemployment benefit obligation” on our Consolidated Balance Sheets at December 31, 2004 was a phone concession for out-of region employees. The out-of-region phone concession, which is not part of the pension plan and not subject to ERISA, allowed for out-of-region retirees to receive reimbursements for phone services provided by a carrier other than SBC. During the second quarter of 2005 we notified certain out-of-region retirees of changes which allowed us to reduce this obligation by approximately $37 at June 30, 2005. We are in the process of notifying the remaining out-of-region retirees and will record an additional reduction of approximately $60 in the third quarter of 2005.
NOTE 7. DISCONTINUED OPERATIONS
In July 2004, we entered into an agreement to sell our interest in the directory advertising business in Illinois and northwest Indiana to Donnelley. In September 2004, we completed the sale and received net proceeds of approximately $1,397 and recorded a gain of approximately $1,357 ($827 net of tax).
In accordance with Statement of Financial Accounting Standards No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets,” we have reclassified the results from our directory advertising business in Illinois and northwest Indiana as discontinued operations, restating previously reported results to reflect the reclassification on a comparable basis. The operational results are presented in the “Income From Discontinued Operations, net of tax” line item on the Consolidated Statements of Income. Prior to the reclassification, these results were reported in our directory segment.
Summarized financial information for the Illinois and northwest Indiana directory advertising business is as follows:
| | Three months ended June 30, | | | Six months ended June 30, | | | 2005 | | 2004 | | | 2005 | | 2004 | | | | | | | | | | | Operating revenues | $ | - | $ | 117 | | $ | - | $ | 233 | Operating income | | - | | 54 | | | - | | 97 | Income taxes | | - | | 21 | | | - | | 38 | Net income from operations | | - | | 33 | | | - | | 59 |
At June 30, 2005 and December 31, 2004, the assets of the discontinued operations were $0. The liabilities of the discontinued operations were $0 at June 30, 2005 and $310 at December 31, 2004 and are presented separately under the caption “Liabilities of discontinued operations” on our Consolidated Balance Sheets. At December 31, 2004, the liabilities of $310 were primarily tax liabilities associated with the gain on the disposition. These liabilities were all paid in 2005, as reflected on the Consolidated Statements of Cash Flows.
17
SBC COMMUNICATIONS INC.
JUNE 30, 2005
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued
Dollars in millions except per share amounts
NOTE 8. PENDING ACQUISITION OF AT&TBELLSOUTH On January 30, 2005,March 4, 2006, we agreed to acquire AT&T Corp. (AT&T)BellSouth in a transaction in which each share of AT&TBellSouth common stock will be exchanged for 0.779421.325 shares of a share of SBCAT&T common stock. In addition, immediately prior to the closing of the transaction, AT&T will pay each AT&T shareholder a special dividend of $1.30 per share. Based on the average closing price of SBC stock on January 28, 2005,AT&T shares for the exchange ratio equals $18.41 per sharetwo days prior to, including, and two days subsequent to the public announcement of the merger (March 5, 2006) of $27.32, the total transaction is valued, for purchase accounting purposes, at approximately $16,000, including$65,000. We and BellSouth jointly own Cingular and the special dividend.internet directory publisher YPC. In the Cingular joint venture, we hold a 60 percent economic interest and BellSouth holds a 40 percent interest and in the YPC joint venture we hold a 66 percent economic interest and BellSouth holds a 34 percent interest. For each joint venture control is shared equally (i.e., 50/50). We and BellSouth each account for the joint ventures under the equity method of accounting, recording the proportional share of Cingular’s and YPC’s income as equity in net income of affiliates on the respective consolidated statements of income and reporting the ownership percentage of Cingular’s net assets as “Investments in and Advances to Cingular Wireless” and the ownership percentage of YPC’s net assets as “Investments in Equity Affiliates” on the respective consolidated balance sheets. After the BellSouth acquisition, AT&TBellSouth, Cingular and YPC will be a wholly owned subsidiarywholly-owned subsidiaries of SBC. AT&T. The transaction has been approved by the Board of Directors of each company and wasalso must be approved by the shareholdersstockholders of AT&T on June 30, 2005.and BellSouth. The transaction also is subject to review by the U.S. Department of Justice and approval by the Federal Communications Commission and various other regulatory authorities. We currently expect the transaction to close in late 2005.by the end of 2006. Note 9. SUBSEQUENT EVENT
In July 2005, we redeemed approximately $809 of callable debt and recorded call premiums, and expensed unamortized discounts and debt issuance costs of $37 in the third quarter.
1820
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in Millionsmillions except per share amounts RESULTS OF OPERATIONS Throughout this document, SBC CommunicationsFor ease of reading, AT&T Inc. is referred to as “we”“we,” “AT&T,” or “SBC.” A reference tothe “Company” throughout this document and the names of the particular subsidiaries and affiliates providing the services have been omitted. AT&T is a “Note”holding company; AT&T does not provide communications services, rather, its subsidiaries and affiliates operate in this section refers to the accompanying Notes to Consolidated Financial Statements.communications services industry both domestically and internationally providing wireline and wireless telecommunications services and equipment as well as directory advertising and publishing services. You should read this discussion in conjunction with the consolidated financial statements, accompanying notes and management’s discussion and analysis of financial condition and results of operations included in our Annual Report on Form 10-K for the year ended December 31, 2004.2005. In ourthe tables throughout this section, percentage increases and decreases that equal or exceed 100% are not considered meaningful and are denoted with a dash.
Consolidated ResultsWe completed our acquisition of AT&T Corp. (ATTC) on November 18, 2005. Consolidated results for the three month period ended March 31, 2006 include results from ATTC. In accordance with U.S. generally accepted accounting principles (GAAP), operating results for ATTC prior to our acquisition, including for the three months ended March 31, 2005, are not included in our operating results and are therefore not discussed. Our financial results in the secondfirst quarter of 2006 and for the first six months of 2005 and 2004 are summarized as follows:
| Second Quarter | Six-Month Period |
| | | First Quarter | | | | | | 2005 | | | 2004 | | | Chan | ge | | 2005 | | | 2004 | | | Chan | ge | | Percent |
|
| | 2006 | | 2005 | | Change | | Operating revenues | | $ | 10,328 | | $ | 10,196 | | | 1.3 | % | $ | 20,576 | | $ | 20,208 | | | 1.8 | % | $ | 15,835 | $ | 10,248 | | 54.5% | | Operating expenses | | | 8,810 | | | 8,756 | | | 0.6 | | | 17,502 | | | 17,252 | | | 1.4 | | | 13,644 | | 8,692 | | 57.0 | | Operating income | | | 1,518 | | | 1,440 | | | 5.4 | | | 3,074 | | | 2,956 | | | 4.0 | | | 2,191 | | 1,556 | | 40.8 | | Income before income taxes | | | 1,484 | | | 1,650 | | | (10.1 | ) | | 2,785 | | | 4,503 | | | (38.2 | ) | | 2,157 | | 1,301 | | 65.8 | | Income from continuing operations | | | 1,000 | | | 1,135 | | | (11.9 | ) | | 1,885 | | | 3,046 | | | (38.1 | ) | | | Income from discontinued | | | | operations, net of tax | | | - | | | 33 | | | - | | | - | | | 59 | | | - | | |
| | | Net Income | | | 1,000 | | | 1,168 | | | (14.4 | ) | | 1,885 | | | 3,105 | | | (39.3 | ) | |
| | Net income | | | 1,445 | | 885 | | 63.3 |
Overview Operating incomeAs noted above, our first quarter 2006 revenues and expenses reflect the addition of ATTC’s results while our first quarter 2005 results do not include ATTC. Accordingly, the following discussion of changes in our revenues and expenses will be significantly affected by the ATTC acquisition. Our operating income increased $78,$635, or 5.4%40.8%, in the secondfirst quarter and $118, or 4.0%, for the first six months of 20052006 and our operating income margin decreased from 15.2% to 13.8%. The decline in operating income margin reflects additional expense associated with merger and integration costs and additional amortization expense on those intangibles identified at the time of our acquisition of ATTC, as well as the lower margins of the products of the acquired business. Operating income increased from 14.1%primarily due to 14.7% in the second quarter and from 14.6% to 14.9% for the first six months. The increases in the quarter and the six-month period were driven by further growth in data and long-distance voice revenues, reflecting our continued emphasis on our bundling strategy and the additionwhich accounted for approximately 28% of new business customers. These increases were partially offset by a decline in our voice revenue as we continue to experience increasing competition. The decline in voice revenue also reflects decreasing wholesale revenues from lines provided under Unbundled Network Element-Platform (UNE-P) rules, reflecting developments in the federal regulatory environment over the past year. During the 12-month transition period for the elimination of the UNE-P requirements (which ends in March 2006), we expect continued decreases in the number of UNE-P lines as competitors move to alternate arrangements to serve their customers or their customers choose an alternative technology. We could experience increased pressure on our operating revenues should a customer that was receiving service from a UNE-P provider switch to an alternative technology or facilities-based competitor (a competitor with its own network). For a detailed discussion on UNE-P, see “December 2004 Unbundling Rules” in the Regulatory Developments sectionfirst quarter of our Annual Report2006 and 23% for the yearquarter ended DecemberMarch 31, 2004.2005, slightly offset by the negative effects of a continued decline in access lines.
Retail access lines continued to decline in the second quarter and for the first six months of 2005 due to increased competition, as customers disconnected both primary and additional lines and began using 19
SBC COMMUNICATIONS INC.
JUNE 30, 2005
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Dollars in Millions except per share amounts
RESULTS OF OPERATIONS - Continued
wireless and to a lesser extent, Voice over Internet Protocol (VoIP) technology offered by competitors and cable instead of phone lines for voice and data; thisdata. This was also a contributing factor in the year-ago period. Retail access lines also declined for both periods due to customers disconnecting their additional 21 AT&T INC. MARCH 31, 2006 Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in millions except per share amounts RESULTS OF OPERATIONS - Continued lines when purchasing our broadband internet-access (DSL) services. While we lose some revenue when a wireline customer shifts from one of our retail primary lines to a competitor that relies on a resale agreement or the UNE-P rules to offer service (i.e., one of our wholesale customers),product, we lose all revenue when a wireline customer shifts to a competitor using an alternative technology such as cable, wireless or VoIP or a facilities-based competitor. However, when a customer signs up for Cingular Wireless (Cingular) service, our net income impact of the lost revenue is lessened because wetheir own a 60% economic interest in Cingular (see Note 5).network facilities. Increasing use ofshifts to competitors’ alternative technologies and facilities-based competition will continue to pressure our operating margins. Although retail access line losses have continued, the trend has slowed,stabilized, reflecting in part our ability to now offer retail nationwide long-distance service in all of our regions as well as the introduction of offerings combining multiple services for one fixed price (bundles). The decline in access lines and the corresponding voice revenue also reflects decreasing wholesale revenues from lines provided under the former Unbundled Network Element-Platform (UNE-P) rules (which ended in March 2006), as competitors moved to alternate arrangements to serve their customers or their customers chose an alternative technology. Competitors representing a majority of our former UNE-P lines have signed commercial agreements with us and therefore remain as our wholesale customers. However, for the remaining UNE-P lines, we believe, based on marketing research, that customers primarily switched to competitors using alternative technologies or their own networks as opposed to returning as our retail customers. Operating revenues Our operating revenues increased $132,$5,587, or 1.3%54.5%, in the secondfirst quarter of 2006 primarily due to our acquisition of ATTC. The increase also reflects growth in data slightly offset by continued pressure in voice, reflecting access line decreases in our traditional SBC 13-state region (“in-region”) and $368, or 1.8%,decreased demand for vertical services and wholesale services including UNE-P lines. At March 31, 2006, we had 7.4 million DSL lines in service, an increase of 1.8 million lines from the first six monthsyear-ago period and 511,000 lines from December 31, 2005; and had 48.8 million in-region access lines, a decrease of 3.1 million lines from the year-ago period and 645,000 from December 31, 2005. Our significantOperating revenue impactschanges are listed below and discussed in greater detail in our “Wireline Segment“Segment Results” section.sections. •
| Data revenues increased $270 in the second quarter and $447 for the first six months, primarily driven by continued growth in DSL.
| •
| Long-distance voice revenues increased $107 in the second quarter and $259 for the first six months, primarily driven by increased bundled sales of combined long-distance and local calling fixed-fee offerings.
|
These increases in data and long-distance voice revenues were partially offset by declines of $231 in the second quarter and $358 for the first six months in voice revenues primarily resulting from the loss of retail access lines and lower prices due to increased competition.
Operating expenses Our operating expenses increased $54,$4,952, or 0.6%57.0%, in the secondfirst quarter of 2006 primarily due to our acquisition of ATTC, and $250, or 1.4%, foralso included merger integration costs of $266 and amortization expense on intangible assets of $266. Our first quarter 2006 expenses also include decreases related to workforce reductions, reflecting a decline of 3,390 employees from December 31, 2005. As of March 31, 2006 we were ahead of our scheduled workforce reductions associated with the first six months of 2005.ATTC acquisition. Our significant expense increaseschanges are listed below and discussed in greater detail in our “Wireline Segment“Segment Results” section.sections. •
| A charge of $236 in the second quarter of 2005 to terminate existing agreements with WilTel Communications (WilTel). See “Other Business Matters” for a discussion of the termination charge and the new agreement.
| •
| Costs associated with equipment sales and related network integration services reflecting sales in the large-business market, and our co-branded SBC | DISH Network satellite TV service, which had more total customers than in the prior year, increased expenses approximately $129 in the second quarter and $227 for the first six months.
| •
| Costs associated with the severe rains and floods in Southern California, increased expenses approximately $100 for the first six months.
| •
| Combined net pension and postretirement cost increased expenses approximately $88 for the first six months.
|
20Interest expense increased $111, or 31.4%, in the first quarter of 2006. The increase in 2006 was primarily due to interest expense on ATTC’s outstanding debt. We expect continued increases in interest expense during 2006 as a result of including ATTC’s outstanding debt in our consolidated financial statements.
22 SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in Millionsmillions except per share amounts RESULTS OF OPERATIONS - Continued Partially offsetting these increases was the fact that we recorded second-quarter 2004 charges of approximately $263 associated with strike preparation and labor settlements, lower depreciation expense of $81 in the second quarter and $181 for the first six months of 2005 in our wireline segment and a decrease of $37 associated with changes in out-of-region phone concessions. Out-of-region phone concessions consist of reimbursements made to retirees for phone services provided by a carrier other than SBC.
Our operating expenses for the remaining periods in 2005 will reflect second-quarter 2005 changes made to our management medical coverage, reducing our annual combined net pension and postretirement cost to between $1,350 and $1,450. Operating expenses in the third quarter will also reflect decreased expenses of approximately $60 associated with the previously discussed changes in out-of-region phone concessions for retirees. (See Note 6)
Interest expenseincome increased $114,decreased $24, or 48.5%22%, in the secondfirst quarter and $235, or 50.3%, for the first six months of 2005.2006. The increase isdecrease in interest income was primarily due to the pay-down by Cingular of our issuing additional debt of $8,750 in the fourth quarter of 2004shareholder loan to finance our portion of Cingular’s acquisition of AT&T Wireless Services Inc. (AT&T Wireless). In July 2005, we redeemed approximately $809 of callable debt and recorded call premiums, and expensed unamortized discounts and debt issuance costs of $37 in the third quarter. Interest income decreased $20, or 16.7%, in the second quarter and $27, or 11.4%, for the first six months of 2005. Thethem; this decrease was primarily a resultpartially offset by our benefiting from the reduced interest expense at Cingular due to our 60% ownership in Cingular, which is reflected in equity in net income of a lower average investment balance in 2005 compared with 2004. In the fourth quarter of 2004 we used a significant amount of these investments to fund our portion of Cingular’s purchase price for AT&T Wireless.affiliates.
Equity in net income of affiliates decreased $188, or 50.9%,increased $392 in the secondfirst quarter and $838, or 87.2%, for the first six months of 2005. Results from our international investments declined approximately $61 in the second quarter and $439 for the first six months.2006. The international declineincrease was largely attributable to both gains that occurred in 2004 and foregone equity income in 2005primarily due to an increase of approximately $357 in our 2004 investment dispositions. The 2005 decrease was also due to lower results from Cingular. Our proportionate share of Cingular’s results decreased approximately $123and an increase of $51 in the second quarter and $403 for the first six months of 2005.results from our international holdings. We account for our 60% economic interest in Cingular under the equity method of accounting and therefore include our proportionate share of Cingular’s results in our “Equity in net income (loss) of affiliates” line item inon our Consolidated Statements of Income. Cingular’s operating results are discussed in detail in the “Cingular Segment Results” section and results from our international holdings are discussed in detail in “International Segment Results.”section. Our accounting for Cingular is described in more detail in Note 4.5. The increase from international holdings in the first quarter was largely attributable to an increase in results from Teléfonos de México, S.A. de C.V. (Telmex) and América Móvil S.A. de C.V. (América Móvil). Our international equity holdings are discussed in detail in our “Other Segment Results” section. Other income (expense) – net We had other income of $34$11 in the secondfirst quarter of 2006 and $81 for$47 in the first six monthsquarter of 2005 as compared to other expense of $442005. Results in the second quarter and other income of $817 for the first six months of 2004. Results for the second quarter of 2005 primarily consisted of gains related to the transfer of wireless properties to Cingular of approximately $24 (see Note 5) and a gain of $9 on the sale of shares of Yahoo! (Yahoo). Results for the second quarter of 2004 included losses of approximately $191 on the sale of shares of TDC and $68 on the sale of shares of Telkom S.A. Limited (Telkom), partially offset by gains of $219 on the sale of shares of Amdocs Limited (Amdocs) and Yahoo.SpectraSite, Inc. (SpectraSite), partially offset by a charge of $21 related to the other-than-temporary decline in the value of various cost investments. 21Income taxesincreased $296, or 71.2%, in the first quarter of 2006. The increase was due to higher income before income taxes in 2006, which was primarily the result of increased operating income and an increase in equity in net income of affiliates (see previous discussion). Our effective tax rate was 33.0% in the first quarter of 2006 and 32.0% in the same period in 2005.
Selected Financial and Operating Data | | March 31, | | | 2006 | | 2005 | Debt ratio1 | | 36.4% | | 40.2% | In-region network access lines in service (000)2 | | 48,768 | | 51,868 | In-region wholesale lines (000)2 | | 4,667 | | 6,503 | DSL lines in service (000) | | 7,432 | | 5,608 | Number of AT&T employees3 | | 186,560 | | 160,880 | Cingular Wireless customers (000)4 | | 55,810 | | 50,350 |
| 1 | See our “Liquidity and Capital Resources” section for discussion. |
| 2 | In-region represents access lines served by AT&T’s incumbent local exchange companies (ILECs). |
| 3 | Number of employees at December 31, 2005 was 189,950. |
| 4 | Amounts represent 100% of the cellular/PCS customers of Cingular. |
23 SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in Millionsmillions except per share amounts RESULTS OF OPERATIONS - Continued Other income for the first six months of 2005 primarily included a gain of $77 on the sale of shares of Amdocs, SpectraSite, Inc. and Yahoo and the gain of $24 mentioned above, from the transfer of wireless properties to Cingular. These gains were partially offset by a charge of $21 related to the other-than-temporary decline in the value of various cost investments. Results for the first six months of 2004 primarily include a gain of approximately $832 on the sale of our investment in Belgacom S.A. (Belgacom), a gain of $57 on the sale of shares of Teléfonos de Mexico, S.A. de C.V. (Telmex) and América Móvil S.A. de C.V. (América Móvil) and gains of $219 mentioned above, on the sale of Amdocs and Yahoo. These 2004 gains were partially offset by losses of $259 mentioned above, on the sales of shares of TDC and Telkom.
Income taxes decreased $31, or 6.0%, in the second quarter and $557, or 38.2%, for the first six months of 2005. Our effective tax rates on continuing operations were 32.6% in the second quarter of 2005 compared to 31.2% in the second quarter of 2004 and 32.3% for the first six months of 2005 compared to 32.4% for the first six months of 2004. The decrease in income taxes in the second quarter and for the first six months of 2005 was primarily due to a decrease in income before income taxes, which was primarily the result of a decrease in “Equity in net income of affiliates” (see previous discussion) and a gain on the sale in the first quarter of 2004 of our interest in Belgacom.
Income from Discontinued Operations decreased $33 in the second quarter and $59 for the first six months of 2005. The decrease was due to the sale of our directory advertising business in Illinois and northwest Indiana in 2004. (See Note 7)
Selected Financial And Operating Data
| | June 30, | | | 2005 | | 2004 | Debt ratio1 | | 38.3% | | 31.0% | Network access lines in service (000) | | 51,032 | | 53,590 | Wholesale lines (000) | | 5,977 | | 7,363 | Long-distance lines in service (000) | | 22,776 | | 18,432 | DSL lines in service (000) | | 5,968 | | 4,277 | Number of SBC employees | | 157,610 | | 167,170 | Cingular Wireless customers2 (000) | | 51,596 | | 25,044 | | | | | | | | | | | | |
1 | See our “Liquidity and Capital Resources” section for discussion. |
2 | Numbers represent 100% of the cellular/PCS customers of Cingular (the 2004 number does not include AT&T Wireless customers prior to Cingular’s October 2004 acquisition of AT&T Wireless). |
22
SBC COMMUNICATIONS INC.
JUNE 30, 2005
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Dollars in Millions except per share amounts
RESULTS OF OPERATIONS - Continued
Segment Results Our segments represent strategic business units that offer different products and services and are managed accordingly. As required by U.S. generally accepted accounting principles (GAAP), ourOur operating segment results presented in Note 45 and discussed below for each segment follow our internal management reporting. Under GAAP segment reporting rules, weWe analyze our various operating segments based on segment income. Interest expense, interest income and other income (expense) – net, and tax expense are managed only on a total company basis and are, accordingly, reflected only in consolidated results. Therefore, these items are not included in the calculation of each segment’s percentage of our total segment income. As a result of our November 18, 2005 acquisition of ATTC, we have revised our segment reporting to represent how we now manage our business, restating prior periods to conform to the current segments. We have fivefour reportable segments that reflect the current management of our business: (1) wireline; (2) Cingular; (3) directory; (4) international; and (5)(4) other. The wireline segment provides both retail and wholesale landline telecommunications services, including local and long-distance voice, switched access, data and messaging services, managed networking to business customers and satellite television services through our agreement with EchoStar Communications Corp (“SBCCorp.
(“AT&T | DISH Network” offering). In discussing regional trends in this segment, the “Midwest” refers to Illinois, Indiana, Michigan, Ohio and Wisconsin; the “Southwest” refers to Arkansas, Kansas, Missouri, Oklahoma and Texas; the “West” refers to California and Nevada; and the “East” refers to Connecticut (all combined, “13-state area”). The Cingular segment reflects 100% of the results reported by Cingular, our wireless joint venture. In our consolidated financial statements, we report our 60% proportionate share of Cingular’s results as equity in net income of affiliates. Cingular’s results in the second quarter and for the first six months of 2004 have been restated to reflect the correction of an error relating to the lease accounting practices of Cingular, which was announced in February 2005, and to conform the presentation of various state gross receipts taxes and other fees to the current year. The directory segment includes all directory operations, including Yellow and White Pages advertising and electronic publishing. Results for this segment are shown under the amortization method which means that revenues and direct expenses are recognized ratably over the life of the directory, typically 12 months. Results for all periods presented in this segment have been restated to reflect the sale of our interest in the directory advertising business in Illinois and northwest Indiana to R.H. Donnelley (see Note 7). In November 2004, a subsidiary in our directory segment entered into a joint venture agreement with BellSouth Corporation (BellSouth) and purchased the online directory provider YellowPages.com (YPC). Our portion of the results from YPCYELLOWPAGES.COM (YPC) is recorded in this segment as equity in net income of affiliates. Our international segment includes all investments with primarily international operations. The other segment includes results from paging services,Sterling Commerce Inc. (Sterling) and all corporate and other operations as well asoperations. The other segment also includes our portion of the equity incomeresults from our investmentinternational equity investments and from Cingular as equity in Cingular.net income of affiliates, as discussed above. Although we analyze Cingular’s revenues and expenses under the Cingular segment, we record our portion of Cingular’s results as equity in net income of affiliates (from non-international investments) in the other segment.
23
SBC COMMUNICATIONS INC.
JUNE 30, 2005
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Dollars in Millions except per share amounts
RESULTS OF OPERATIONS - Continued
The following tables show components of results of operations by segment. A discussion of significant segment results is also presented following each table. Capital expenditures for each segment are discussed in “Liquidity and Capital Resources.” Wireline
Segment Results
| | Second Quarter | | | Six-Month Period | | | | | | | Percent | | | | | | | Percent | | | 2005 | | 2004 | | Change | | | 2005 | | 2004 | | Change | Segment operating revenues | | | | | | | | | | | | | | Voice | $ | 4,974 | $ | 5,205 | | (4.4)% | | $ | 10,060 | $ | 10,418 | | (3.4)% | Data | | 2,997 | | 2,727 | | 9.9 | | | 5,821 | | 5,374 | | 8.3 | Long-distance voice | | 922 | | 815 | | 13.1 | | | 1,823 | | 1,564 | | 16.6 | Other | | 484 | | 480 | | 0.8 | | | 962 | | 911 | | 5.6 | Total Segment Operating Revenues | | 9,377 | | 9,227 | | 1.6 | | | 18,666 | | 18,267 | | 2.2 | Segment operating expenses | | | | | | | | | | | | | | Cost of sales | | 4,138 | | 4,091 | | 1.1 | | | 8,320 | | 8,112 | | 2.6 | Selling, general and administrative | | 2,433 | | 2,318 | | 5.0 | | | 4,716 | | 4,501 | | 4.8 | Depreciation and amortization | | 1,782 | | 1,863 | | (4.3) | | | 3,580 | | 3,761 | | (4.8) | Total Segment Operating Expenses | | 8,353 | | 8,272 | | 1.0 | | | 16,616 | | 16,374 | | 1.5 | Segment Income | $ | 1,024 | $ | 955 | | 7.2% | | $ | 2,050 | $ | 1,893 | | 8.3% |
Our wireline segment operating income margin was 10.9% in the second quarter of 2005, compared to 10.4% in the second quarter of 2004, and 11.0% for the first six months of 2005, compared to 10.4% for the first six months of 2004. The improvement in our wireline segment operating income margin for the quarter and the first six months was due primarily to the continued growth in our data and long-distance voice revenue, which more than offset the loss of voice revenue from the decline in total access lines (as shown in the following table) from 2004 to 2005 of approximately 2.6 million lines, or 4.8%.
Voice revenue declined due to customers continuing to disconnect primary and additional lines and using alternative technologies, such as wireless, and to a lesser extent VoIP and cable instead of phone lines for voice and data; our bundling strategy and other pricing responses to competitors’ offerings; and lower demand for services. Voice revenue also has declined over the past several years as our retail customers have disconnected their lines in order to obtain service from competitors who lease our UNE-P lines. However, that particular trend started to change in the third quarter of 2004 and for this quarter UNE-P lines declined by 1.5 million, or 21.9%, from June 30, 2004 levels (see table below). The impact of the UNE-P rules on our operating revenue is discussed below.
Our operating income margin was also pressured on the cost side for the second quarter due to a charge to terminate existing agreements with WilTel and by higher costs caused by our growth initiatives in long-
24 SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in Millionsmillions except per share amounts RESULTS OF OPERATIONS - Continued distanceWireline
Segment Results | First Quarter | | | | | | Percent | | 2006 | 2005 | | Change | Segment operating revenues | | | | | | | | Voice | $ | 8,722 | $ | 5,852 | | 49.0% | | Data | | 4,442 | | 2,391 | | 85.8 | | Other | | 1,575 | | 939 | | 67.7 | | Total Segment Operating Revenues | | 14,739 | | 9,182 | | 60.5 | | Segment operating expenses | | | | | | | | Cost of sales | | 6,856 | | 4,123 | | 66.3 | | Selling, general and administrative | | 3,701 | | 2,170 | | 70.6 | | Depreciation and amortization | | 2,430 | | 1,773 | | 37.1 | | Total Segment Operating Expenses | | 12,987 | | 8,066 | | 61.0 | | Segment Income | $ | 1,752 | $ | 1,116 | | 57.0% | |
Operating Margin Trends Our wireline segment operating income increased $636, or 57.0%, in the first quarter of 2006 reflecting incremental revenue and DSLexpenses from our acquisition of ATTC, while our operating income margin decreased from 12.2% in the first quarter of 2005 to 11.9% in the first quarter of 2006. Exclusive of the results attributable to the acquisition of ATTC, operating income increased primarily due to growth in data revenue. The decrease in operating income margin reflects additional expense associated with merger and integration costs and additional amortization expense on those intangibles identified at the time of our acquisition of ATTC. While voice revenue increased due to the acquisition of ATTC, in-region retail access lines continued to decline due to customers continuing to disconnect primary and additional lines and switching to competitors’ alternative technologies, such as wireless, and to a lesser extent VoIP and cable for voice and data. Retail access lines also declined for both periods due to customers disconnecting their additional lines when purchasing our broadband internet-access (DSL) services. While we lose some revenue when a wireline customer shifts from one of our retail primary lines to a competitor that relies on a resale or wholesale product, we lose all revenue when a wireline customer shifts to a competitor’s alternative technology such as cable, wireless or VoIP or a facilities-based competitor. Increasing use of competitor's alternative technologies and facilities-based competition will continue to pressure our operating margins. However, although retail access line losses have continued, the trend has slowed, reflecting in part our ability to offer retail nationwide long-distance service as well as our co-branded SBC | Dish Network satellite TV service and sales in the large-business market, andofferings combining multiple services for the first quarter, by higher repair costs caused by severe weather.one fixed price (bundles). Following is a summary of our switched access lines at June 30, 2005 and 2004:
Switched Access Lines | | | | | June 30, | | | | | Increase | (in 000’s) | 2005 | 2004 | (Decrease) | | | | | Retail Consumer | | | | Primary | 23,036 | 23,398 | (362) | Additional | 4,108 | 4,581 | (473) | Retail Consumer Subtotal | 27,144 | 27,979 | (835) | | | | | Retail Business | 17,513 | 17,794 | (281) | Retail Subtotal | 44,657 | 45,773 | (1,116) | Percent of total switched access lines | 87.5% | 85.4% | | | | | | UNE-P | 5,444 | 6,974 | (1,530) | Resale | 533 | 389 | 144 | Wholesale Subtotal | 5,977 | 7,363 | (1,386) | Percent of total switched access lines | 11.7% | 13.7% | | | | | | Payphone (Retail and Wholesale) | 398 | 454 | (56) | Percent of total switched access lines | 0.8% | 0.9% | | | | | | Total Switched Access Lines | 51,032 | 53,590 | (2,558) | | | | | DSL Lines in Service | 5,968 | 4,277 | 1,691 | | | | | |
Total switched access lines in service at June 30, 2005 declined 4.8% from June 30, 2004 levels. Retail access lines, while declining 2.4% from June 30, 2004 levels, represent 87.5% of total switched access lines at June 30, 2005 compared to 85.4% a year earlier. During this same period, wholesale lines (which include UNE-P, commercially negotiated UNE-P replacements and resale) decreased 18.8% and at June 30, 2005 represented 11.7% of total access lines, down from 13.7% a year earlier.
The decline in total access lines reflects many factors including the disconnection of additional lines as our existing customers purchase our DSL broadband services and for other reasons, the continued growth in
25 SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in Millionsmillions except per share amounts RESULTS OF OPERATIONS - Continued alternative communication technologies suchWireline Operating Results
All variances other than those specifically stated as wireless, cable and other internet-based systems and continuing slow demand from U.S. businesses although business demand is improving on a sequential quarterly basis. While we lose some revenue when a wireline customer shifts from onebeing due to the ATTC acquisition are related to the operations of our retail lines to a competitor that relies on the UNE-P rules or a resale agreement to offer service (i.e., one of our wholesale customers), we lose all customer revenue when a retail wireline customer shifts to an alternative technology such as cable, wireless or the internet using VoIP or a competitor using its own traditional network. The UNE-P rules are scheduled to end after a twelve-month transition period that began March 11, 2005. However, it is unclear whether customers of competitors using these UNE-P lines will be retained by our wholesale customers that have negotiated commercial arrangements to replace the UNE-P or that have resale agreements, or whether customers that had used UNE-P service will return as our retail customers, shift to using an alternative technology or to a competitor using its own network. Increasing customer shifts from our traditional retail base to either alternative technologies or competitors using commercial or resale arrangement or their own facilities, as well as our pricing responses to retain or regain retail customers, will continue to pressure our wireline segment’s operating margins.SBC. Voicerevenues decreased $231,increased $2,870, or 4.4%49.0%, in the secondfirst quarter and $358, or 3.4%, for the first six months of 20052006 primarily due to the lossacquisition of retail access lines. TheATTC. Included in voice revenues are revenues from long-distance, local voice and local wholesale services. Voice revenues do not include any of our VoIP revenues, which are included in data revenues. In the first quarter of 2006, revenue increased $2,852 in long-distance and $194 in local voice, partially offset by revenue declines of $176 in local wholesale. On a sequential basis, revenues in our traditional SBC regions increased in line with the fourth quarter of 2005 but were partially offset by a continuing decline in pro forma revenues from ATTC’s traditional mass-market customer category, which include revenues from the traditional ATTC standalone long-distance and bundled local services for consumers and small business. The increase in long-distance revenues were almost entirely driven by the increase in long-distance customers due to the acquisition of ATTC. Additionally, in-region retail lineslong-distance revenues increased $99 in the first quarter of 2006, reflecting our higher long-distance penetration levels. Sales of combined long-distance and local calling fixed-fee offerings (referred to as “bundling”) also contributed to the increased long-distance revenues and customers. Long-distance revenues continued to increase in our traditional SBC Midwest, West and Southwest regions. The increase in local voice revenues of $194 in the first quarter primarily reflects our acquisition of ATTC. Our local voice revenue growth will continue to be negatively impacted due to increased competition, including customers usingshifting to competitors’ wireless, VoIP technology and cable instead of phone linesofferings for voice, and data, and the disconnection of additional lines for DSL service and other reasons. Local voice revenues were negatively impacted by declines in customer demand, calling features, inside wire and retail payphone revenues. The access-line declinesdecline in customer demand decreased revenues approximately $98 in the second quarter and $208 for the first six months of 2005. Pricing responses to competitors’ offerings and regulatory changes reduced revenues approximately $50 in the second quarter and $61 for the first six months.$88. A decline in demand for calling features (e.g., Caller ID and voice mail), due primarily to the access-lineaccess line declines, decreased revenues approximately $25$47 in the secondfirst quarter of 2006. Lower demand for inside wire and $56 forretail payphone services decreased revenues approximately $38 in the first six monthsquarter of 2006. We expect payphone access lines and revenue to continue to decline in future periods. Voice revenue was also lower due to receiving a settlement of $32 from another carrier in the first quarter of 2005. We also expect mass-market consumer-based revenues acquired with ATTC to continue to decline on a sequential basis, but will positively contribute to results on a year-over-year basis. Partially offsetting these demand-related declines were revenue increases of $54 related to pricing increases for calling features in the first quarter of 2006. Lower demand for wholesale services, primarily due to the decline in UNE-P lines provided to competitors, decreased revenue approximately $13$176 in the secondfirst quarter and $22 forof 2006. Lines provided under the first six months of 2005. Continued declinesformer UNE-P rules (which ended in demand for voice equipment located on customer premises decreased revenues approximately $10 in the second quarter and $33 for the first six months. Revenue from payphone services decreased approximately $10 in the second quarter and $20 for the first six months, primarily dueMarch 2006) declined, as competitors moved to lower demand. We expect payphone access lines and revenuealternate arrangements to continue to decline in future periods. Revenue from ‘local plus’ plans (expanded local calling area) declined approximately $6 in the second quarter and $17 for the first six months, as moreserve their customers or their customers chose broader long-distancean alternative technology. Competitors representing a majority of our UNE-P lines have signed commercial agreements with us and other bundled offerings. Partially offsetting these revenue declines were increased revenues withtherefore remain our wholesale customers, including settlements and billing adjustments, of approximately $64 for the first six months of 2005, of which $32 related to a carrier settlement in March 2005. Data revenues increased $270, or 9.9%, in the second quarter and $447, or 8.3%, for the first six months of 2005. This increase was primarily due to continued growth in DSL, our broadband internet-access service. DSL and dial-up internet service increased data revenues approximately $114 in the second quarter and $240 for the first six months of 2005. The number of DSL lines in service grew to approximately 6.0 million
customers. 26 SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in Millionsmillions except per share amounts RESULTS OF OPERATIONS - Continued For the remaining UNE-P lines, we believe, based on marketing research, that customers primarily switched to competitors using alternative technologies or their own networks as opposed to returning as our retail customers. Datarevenues increased $2,051, or 85.8%, in the first quarter of 2006, with increases of $779 in Internet Protocol (IP) data, $666 in transport and $606 in packet switched services, which were almost entirely due to the acquisition of ATTC. Revenues from our traditional SBC regions increased approximately 9.0% compared to 4.3 million at June 30, 2004. Additionally, revenuethe first quarter of 2005 and 2.0% sequentially, while pro forma revenues from ATTC’s traditional enterprise categories declined slightly compared to the first quarter of 2005 and sequentially. Included in IP data equipment salesrevenues are services for dedicated internet access, virtual private network and network integrationother hosting services. Contributing to the increase in IP data services was continued growth in DSL, our broadband internet-access service. DSL internet service increased data revenues approximately $104$103 in the secondfirst quarter reflecting an increase in DSL lines in service, which was partially driven by lower-priced promotional offerings and $124 for the first six months. Revenuespricing responses to competitors. The number of DSL lines in service grew to approximately 7.4 million, a 32.5% increase from large-business customers typically consist of revenue from the initial installation of equipment followed by services provided over multiple years.March 31, 2005. Revenue from our high-capacity transport services increased approximately $26 in the second quarter and $50 for the first six months of 2005. Our high-capacity transport services, which include DS1s and DS3s (types of dedicated high-capacity lines), and SONET (a dedicated high-speed solution for multi-site businesses), represented about 57% and 59%50% of total data revenues in the secondfirst quarter of 2006 and for the first six months of 2005, respectively, and 62%65% of total data revenues in the secondfirst quarter and for the first six months of 2004.2005.
Long-distance voice revenues increased $107, or 13.1%, in the second quarterOur packet switched services includes frame relay, asynchronous transfer mode (ATM) and $259, or 16.6%, for the first six months of 2005. These increases were primarily driven by the increase in long-distance lines in service since the second quarter of 2004. The number of long-distance lines in service grewmanaged packet services. As customers continue to approximately 22.8 millionshift from this traditional technology to IP-based technology, we expect these services to decline as compared to 18.4 million at June 30, 2004. Sales of combined long-distance and local calling fixed-fee offerings (referred to as “bundling”) also contributed to the increased long-distance revenues and lines. Salesa percentage of our bundling offers continued to increase in our Midwest, West and Southwest regions with the most significant improvements in results occurring in our Midwest region. However, we expect this growth to continue to slow, reflecting the market continuing to mature since we began providing service throughout our regions in late 2003.
Retail long-distance revenues increased approximately $112 in the second quarter and $269 for the first six months of 2005, reflecting our higher long-distance penetration levels. Also contributing to the increase was continued growth in our international and other long-distance services. Other long-distance revenues increased approximately $39 in the second quarter and $73 for the first six months of 2005, which includes wholesale long-distance services sold to Cingular and retail international long-distance. Partially offsetting these increases was a decline of approximately $35 in the second quarter and $77 for the first six months of 2005 due to increased competition and a reduction in our billed minutes of use mainly related to the increased sales of our fixed-fee bundles, which do not separately bill for minutes of use.overall data revenues.
Otheroperating revenues increased $4, or 0.8%$636 in the secondfirst quarter of 2006, primarily due to incremental revenue of $601 from our acquisition of ATTC. The major items included in other operating revenues are integration services and $51, or 5.6% for the first six months of 2005.customer premises equipment, outsourcing, directory and operator assistance services and government-related services. Our co-branded SBCAT&T | DISH Network satellite TV service increased revenue approximately $59$15 in the second quarter and $123 for the first six months of 2005. However, we expect future revenue growth for this service to reflect our strategy to target use of this service in those markets where the rate or risk of customer defections is highest.2006. Partially offsetting this increase,these revenue fromincreases were reduced demand for directory and operator assistance, billing and collection services provided to other carriers, wholesale and other miscellaneous products and services, decreased approximately $22 in the second quarter and $52 for the first six months. Various one-time billing adjustmentswhich decreased revenue approximately $33$42 in the second quarter and $28 for the first six months of 2005.2006. 27
SBC COMMUNICATIONS INC.
JUNE 30, 2005
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Dollars in Millions except per share amounts
RESULTS OF OPERATIONS - Continued
Cost of salesexpenses increased $47, or 1.1%,$2,733 in the secondfirst quarter and $208, or 2.6%, forof 2006, primarily related to the first six monthsacquisition of 2005.ATTC, which increased expenses approximately $2,800. Cost of sales consists of costs we incur to provide our products and services, including costs of operating and maintaining our networks. Costs in this category include our repair technicians and repair services, certain network planning and engineering expenses, operator services, information technology, property taxes related to elements of our network, and payphone operations. Pension and postretirement costs, net of amounts capitalized as part of construction labor, are also included to the extent that they are allocated to our network labor force and other employees who perform the functions listed in this paragraph. Costs associated with equipment sales and related network integration services, and our co-branded SBC | DISH Network satellite TV service increased approximately $129 in the second quarter and $227 for the first six months of 2005 reflecting our emphasis on growth in DSL and sales in the large business market and video. Our DISH TV service has relatively high initial acquisition costs. Costs associated with equipment for large-business customers (as well as DSL and video) typically are greater than costs associated with services that are provided over multiple years.
Traffic compensation expense (for access to another carrier’s network) increased approximately $148 in the second quarter and $119 for the first six months of 2005. Approximately $50 in the second quarter and $47 for the first six months of 2005 resulted from higher traffic expense generated from our long-distance service, partially offset by lower rates paid for local traffic (telephone calls) terminating on competitor networks and wireless customers. Expense also increased $98 in the second quarter and for the first six months of 2005 resulting from traffic compensation settlements which reduced expense in 2004 and that did not recur. Offsetting these increases, traffic compensation expense decreased approximately $26 for the first six months related to a carrier settlement in March 2005.
Salary and wage merit increases and other bonus accrual adjustments increased expense approximately $49 in the second quarter and $61 for the first six months. Non-employee related expenses such as contract services, agent commissions and materials and supplies costs increased approximately $9 in the second quarter and $28 for the first six months. We incurred higher than normal weather-related repair costs of approximately $100 for the first six months of 2005 primarily related to floods in Southern California.
Partially offsetting the increases, lower employee levels decreased expenses, primarily salary and wages, approximately $82 in the second quarter and $183 for the first six months. Expenses also decreased $154 in the second quarter of 2005 and for the first six months of 2005 due to the one-time accrual for a retiree bonus as a result of the settlement of our labor contract negotiations in the second quarter of 2004.
Our combined net pension and postretirement cost was essentially flat in the second quarter and increased approximately $57 for the first six months of 2005, primarily resulting from changes made to management medical coverage in the second quarter of 2005 and second-quarter 2004 modifications of nonmanagement retiree medical coverage.
2827
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in Millionsmillions except per share amounts RESULTS OF OPERATIONS - Continued As partTraffic compensation expense (for access to another carrier’s network) increased $113 in 2006, due primarily to growth in Yahoo! Inc. and long-distance service and as a result of an internal business unit realignment, cost of sales expenses of $46 incurred by the former unitdecreased costs recorded in the second quarter of 2004 were reported by another unit as selling expenses in 2005. This resulted in reduced expense in the secondfirst quarter of 2005 related to a carrier settlement. Benefit expenses, consisting primarily of our combined net pension and forpostretirement cost, increased $35 in 2006, primarily due to changes in our actuarial assumptions, which included the reduction of our discount rate from 6.00% to 5.75%, and net losses on plan assets in prior years. Salary and wage merit increases and other bonus accrual adjustments increased expense $31 in 2006.
Partially offsetting these increases were lower nonemployee-related expenses such as contract services, agent commissions and materials and supplies costs, which decreased $60 in the first six monthsquarter of 2005.2006. Lower employee levels decreased expenses, primarily salary and wages, $39 in 2006. Costs associated with equipment sales and related network integration services decreased $34 in 2006 primarily as a result of the September 2005 amendment of our agreement for our co-branded AT&T | DISH Network satellite TV service. Prior to restructuring our relationship with EchoStar in September 2005, our co-branded AT&T | DISH Network satellite TV service had relatively high initial acquisition costs. Costs associated with equipment for large-business customers (as well as DSL and, previously, video) typically are greater than costs associated with services that are provided over multiple years. Expenses also decreased in 2006 resulting from repair costs of approximately $100 incurred in the first quarter of 2005 related to severe weather in our traditional SBC regions. Selling, general and administrativeexpenses increased $115, or 5.0%,$1,531 in the secondfirst quarter and $215, or 4.8%, forof 2006, primarily due to the first six months of 2005.ATTC acquisition, which increased expenses approximately $1,250. Selling, general and administrative expenses consist of our provision for uncollectible accounts,accounts; advertising costs,costs; sales and marketing functions, including our retail and wholesale customer service centers,centers; centrally managed real estate costs, including maintenance and utilities on all owned and leased buildings,buildings; credit and collection functions, andand; corporate overhead costs, such as finance, legal, human resources and external affairs. Pension and postretirement costs are also included to the extent they relate to employees who perform the functions listed in this paragraph. We incurred a chargeOther wireline segment costs increased $274 in 2006, most of $236which was advertising related to promotion of the new AT&T name. In addition, advertising expense increased $25 in 2006 primarily driven by our promotion of the second quarterHome Turf campaign and sponsorship of 2005 to terminate existing agreements with WilTel, which will continue to provide transitional and out-of-market long distance services under a new agreement following the close of our planned acquisition of AT&T (see “Other Business Matters” for additional information).Winter Olympics. Salary and wage merit increases and other bonus accrual adjustments increased expenses approximately $16$22 in the second quarter2006. Benefit expenses, consisting primarily of our combined net pension and $43 for the first six months of 2005. Expenses alsopostretirement cost, increased approximately $20 for the first six months of 2005$19 in 2006 primarily due to higher severance accruals.
Partially offsettingchanges in our actuarial assumptions, which included the increases, lower employee levels decreased expenses, primarily salary and wages, approximately $35 in the second quarter and $76 for the first six months. Expenses also decreased $79 in the second quarter of 2005 and for the first six months of 2005 due to the one-time accrual for a retiree bonus as a result of the settlementreduction of our labor contract negotiationsdiscount rate from 6.00% to 5.75% and net losses on plan assets in the second quarter of 2004. Advertising expense decreased approximately $26 in the second quarter and $57 for the first six months of 2005 primarily driven by higher costs in 2004 from our launch of long-distance service in our Midwest region and bundling initiatives. Other employee related expenses including travel, training and conferences decreased approximately $23 in the second quarter and $10 for the first six months of 2005.
Non-employeeprior years. Nonemployee related expenses, such as contract services, agent commissions and materials and supplies costs, and corporate allocations decreased approximately $10increased $30 in the second quarter and increased $76 for the first six months of 2005, primarily due to higher parent charges and contract services during the first six months. Our combined net pension and postretirement cost was essentially flat in the second quarter and increased approximately $28 for the first six months of 2005, primarily resulting from changes made to management medical coverage in the second quarter of 2005 and second-quarter 2004 modifications of nonmanagement retiree medical coverage.2006.
As part of an internal business unit realignment, cost of sales expenses of $46 incurred by the former unit in the second quarter of 2004 were reported by another unit as selling expenses in 2005. This resulted in increased expense in the second quarter of 2005 and for the first six months of 2005.
2928
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in Millionsmillions except per share amounts RESULTS OF OPERATIONS - Continued Partially offsetting these increases were lower employee levels, which decreased expenses, primarily salary and wages, $69 in the first quarter of 2006. Our provision for uncollectible accounts decreased $28 in 2006 as we experienced fewer losses from our retail customers and a decrease in bankruptcy filings by our wholesale customers. Depreciation and amortizationexpenses increased $657 in 2006. Expenses increased $734 due to the acquisition of ATTC, of which $266 related to amortization of intangible assets, primarily customer lists and relationships, identified at the time of the merger. Expenses related to traditional SBC decreased $81, or 4.3%,$77 in the secondfirst quarter and $181, or 4.8%, for the first six months of 2005. Lower expense in 2005 was2006, due primarily to significantly lower capital expenditures over the last three yearssince 2001.. 30Supplemental Information
Access Line Trends Following is a summary of our in-region switched access lines at March 31, 2006 and 2005: In-Region1 | | | | Switched Access Lines | March 31, | | | | | Increase | (in 000’s) | 2006 | 2005 | (Decrease) | | | | | Retail Consumer | | | | Primary | 22,630 | 23,222 | (592) | Additional | 3,786 | 4,218 | (432) | Retail Consumer Subtotal | 26,416 | 27,440 | (1,024) | | | | | Retail Business | 17,377 | 17,507 | (130) | Retail Subtotal | 43,793 | 44,947 | (1,154) | Percent of total switched access lines | 89.8% | 86.7% | | | | | | Sold to ATTC | 1,517 | 2,144 | (627) | Sold to other CLECs2 | 3,150 | 4,359 | (1,209) | Wholesale Subtotal | 4,667 | 6,503 | (1,836) | Percent of total switched access lines | 9.6% | 12.5% | | | | | | Payphone (Retail and Wholesale) | 308 | 418 | (110) | Percent of total switched access lines | 0.6% | 0.8% | | | | | | Total Switched Access Lines | 48,768 | 51,868 | (3,100) | | | | | DSL Lines in Service | 7,432 | 5,608 | 1,824 | | | | | |
1 In-region represents access lines served by AT&T’s ILECs. 2Competitive local exchange carriers (CLECs) 29 SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in Millionsmillions except per share amounts RESULTS OF OPERATIONS - Continued Total in-region switched access lines in service at March 31, 2006 declined 3,100, or 6.0%, from March 31, 2005 levels. Retail access lines, while declining 2.6% from 2005 levels, represent 89.8% of total in-region switched access lines at March 31, 2006, compared to 86.7% a year earlier. During this same period, wholesale lines decreased 28.2% and at March 31, 2006 represented 9.6% of total access lines, down from 12.5% a year earlier. The decline in total access lines reflects many factors, including the disconnection of additional lines as our existing customers purchase our DSL broadband services and for other reasons, and the continued growth in alternative communication technologies such as wireless, cable and other internet-based systems. However, recently, declines in our retail business access lines have been partially offset by sales of our business internet-based systems (which are reported as data revenues). We do not currently offer a residential internet-based service except in limited areas served by ATTC prior to the acquisition. The decline in our wholesale lines reflects the end of the UNE-P rules in March 2006. Cingular Segment Results | | Second Quarter | | Six-Month Period | First Quarter | | | | | | | | Percent | | | | | | | Percent | | | | Percent | | | 2005 | | 2004 | | Change | | | 2005 | | 2004 | | Change | 2006 | 2005 | | Change | Segment operating revenues | | | | | | | | | | | | | | | | | | | | | Service revenues | $ | 7,719 | $ | 3,833 | | - | | $ | 15,138 | $ | 7,416 | | - | $ | 8,005 | $ | 7,419 | | 7.9% | | Equipment revenues | | 890 | | 354 | | - | | | 1,700 | | 738 | | - | | 975 | | 810 | | 20.4 | | Total Segment Operating Revenues | | 8,609 | | 4,187 | | - | | | 16,838 | | 8,154 | | - | | 8,980 | | 8,229 | | 9.1 | | Segment operating expenses | | | | | | | | | | | | | | | | | | | | | Cost of services and | | | | | | | | | | | | | | | equipment sales | | 3,523 | | 1,488 | | - | | | 6,962 | | 2,980 | | - | | Cost of services and equipment sales | | | 3,647 | | 3,439 | | 6.0 | | Selling, general and administrative | | 2,953 | | 1,463 | | - | | | 5,954 | | 2,835 | | - | | 2,846 | | 3,001 | | (5.2) | | Depreciation and amortization | | 1,629 | | 565 | | - | | | 3,304 | | 1,118 | | - | | 1,680 | | 1,675 | | 0.3 | | Total Segment Operating Expenses | | 8,105 | | 3,516 | | - | | | 16,220 | | 6,933 | | - | | 8,173 | | 8,115 | | 0.7 | | Segment Operating Income | | 504 | | 671 | | (24.9) | | | 618 | | 1,221 | | (49.4) | | 807 | | 114 | | - | | Interest Expense | | 326 | | 199 | | 63.8 | | | 664 | | 397 | | 67.3 | | 297 | | 338 | | (12.1) | | Equity in net income (loss) of | | | | | | | | | | | | | | | affiliates – net | | 1 | | (95) | | - | | | 3 | | (203) | | - | | Equity in Net Income of Affiliates | | | - | | 2 | | - | | Other – net | | (8) | | (40) | | 80.0 | | | (4) | | (63) | | 93.7 | | (32) | | 4 | | - | | Segment Income (Loss) | $ | 171 | $ | 337 | | (49.3)% | | $ | (47) | $ | 558 | | - | $ | 478 | $ | (218) | | - | |
Accounting for Cingular We account for our 60% economic interest in Cingular under the equity method of accounting in our consolidated financial statements since we share control equally (i.e., 50/50) with our 40% economic partner BellSouth Corporation (BellSouth) in the joint venture. We have equal voting rights and representation on the boardBoard of directorsDirectors that controls Cingular. This means that our consolidated results include Cingular’s results in the “Equity in net income of affiliates” line. However, when analyzing our segment results, we evaluate Cingular’s results on a stand-alone basis using information provided by Cingular during the year. Accordingly, in theour segment table above,presentation, we present 100% of Cingular’s revenues and expenses under “Segment operating revenues” and “Segment operating expenses.” Including 100% of Cingular’s results in our segment operations (rather than 60% in equity in net income of affiliates) affects the presentation of this segment’s revenues, expenses, operating income, nonoperating items and segment income but does not affect our consolidated net income. In We discuss Cingular’s liquidity and capital expenditures under the first quarter of 2005, to be consistent with industry practices, Cingular changed its income statement presentation for the currentheading “Cingular” within “Liquidity and prior-year periods to record billings to customers for various state gross receipts taxes and other fees as “Service revenues” and the taxes assessed by the various state jurisdictions and other fees as “Cost of services and equipment sales.Capital Resources.” This amount totaled $32 in the second quarter and $57 for the first six months of 2004. Operating income and net income for all restated periods were not affected.
3130
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in Millionsmillions except per share amounts RESULTS OF OPERATIONS - Continued In February 2005, Cingular announced restated 2004 results to correct an error relating to its lease accounting practices. This correction, which is reflected in the table above, reduced Cingular’s previously reported “Segment Operating Income” by approximately $9 in the second quarter and $18 for the first six months of 2004 and “Segment Income” by $12 in the second quarter and $24 for the first six months of 2004.
Acquisition of AT&T Wireless
On October 26, 2004, Cingular acquired AT&T Wireless for approximately $41,000 in cash. In connection with the acquisition, we entered into an investment agreement with BellSouth and Cingular. Under the investment agreement, we and BellSouth funded, by means of an equity contribution to Cingular, a significant portion of the acquisition’s purchase price. Based on our 60% equity ownership of Cingular, and after taking into account cash on hand at AT&T Wireless, we provided additional equity of approximately $21,600 to fund the purchase price. In exchange for this equity contribution, Cingular issued to us and BellSouth new membership interests in Cingular. Equity ownership and management control of Cingular remains unchanged after the acquisition.
Several class-action lawsuits have been filed against AT&T asserting claims under the federal securities laws in connection with the offering of AT&T Wireless tracking stock in April 2000. The plaintiffs have demanded damages in excess of $2,100 related to the offering of AT&T Wireless tracking stock. In connection with the split-off of AT&T Wireless, certain provisions of the separation agreement between AT&T Wireless and AT&T may result in Cingular, due to its acquisition of AT&T Wireless, being allocated as much as 70% of any liabilities arising out of these actions to the extent they relate to AT&T Wireless tracking stock. At this time, management is assessing the potential amount, if any, of this preacquisition liability.
In the segment discussion below, Cingular’s 2004 operating results and customer metrics do not include AT&T Wireless since the acquisition closed in the fourth quarter of 2004.
32
SBC COMMUNICATIONS INC.
JUNE 30, 2005
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Dollars in Millions except per share amounts
RESULTS OF OPERATIONS - Continued
Cingular’s Customer and Operating Trends Cingular is the largest provider of mobile wireless voice and data communications services in the United States, based on the number of wireless customers. Cingular also has license coverage serving an aggregate population of potential customers, referred to as “POPs,” of nearly 292 million, including all of the 100 largest metropolitan areas. As of June 30, 2005,March 31, 2006, Cingular served 51.6approximately 55.8 million cellular/PCS (wireless) customers, compared to approximately 2554.1 million at June 30, 2004.December 31, 2005 and 50.4 million at March 31, 2005. Cingular’s increase in customer gross additions during the second quarter andin the first six monthsquarter of 2006 compared to the first quarter of 2005 was primarily due to the acquisition of AT&T Wirelessdriven by an increase in late October 2004reseller and the resulting inclusion of AT&T Wireless customers in Cingular’s results. The increase was also due to Cingular’sprepaid customer growth, combined with its larger distribution network, its broad range of service offerings and increased advertising.advertising over the past year. Cingular’s recent customer activity is listed below:
Wireless Customer Activity | | Three-Month Period | | (in 000’s) | | June 30, 2005 | | March 31, 2005 | | December 31, 2004 | | Gross additions | | 4,384 | | 4,763 | | 4,930 | | Net additions | | 1,071 | | 1,419 | | 1,713 | | Other adjustments* | | 156 | | (159) | | 21,724 | | Net additions including other adjustments* | | 1,227 | | 1,260 | | 23,437 | |
*Other adjustments include customers gained or lost through property divestitures related to the AT&T Wireless acquisition and other adjustments. In the fourth quarter of 2004 other adjustments included approximately 21.9 million subscribers related to Cingular’s acquisition of AT&T Wireless. | | Three-Month Period Ended | (in 000s) | | Mar 31, 2006 | Dec 31, 2005 | Sep 30, 2005 | Jun 30, 2005 | | Mar 31, 2005 | | Gross additions | | 4,737 | 5,136 | 4,386 | 4,292 | | 4,672 | | Net additions | | 1,679 | 1,820 | 867 | 952 | | 1,367 | | Other adjustments1 | | (13) | 32 | (17) | 140 | | (149) | | Net additions including other adjustments1 | | 1,666 | 1,852 | 850 | 1,092 | | 1,218 | |
| 1 | Other adjustments include customers gained or lost through property divestitures related to the AT&T Wireless Services Inc. (AT&T Wireless) acquisition and other adjustments. |
Competition and the slowing rate of new wireless users as the wireless market matures will continue to adversely impact Cingular’s gross additions and revenue growth, increase expenses and put pressure on margins. Cingular expects that future revenue growth will become increasingly dependent on minimizing customer turnover (customer churn) and increasing average revenue per user/customer (ARPU). Cingular’s ARPU has weakened over the past several years as it has offered a broader array of plans to expand its customer base and responded to increasing competition, resulting in pricing reductions. While Cingular’s ARPU has somewhat stabilized somewhat recently, Cingular nevertheless expects continued pressure on ARPU notwithstanding increasing revenue from data services. Cingular expects its cost of services to continue increasing due to higher network system usage, includingwhich includes the costs Cingular is now paying T-Mobile USA (T-Mobile) for the utilizationuse of its network in California and Nevada, higher costs as Cingular integratesassociated with integrating AT&T Wireless’ network and operations, and, to a lesser extent, redundantincreased expenses related to operating, multiple networks as Cingular’s customer base transitions from itsmaintaining and decommissioning Time Division Multiple Access (TDMA) network to itsnetworks that duplicated Global System for Mobile Communication (GSM) networks while integrating the networks acquired from AT&T Wireless. Cingular’s remaining purchase commitment to T-Mobile was approximately $409 at March 31, 2006. Operating costs will substantially increase in the event that Cingular’s network expansion in California and Nevada is not completed prior to fulfilling the purchase commitment with T-Mobile. However, this network expansion is proceeding on schedule and Cingular currently expects this network expansion to be completed on time, and as of March 31, 2006, approximately 70% of Cingular’s customers in California and Nevada are now on the Cingular network. Cingular’s Operating Results
Our Cingular segment operating income margin was 5.9% in the second quarter (1.4% in the first quarter of 2005) and 3.7% for the first six months of 2005, compared to 16.0% in the second quarter and 15.0% for the first six months of 2004. The lower 2005 margin was caused by increased expenses that were only partially offset by increased revenues. The primary driver for the 2005 increases in almost every component of Cingular’s total operating revenues and operating expenses was the acquisition of AT&T Wireless in late October 2004 and the resulting inclusion of AT&T Wireless operating results and wireless customers in Cingular’s results.
3331
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in Millionsmillions except per share amounts RESULTS OF OPERATIONS - Continued Cingular’s operating expenses increased $4,589ARPU declined 2.3% in the secondfirst quarter of 2006. The decline in ARPU was due to a decrease in local service, net roaming revenue and $9,287 for the first six months of 2005other revenue per customer partially offset by an increase in average data revenue per customer, which increased 41.1%. Local service revenue per customer declined primarily due to incremental expensesan increase in reseller customers which provide significantly lower ARPU than non-reseller customers, and customer shifts to all-inclusive rate plans that offer lower monthly charges, as well as Cingular’s free mobile-to-mobile plans, which allow Cingular customers to call other Cingular customers at no charge and to a lesser extent “rollover” minutes (which allow customers to carry over unused minutes from AT&T Wireless; mergermonth to month for up to one year). An increase in customers on rollover plans tends to lower average monthly revenue per customer since unused minutes (and associated revenue) are deferred until subsequent months for up to one year.
The effective management of wireless customer churn is critical to Cingular’s ability to maximize revenue growth and integration costsmaintain and improve margins. Cingular’s wireless customer churn rate is calculated by dividing the aggregate number of $204wireless customers (prepaid and postpaid) who cancel service during each month in a period by the total number of wireless customers at the beginning of each month in that period. Cingular’s churn rate was 1.9% in the secondfirst quarter and $309 forof 2006, down from 2.2% in the first six monthsquarter of 2005 related to2005. The churn rate for Cingular’s postpaid customers was 1.6% in the first quarter of 2006, down from 1.9% in the first quarter of 2005. The decline in postpaid churn reflects benefits from the acquisition of AT&T Wireless; acquisition costsWireless, including more affordable rate plans, broader network coverage, higher network quality, exclusive devices and free mobile-to-mobile calling among Cingular’s 55.8 million customers. Cingular’s Operating Results Our Cingular segment operating income margin was 9.0% in the first quarter of 2006, which improved over margins of 6.2% in the fourth quarter of 2005 and 1.4% in the first quarter of 2005. The higher margin in the first quarter of 2006 compared to the first quarter of 2005 was primarily due to revenue growth of $751. Servicerevenues are comprised of local voice and data services, roaming, long-distance and other revenue. Service revenues increased $586, or 7.9%, in the first quarter of 2006 and consisted of: Local voice revenues increased $339, or 5.5%, in the first quarter primarily due to a 10.5% increase in Cingular’s average number of wireless customers, partially offset by a decline in local service ARPU of 4.5%. Data service revenues increased $303, or 53.2%, due to a 41.1% increase in average data revenue per customer and increased use of text messaging and internet access services. Data service revenues represented 9.7% of Cingular’s total revenues in the first quarter. Roaming revenues from Cingular customers and other wireless carriers for use of Cingular’s network decreased $32, or 6.9%, in the first quarter. Long-distance and other revenue decreased $24, or 11.8%, in the first quarter primarily as a result of a decline in property management revenues, which were partially offset by increased domestic long-distance revenue. 32 AT&T INC. MARCH 31, 2006 Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in millions except per share amounts RESULTS OF OPERATIONS - Continued Equipmentrevenues increased $165, or 20.4%, in the first quarter of 2006 due to increased handset revenues primarily as a result of higher priced handsets, partially offset by a decline in gross prepaid customer additions. Cost of services and equipment sales expenses increased $208, or 6.0%, in the first quarter of 2006 primarily due to increases in network usage and associated network system expansion. Cost of services increased $176, or 8.2%, in the first quarter of 2006 primarily due to the following: Increases in network usage with significantlyan increase in minutes of use of 22.8% in the first quarter of 2006. Higher roaming and long-distance cost, partially offset by declines in Universal Service Fund, regulatory fees and reseller expenses. The reseller decrease resulted from a 43% decrease in minutes of use on the T-Mobile network. Equipment sales expense increased slightly in the first quarter of 2006 by $32, or 2.5%, due to handset unit sales associated an increase in the average cost per unit sold of 13.3% due to sales of higher quality handsets for gross customer additions; extensiveadditions, including exclusive devices, partially offset by a decline in gross prepaid customer retention and customer service initiatives; and higher depreciation and amortization expenses including amortization expense related to Cingular’s purchase price valuation of AT&T Wireless customer contracts and other intangible assets acquired of $445 in the second quarter and $931 for the first six months of 2005. Network operating costs also increased due to growth in customer usage, increased costs Cingular is now paying T-Mobile for the use of its network in California and Nevada and redundant expenses related to concurrently operating its TDMA and GSM networks (see “Other Cingular Transactions” below). Handsetadditions. Total equipment costs increased $725 in the second quarter and $1,483 for the first six months of 2005. Equipment costs increased at acontinue to be higher rate than equipment revenues due to Cingular’s sales of handsets below cost, through direct sales sources, to customers who committed to one-year or two-year contracts or in connection with other promotions. Largely offsetting these expense increases was revenue growth of $4,422 in the second quarter and $8,684 for the first six months of 2005, including incremental revenues from the acquisition of AT&T Wireless. ARPU decreased 0.6% in the second quarter and increased 0.9% for the first six months of 2005promotions, though this difference narrowed compared to the secondfirst quarter of 2005.
Selling, general and administrative expenses decreased $155, or 5.2%, in the first six monthsquarter of 2004. The2006 due to decreases in general and administrative expenses of $123, or 7.1%, and selling expenses of $32, or 2.5%. Selling, general and administrative expenses included integration costs of approximately $46 in the first quarter of 2006 and $102 in the first quarter of 2005, which included employee termination costs, re-branding and advertising of the Cingular and AT&T Wireless combination and customer service and systems integration costs. Decreases in selling, general and administrative expenses were primarily due to the following: Other administrative expenses decreased $50 in the first quarter of 2006 primarily due to a decline in the second quarter ARPU wasemployee costs and employee-related benefits due to a decrease in localheadcount. Customer service expenses decreased $46 in the first quarter of 2006 due to a decline in the number of call center outsourced professional services. Selling expense decreased $32 mainly from declines of $28 in marketing and net roaming revenueadvertising and $13 in commissions expense, partially offset by an increase of $9 in sales expense. Billing, bad debt and other customer maintenance expense decreased $27 in the first quarter primarily due to fewer account write-offs, cost savings related to transitioning to one billing system, partially offset by an increase in average data revenue per customer of approximately 185% and increased long-distance revenue per customer. The six-month increase in ARPU was due to increases in average data revenue per customer of approximately 205% for the first six months, increased long distance and regulatory fees revenue, partially offset by a decline in the local service revenue and net roaming revenue. Local service revenue declined primarily due to customer shifts to all-inclusive rate plans that offer lower monthly charges and “rollover” minutes (which allow customers to carry over unused minutes from month to month for up to one year) as well as Cingular’s free mobile to mobile plans, which allow Cingular customers to call other Cingular customers at no charge. An increase in customers on rollover plans tends to lower average monthly revenue since unused minutes (and associated revenue) are deferred until subsequent months, up to one year. These revenue and expense fluctuations are discussed in more detail below.equipment maintenance expenses. The effective management of wireless customer churn is critical to Cingular’s ability to maximize revenue growth and maintain and improve margins. Cingular’s wireless customer churn is calculated by dividing the aggregate number of wireless customers who cancel service during each month in a period by the total number of wireless customers at the beginning of each month in that period. For the second quarter and the first six months of 2005, Cingular’s churn rate was 2.2%, down from a 2.7% churn rate in the second quarter and first six months of 2004. Cingular’s second quarter churn rate remained unchanged from the churn rate for the first quarter of 2005. The decline in Cingular’s churn rate compared to 2004 resulted primarily from a lower postpaid customer churn rate, a change in methodology of calculating churn related to Cingular’s reseller customers and changes resulting from conforming Cingular’s and AT&T Wireless’ churn methodologies. Cingular’s postpaid churn rate was 1.8% in the second quarter and 1.9% for the first six months of 2005, down from a 2.3% churn rate in both the second quarter and for the first six months of 2004.
3433
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in Millionsmillions except per share amounts RESULTS OF OPERATIONS - Continued Beginning in the first quarter of 2005, Cingular adopted a new reseller churn calculation methodology that resulted in an aggregate churn calculation that is more comparable with its major competitors. Prior to 2005, Cingular included gross reseller disconnects in its churn calculation. Effective with the first quarter of 2005, Cingular’s churn calculation is based on total net reseller disconnects. This change resulted in an improvement to second quarter and first six months of 2005 reported churn of approximately 30 basis points. Changes to conform the traditional Cingular presentation to certain of the AT&T Wireless churn methodologies resulted in an improvement to second quarter and first six months of 2005 reported churn of less than 10 basis points.
The decline in postpaid churn reflects Cingular’s ability to provide more attractive offerings to customers due to the acquisition of AT&T Wireless, including more affordable rate plans, broader network coverage, higher network quality, exclusive devices and free mobile-to-mobile calling among Cingular’s 51.6 million customers.
Service revenues are comprised of local voice and data services, roaming, long-distance and other revenue. The primary driver for the second quarter and first six months of 2005 increase in Cingular’s total operating revenues was the acquisition of AT&T Wireless in late October 2004 and inclusion of AT&T Wireless operating results. Service revenues increased $3,886 in the second quarter and $7,722 for the first six months of 2005 and consisted of:
•
| Local voice revenues increased approximately $3,036 in the second quarter and $6,111 for the first six months due to the acquisition of AT&T Wireless (which more than doubled Cingular’s average number of wireless customers) and greater billed minutes of use. Increased Universal Service Fund (USF) and regulatory compliance fees also contributed to the local voice revenues increase in the second quarter and first six months of 2005.
| •
| Data service revenues increased $488 in the second quarter and $921 for the first six months due to increased average revenue per customer, increased use of text messaging services and the inclusion of former AT&T Wireless customers (who on average were heavier data users than Cingular customers). Data ARPU increased approximately 185% in the second quarter and 205% for the first six months of 2005 compared to 2004. Data service revenues represented approximately 7.6% of Cingular’s total revenues in the second quarter and 7.3% for the first six months of 2005.
| •
| Roaming revenues from Cingular customers and other wireless carriers for use of Cingular’s network increased $262 in the second quarter and $460 for the first six months primarily due to roaming revenues from the acquired AT&T Wireless customer base.
| •
| Long-distance and other revenue increased $100 in the second quarter and $230 for the first six months primarily due to increased long-distance revenues from the acquired AT&T Wireless customer base as well as increased international calling and property management fees.
|
Equipment revenues increased $536 in the second quarter and $962 for the first six months of 2005 due to increased handset revenues primarily as a result of significantly higher gross customer additions
35
SBC COMMUNICATIONS INC.
JUNE 30, 2005
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Dollars in Millions except per share amounts
RESULTS OF OPERATIONS - Continued
and increases in existing customers upgrading their units. Upgrade unit sales reflect an increase in GSM upgrades and Cingular’s efforts to migrate former AT&T Wireless customers to Cingular service offerings.
Cost of services and equipment sales expenses increased $2,035 in the second quarter and $3,982 for the first six months of 2005 primarily due to increased cost of services resulting from incremental costs related to the acquired AT&T Wireless network. Cost of services increased $1,310 in the second quarter and $2,499 for the first six months of 2005 due to increases in network usage with a minutes of use increase of more than 150%, increased costs Cingular is now paying T-Mobile for the use of its network in California and Nevada, increased redundant expenses related to concurrently operating TDMA and GSM networks, higher roaming and long-distance cost and increased USF and regulatory fees related to the increase in the customer base.
Equipment sales expense increased $725 in the second quarter and $1,483 for the first six months of 2005 primarily due to higher handset unit sales associated with the increase in gross customer additions of 79.5% in the second quarter and 85.2% for the first six months, existing customers upgrading their units and the continued migration of former AT&T Wireless customers to Cingular service offerings. Equipment costs increased at a higher rate than equipment revenues due to Cingular’s sales of handsets below cost, through direct sales sources, to customers who committed to one-year or two-year contracts or in connection with other promotions.
Selling, general and administrative expenses increased $1,490 in the second quarter and $3,119 for the first six months of 2005 primarily due to incremental expenses associated with the acquisition of AT&T Wireless. These increases include $76 of integration costs in the second quarter and $178 for the first six months of 2005, which includes employee termination costs, re-branding and advertising of the Cingular and AT&T Wireless combination and customer service and systems integrations costs.
Total selling expenses increased $568, or 80.0%, in the second quarter and $1,195, or 88.3%, for the first six months of 2005 primarily due to the increase in gross customer additions of 79.5% in the second quarter and 85.2% for the first six months. Total selling expenses include sales, marketing, advertising and commissions expense. Commissions expense increased $204 in the second quarter and $424 for the first six months of 2005 and advertising expenses increased $158 in the second quarter and $348 for the first six months of 2005. Cingular’s sales expense increased approximately $183 in the second quarter and $370 for the first six months of 2005 primarily due to increased sales personnel costs associated with the acquired AT&T Wireless sales force.
General and administrative expenses increased $922 in the second quarter and $1,924 for the first six months of 2005 primarily due to incremental expenses from AT&T Wireless and integration costs, mentioned previously. General and administrative expenses include customer service, upgrade commissions, billing, bad debt, other maintenance and other administrative expense. Customer service expenses increased $323 in the second quarter and $683 for the first six months due to a higher number of employees and employee-related expenses related to the significant increase in customers, as well as customer retention and customer service improvement initiatives. Upgrade commissions increased $97 in the second quarter and $196 for the
36
SBC COMMUNICATIONS INC.
JUNE 30, 2005
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Dollars in Millions except per share amounts
RESULTS OF OPERATIONS - Continued
first six months due to the increased customer migration and handset upgrade activity, mentioned previously. Billing, bad debt and other customer maintenance expense increased $220 in the second quarter and $426 for the first six months primarily due to the significant increase in Cingular’s customer base. Other administrative expenses increased $282 in the second quarter and $619 for the first six months primarily due to incremental expenses associated with the acquired AT&T Wireless administrative functions.
Depreciation and amortization expenses increased $1,064$5, or 0.3%, in the secondfirst quarter and $2,186 for the first six months of 2005.2006. Depreciation expense increased $644$146 in the secondfirst quarter and $1,300 for the first six monthsof 2006 primarily due to incremental depreciation associated with the property, plant and equipment acquired in the AT&T Wireless acquisition. Depreciation expense increased duerelated to Cingular’s on-goingongoing capital spending associated with its GSM network. Additionally, depreciation expense increased due to accelerated depreciation on certain TDMA network assets based on Cingular’s projected transition of network traffic to GSM technology and accelerated depreciation on certain other network assets, which includes integration costs of $109 in the second quarter and first six months.assets. Substantially all of Cingular’s TDMA assets are anticipated to be fully depreciated by the end of 2007. Amortization expense increased $420decreased $141 in the secondfirst quarter and $886 for the first six months of 20052006 primarily relateddue to the purchase price valuationdeclining amortization of the AT&T Wireless customer contracts and other intangible assets acquired, partially offset by intangible assets that became fullywhich are amortized during 2004. 37
SBC COMMUNICATIONS INC.
JUNE 30, 2005
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Dollars in Millions except per share amounts
RESULTS OF OPERATIONS - Continued
Other Cingular Transactions
In November 2004, Cingular entered into a number of agreements to divest certain assets and spectrum in certain markets in response tousing the agreement made with the U.S. Department of Justice (DOJ) and the Federal Communications Commission (FCC) as a condition to receiving regulatory approval to acquire AT&T Wireless. In April 2005, Cingular sold certain former AT&T Wireless assets and properties, including licenses, network assets, and subscribers that Cingular operated in several markets, the largest of which is Oklahoma City, Oklahoma to Alltel Corporation (Alltel). As part of this agreement, Cingular also sold 20 MHz of spectrum and the network assets formerly held by AT&T Wireless in Wichita, Kansas, which it was not required to divest. Additionally, in February 2005, Cingular sold 10 MHz of former AT&T Wireless spectrum in each of Dallas, Texas and Detroit, Michigan to MetroPCS and 10 MHz of former AT&T Wireless spectrum in Knoxville, Tennessee to Cellco Partnership (d/b/a Verizon Wireless). In March 2005, Cingular sold AT&T Wireless properties and assets in specific rural regions of Arkansas, Mississippi, Missouri and Texas. Finally, in April 2005, Cingular completed the disposition of AT&T Wireless assets in Missouri. No gains or losses were recognized on the sale of these former AT&T Wireless properties or spectrum. Cingular has completed all required divestitures required by the FCC and DOJ.
In January 2005, Cingular and T-Mobile dissolved their network infrastructure joint venture. In connection with the dissolution, Cingular sold its ownershipsum of the California/Nevada network assets to T-Mobile for approximately $2,500 in cash. In connection with the dissolution, Cingular was required to contribute an additional $200 to the venture to equalize the capital accounts. Cingular expects to use a significant portionmonths digits method of the proceeds from the sale to fund capital expenditures through July 2005 (see “Liquidity and Capital Resources”). At June 30, 2005, $1,488 of these funds remains designated for future capital expenditures.
In May 2005, we transferred wireless properties to Cingular to settle a liability related to the formation of Cingular. This transfer resulted in a decrease of approximately $35 to our “Investment in Cingular” account.
In June 2005, Cingular agreed to sell former AT&T Wireless operations and licenses in the Caribbean and Bermuda to Digicel Limited for approximately $61. This transaction is contingent upon regulatory approvals.
In July 2005, we received additional net repayments totaling approximately $1,179 from Cingular, which was applied as a reduction on our shareholder loan to Cingular.
38
SBC COMMUNICATIONS INC.
JUNE 30, 2005
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Dollars in Millions except per share amounts
RESULTS OF OPERATIONS - Continued
Supplemental Information
Because Cingular’s acquisition of AT&T Wireless has a significant effect on comparative financial information, we have included the following sequential quarterly results for comparative purposes.
Cingular
Sequential Segment Results
| Three-Month Period Ended | | | June 30, | | March 31, | | December 31, | | | 2005 | | 2005 | | 2004 | Segment operating revenues | | | | | | | Service revenues | $ | 7,719 | $ | 7,419 | $ | 6,313 | Equipment revenues | | 890 | | 810 | | 806 | Total Segment Operating Revenues | | 8,609 | | 8,229 | | 7,119 | Segment operating expenses | | | | | | | Cost of services and equipment sales | | 3,523 | | 3,439 | | 2,939 | Selling, general and administrative | | 2,953 | | 3,001 | | 2,947 | Depreciation and amortization | | 1,629 | | 1,675 | | 1,386 | Total Segment Operating Expenses | | 8,105 | | 8,115 | | 7,272 | Segment Operating Income (Loss) | | 504 | | 114 | | (153) | Interest Expense | | 326 | | 338 | | 303 | Equity in net income (loss) of | | | | | | | affiliates – net | | 1 | | 2 | | (114) | Other – net | | (8) | | 4 | | 13 | Segment Income (Loss) | $ | 171 | $ | (218) | $ | (557) |
39
SBC COMMUNICATIONS INC.
JUNE 30, 2005
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Dollars in Millions except per share amounts
RESULTS OF OPERATIONS - Continued
amortization. Directory Segment Results | | Second Quarter | | | Six-Month Period | | | | | | | Percent | | | | | | | Percent | | | 2005 | | 2004 | | Change | | | 2005 | | 2004 | | Change | Total Segment Operating Revenues | $ | 925 | $ | 933 | | (0.9)% | | $ | 1,854 | $ | 1,871 | | (0.9)% | Segment operating expenses | | | | | | | | | | | | | | Cost of sales | | 234 | | 221 | | 5.9 | | | 475 | | 449 | | 5.8 | Selling, general and administrative | | 199 | | 199 | | - | | | 401 | | 381 | | 5.2 | Depreciation and amortization | | 1 | | 2 | | (50.0) | | | 3 | | 5 | | (40.0) | Total Segment Operating Expenses | | 434 | | 422 | | 2.8 | | | 879 | | 835 | | 5.3 | Segment Operating Income | | 491 | | 511 | | (3.9) | | | 975 | | 1,036 | | (5.9) | Equity in Net Income (Loss) of Affiliates | | - | | - | | - | | | (1) | | - | | - | Segment Income | $ | 491 | $ | 511 | | (3.9)% | | $ | 974 | $ | 1,036 | | (6.0)% |
In September 2004, we sold our interest in the directory advertising business in Illinois and northwest Indiana. Our directory segment results for all periods shown have been restated to exclude the results of those operations. In November 2004, a subsidiary in our directory segment entered into a joint venture agreement with BellSouth and acquired the internet directory provider, YPC. We account for our interest in YPC under the equity method of accounting in our consolidated financial statements since we share control equally in the joint venture. Operating results for this joint venture are reported in the “Equity in Net Income of Affiliates” line.
| First Quarter | | | | | | Percent | | 2006 | 2005 | | Change | Total Segment Operating Revenues | $ | 923 | $ | 929 | | (0.6)% | | Segment operating expenses | | | | | | | | Cost of sales | | 288 | | 280 | | 2.9 | | Selling, general and administrative | | 159 | | 164 | | (3.0) | | Depreciation and amortization | | 1 | | 2 | | (50.0) | | Total Segment Operating Expenses | | 448 | | 446 | | 0.4 | | Segment Operating Income | | 475 | | 483 | | (1.7) | | Equity in Net Income (Loss) of Affiliates | | (5) | | (1) | | - | | Segment Income | $ | 470 | $ | 482 | | (2.5)% | |
Our directory segment operating income margin was 53.1%51.5% in the secondfirst quarter of 2005,2006, compared to 54.8%52.0% in the secondfirst quarter of 2004 and 52.5% for the first six months of 2005 compared to 55.4% for the first six months of 2004.2005. See further discussion of the details of our directory segment revenue and expense fluctuations below. Operating revenues decreased $8,$6, or 0.9%0.6%, in the secondfirst quarter and $17, or 0.9%, for the first six months of 2005.2006. Revenues in the second quarter and for the first six months of 20052006 decreased primarily as a result of decreased demand for local Yellow Pages advertising which was partially offset by an increase in national Yellow Pages andincreased internet revenue. Internet advertising revenues increased $9 in the second quarter and $17 for the first six months of 2005.revenues. These results reflect the impact of competition from other publishers, other advertising media and continuing economic pressures on advertising customers. Cost of sales increased $13, or 5.9%, in the second quarter and $26, or 5.8%, for the first six months of 2005. The increase is primarily the result of increased costs for employee benefits, publishing and distribution of approximately $12 in the second quarter and $21 for the first six months of 2005.
Selling, general and administrative expenses were flat in the second quarter and increased $20, or 5.2%, for the first six months of 2005. The increases for the first six months are primarily due to higher employee benefit and salary costs of $13 and bad debt expense of $8. These increases were partially offset by decreases in contracted services and other expenses.
4034
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in Millionsmillions except per share amounts RESULTS OF OPERATIONS - Continued Cost of salesincreased $8, or 2.9%, in the first quarter of 2006. The increase was driven by higher costs for internet traffic, publishing and commissions. InternationalSelling, general and administrative expenses decreased $5, or 3%, in the first quarter of 2006 primarily due to lower bad debt expense, partially offset by increased other directory segment costs, including benefits.
Other Segment Results | | Second Quarter | | Six-Month Period | First Quarter | | | | | | | Percent | | | | | | | Percent | | | | Percent | | | | 2005 | | 2004 | | Change | | | 2005 | | 2004 | | Change | 2006 | 2005 | | Change | | Total Segment Operating Revenues | $ | 2 | $ | 6 | | (66.7)% | | $ | 5 | $ | 11 | | (54.5)% | $ | 203 | $ | 169 | | 20.1% | Total Segment Operating Expenses | | 4 | | 6 | | (33.3) | | | 11 | | 18 | | (38.9) | | 239 | | 212 | | 12.7 | Segment Operating Income (Loss) | | (2) | | - | | - | | | (6) | | (7) | | 14.3 | | (36) | | (43) | | 16.3 | Equity in Net Income of Affiliates | | 88 | | 149 | | (40.9) | | | 162 | | 601 | | (73.0) | | Segment Income | $ | 86 | $ | 149 | | (42.3)% | | $ | 156 | $ | 594 | | (73.7)% | | Equity in Net Income (Loss) of Affiliates | | | 339 | | (58) | | - | Segment Income (Loss) | | $ | 303 | $ | (101) | | - | |
Our internationalother segment consistsoperating results in the first quarter of 2006 and 2005 consist primarily of Sterling, corporate and other operations. Sterling provides business integration software and services. Operating revenues increased $34 in the first quarter of 2006 primarily due to increased operating revenue at Sterling. Operating expenses increased $27 in the first quarter of 2006 primarily due to increased corporate expenses (including) advertising costs and incremental ATTC corporate expenses) and increased operating expenses at Sterling, partially offset by management fees paid in 2005 that did not recur in 2006. 35 AT&T INC. MARCH 31, 2006 Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in millions except per share amounts RESULTS OF OPERATIONS - Continued Our other segment includes our equity investments in international companies, the income from which we report as equity in net income of affiliates. Revenues from direct international operations are less than 1% of our consolidated revenues. Our earnings from foreign affiliates are sensitive to exchange-rate changes in the value of the respective local currencies. Our foreign investments are recorded under GAAP, which include adjustments for the purchase method of accounting and exclude certain adjustments required for local reporting in specific countries. In discussing “EquityOur other segment also includes our 60% proportionate share of Cingular’s results as equity in Net Incomenet income of Affiliates,” all dollar amounts refer to the effect on our income. We first summarizeaffiliates. Our equity in a table the individual results for our significant equity holdings then discuss our quarterly results.net income of affiliates by major investment is listed below: | | First Quarter | | | 2006 | | 2005 | Cingular | $ | 213 | $ | (144) | Telmex | | 61 | | 51 | América Móvil | | 55 | | 27 | Other | | 10 | | 8 | Other Segment Equity in Net Income (Loss) of Affiliates | $ | 339 | $ | (58) |
Segment operating revenuesEquity in net income of affiliates decreased $4, or 66.7%,increased $397 in the secondfirst quarter and $6, or 54.5%, for the first six months of 20052006. The increase was primarily due to lower management-fee revenues.an increase of $357 in our proportionate share of Cingular’s results. Also contributing to the increase was increased equity income of $38 from Telmex and América Móvil reflecting higher revenue levels at both companies including significant increases in wireless subscribers at América Móvil.
Segment operating expenses decreased $2, or 33.3%, in the second quarter and $7, or 38.9%, for the first six months of 2005 primarily due to lower employee costs resulting from fewer foreign-based employees.
4136
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in Millions except per share amounts RESULTS OF OPERATIONS - Continued
Our equity in net income of affiliates by major investment is listed below:
| | Second Quarter | | Six-Month Period | | | 2005 | | 2004 | | 2005 | | 2004 | América Móvil | $ | 50 | $ | 21 | $ | 77 | $ | 60 | Belgacom 1 | | - | | - | | - | | 49 | TDC 1 | | - | | 48 | | - | | 328 | Telkom1 | | - | | 39 | | - | | 73 | Telmex | | 47 | | 37 | | 98 | | 88 | Other | | (9) | | 4 | | (13) | | 3 | International Equity in Net Income of Affiliates | $ | 88 | $ | 149 | $ | 162 | $ | 601 |
1 Investment sold
Equity in net income of affiliates decreased $61, or 40.9%, in the second quarter and $439, or 73.0%, for the first six months of 2005, primarily due to income recorded in 2004 attributable to investments which were subsequently sold during 2004. Our results in 2005 did not include income recorded in 2004 from: Telkom of approximately $39 in the second quarter and $73 for the first six months; TDC A/S (TDC) of $48 in the second quarter and $328 for the first six months (including the 2004 gain of $235 from TDC’s sale of its interest in Belgacom); and Belgacom of $49 for the first six months.
During the second quarter of 2005 our equity investments in Mexico (América Móvil and Telmex) reported better results primarily due to lower financing costs. These investments also reported higher earnings reflecting improved operating results in the second quarter and for the first six months of 2005.
42
SBC COMMUNICATIONS INC.
JUNE 30, 2005
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Dollars in Millions except per share amounts
RESULTS OF OPERATIONS - Continued
Other
Segment Results
| | Second Quarter | | | Six-Month Period | | | | | | | Percent | | | | | | | Percent | | | 2005 | | 2004 | | Change | | | 2005 | | 2004 | | Change | Total Segment Operating Revenues | $ | 56 | $ | 57 | | (1.8)% | | $ | 115 | $ | 117 | | (1.7)% | Total Segment Operating Expenses | | 52 | | 83 | | (37.3) | | | 60 | | 83 | | (27.7) | Segment Operating Income (Loss) | | 4 | | (26) | | - | | | 55 | | 34 | | 61.8 | Equity in Net Income (Loss) of Affiliates | | 94 | | 220 | | (57.3) | | | (38) | | 360 | | - | Segment Income | $ | 98 | $ | 194 | | (49.5)% | | $ | 17 | $ | 394 | | (95.7)% |
Our other segment results in the second quarter and for the first six months of 2005 and 2004 primarily consist of corporate and other operations. Revenues decreased in the second quarter and for the first six months of 2005 primarily as a result of lower revenues from our paging subsidiary, which we entered into an agreement to sell in July 2005 for aproximately $15. Expenses decreased in the second quarter and for the first six months of 2005 as a result of various adjustments including intercompany billing that had an unfavorable impact in the second quarter of 2004 that did not recur in 2005. Substantially all of the equity in net income (loss) of affiliates represents the equity income (loss) from our investment in Cingular.
43
SBC COMMUNICATIONS INC.
JUNE 30, 2005
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Dollars in Millionsmillions except per share amounts
COMPETITIVE AND REGULATORY ENVIRONMENT OverviewAT&T subsidiaries operating outside the U.S. are subject to the jurisdiction of national regulatory authorities in the market where service is provided, and regulation is generally limited to operational licensing authority for the provision of enterprise (i.e., large business) services. Subsidiaries operating within the U.S. are subject to federal and, to a lesser extent, state regulatory authorities. In the Telecommunications Act of 1996 (Telecom Act), Congress established a pro-competitive, deregulatory national policy framework to bring the benefits of competition and investment in advanced telecommunications facilities and services to all Americans by opening all telecommunications markets to competition and reducing or eliminating burdensome regulation. Since the Telecom Act was passed, the FCCFederal Communications Commission (FCC) and some state regulatory commissions have maintained many of the extensive regulatory requirements applicable to incumbent local exchange companies (ILECs), including our wireline subsidiaries, and imposed significant new regulatory requirements, including rules requiring us to unbundle our traditional network, in an effort to jump-start a specific definition of purported competition. However, over the past year, the FCC has begun to curtail and, in some cases, eliminate certain of these requirements in order to promote investment and deployment of next generation, broadband services and facilities, and in response to a series of federal court decisions that the FCC’s rules (in particular, those requiring ILECs to unbundle their networks) exceeded the FCC’s authority. For example, in February 2005, in response to a March 2004 decision by the United States Court of Appeals for the District of Columbia Circuit (D.C. Circuit), which overturned significant portions of the FCC’s third set of unbundling rules, including those mandating the availability of the UNE-P, the FCC released new rules that will eliminate the requirement that our wireline subsidiaries provide the UNE-P. Those new rules became effective March 11, 2005.subsidiaries. Set forth inWe are actively pursuing additional legislative and regulatory measures to reduce or eliminate regulatory requirements that inhibit our ability to provide the following paragraphsfull range of services increasingly demanded by our customers. For example, we are supporting legislative efforts at both the state and federal levels, as well as proposed rules at the FCC, that would offer a streamlined process for new video service providers to compete with traditional cable television providers. During 2006, Indiana and Kansas passed legislation that enables new video entrants to acquire a state-wide franchise to offer video services, see “Video Legislation” below. In addition, we are supporting efforts to update regulatory treatment for retail services. Several bills are also pending before Congress that would both reform the Telecom Act and promote additional video competition. Passage of legislation is a summaryuncertain and depends on many factors, but we believe that the increasing pace of the most significant developmentstechnological change and competition in our regulatory environment during the second quarter of 2005. While these issues, for the most part, apply onlyindustry will encourage lawmakers to our wireline subsidiaries, the words “we” or “our” are usedremove artificial barriers to simplify the discussion. In addition, the following discussions are intended as a condensed summary of the issues rather than a precise legal description of all of those specific issues.competition.
BroadbandTriennial Review Remand Order In JuneEffective March 11, 2005, the Supreme CourtTriennial Review Remand Order (TRRO) eliminated our obligation to provide local switching and hence the UNE-P, for mass-market customers, subject to a 12-month transition period. Since this transition period started, our wholesale customers representing a majority of our UNE-P lines have signed commercial agreements with us. For the United States ruledremaining UNE-P lines, we believe, based on marketing research, that it was reasonable for the FCC to find that internet services provided by cable companies should be defined as “information services,” rather than “telecommunications services.” This decision preserves the FCC’s deregulatory framework for cable internet services because providers of information services do not have to comply with rules requiring them to lease linescustomers primarily converted to competitors using alternative technologies or meet certaintheir own networks as opposed to returning as our retail customers. At the March 11, 2006 transition deadline we re-priced to market-based or resale-like rates any UNE-P lines that had not been converted, except in the state of Illinois where competitive local exchange carriers have the right under state law to retain the lines that are in service standards and state public utility requirements. Following the Court’s decision, the Chairmanat UNE-P equivalent rates. We had less than 100,000 UNE-P lines in Illinois as of the FCC indicated that broadband services offered by telephone companies should be regulated in a similar manner to broadband services offered by cable companies, and has suggested that the FCC is working to adopt similar rules for both telephone companies and cable companies.March 11, 2006.
VoIP E911 OrderVideo LegislationIn May 2005,March 2006, Indiana passed a state telecommunications deregulation bill that will make it easier for telecommunications companies to offer television service. The law prohibits the FCC required certain VoIP providersregulation of advanced services, broadband services, information services and retail IP enabled service, commercial mobile service and new services (any service not commercially available on March 28, 2006), and deregulates prices for basic telecommunications service after a three-year transition period. It also creates statewide video franchising to include E911 capability in their VoIP services. E911 capability enables a subscriber to call public safety authorities (police, fire department, etc.) and have the subscriber’s telephone number and location automatically transmitted to those authorities. The FCC’s requirement applies to VoIP services that allow a user to send calls to a public switched telephone network (PSTN), including our wireline subsidiaries’ traditional networks, and receive calls from the PSTN.replace individual local agreements.
In April 2006, Kansas passed a state video franchise bill that will allow video providers to be granted statewide authorization and to avoid city-by-city franchise negotiations. The bill specifically lists wireline, 4437
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in Millions except per share amounts OTHER BUSINESS MATTERSCOMPETITIVE AND REGULATORY ENVIRONMENT – Continued
wireless, satellite or any other alternative technology as acceptable mediums for providing service to customers, and states that video providers will not be required to comply with mandatory facility build-out provisions nor provide video service to any customer using a specific technology. Number Portability Since 1999, customers have been able to retain their numbers when switching their local service between wireline companies. The FCC allowed incumbent local exchange companies including SBC’s traditional wireline subsidiaries, to recover their carrier-specific costs of implementing wireline number portability through customer charges over a five-year term based on an estimated number of customers over that term. Because of the downturn in the telecommunications market since 1999, which led to fewer access lines, many companies, including the SBC subsidiaries, had fewer customers than were estimated and were therefore unable to fully recover their number portability implementation costs. Accordingly, in February 2005, we asked the FCC to waive the five-year limitation on recovery of number portability costs and, in March 2006, we asked the Commission, in the alternative, to allow us to include our remaining, unrecovered number portability costs through the existing End User Common Line charge. If our request is granted, we will be able to recover approximately $190 of those costs. 38 Pending Acquisition of AT&T
On January 30, 2005, we agreed to acquire AT&T Corp. (AT&T) using shares of SBC common stock. The transaction has been approved by the Board of Directors of each company and was also approved by the shareholders of AT&T on June 30, 2005. The transaction is subject to review by the DOJ and approval by the FCC and various other regulatory authorities. We expect the transaction to close by late 2005. We expect that the acquisition of AT&T will create overall net synergies, primarily from reduced costs, with a present value of more than $15,000. We expect that approximately 85 to 90 percent of the synergies will come from reduced costs in areas such as network operations and information technology, and from combining business services organizations and eliminating duplicative corporate functions. We expect that the acquisition will slow our revenue growth rate in the near term following the closing, but that the transaction will increase our earnings per share beginning in 2008.
In June 2005, we announced an agreement with WilTel to terminate the existing Master Alliance Agreement, Transport Services Agreement, Network Development and Operation Agreement and other associated agreements (Old SA) and to enter into a new Master Service Agreement (New SA). The New SA was effective as of June 15, 2005 and will expire on December 31, 2009, unless terminated earlier. The terms of the New SA are not contingent on the closing of our pending acquisition of AT&T. We recorded a pre-tax charge of approximately $236 in the second quarter of 2005 resulting from the fee to be paid to terminate the Old SA. The New SA allows us to immediately facilitate the planning for an efficient transition of services from WilTel’s network to AT&T’s network and for network diversity services to customers on both networks following the closing of the pending acquisition of AT&T.
We have agreed to spend a total of $600 over the three calendar years of 2005, 2006 and 2007, and a total of $75 over the two calendar years of 2008 and 2009, for services to be provided on WilTel’s network. We have purchased services valued at $120 during the first six months of 2005, resulting in an outstanding balance of $480 remaining for the three-year period. In addition, we are entitled to an $18 credit against services purchased during the remainder of 2005. If we fail to spend the required $600 or $75 during the respective designated periods, we will pay the amount of any deficiency and receive a credit equal to such amount to be used for future services. If we spend more than $600 during the initial three-year period, any excess will be credited toward the $75 commitment in the second period. In addition, we have agreed to pay up to $50 in incentive payments should WilTel achieve certain service performance goals during 2006 and 2007.
Project Lightspeed
We are continuing our efforts to develop a network capable of delivering a new generation of integrated IP video, super-high-speed broadband and VoIP services to our residential and small-business customers, which we refer to as Project Lightspeed. We have begun phased technical trials as well as deploying the fiber-to-the-premises portion of the network and began placing fiber for the fiber-to-the-node portion of the network in preparation for deployment. As part of our initial deployment, we expect to reach approximately 18 million households by the first half of 2008. We expect to provide in one limited market the first set of products, including IP video, in late 2005 or early 2006. Subject to successful results from this limited controlled launch and successful testing of our advanced IP video services, we then plan to enter additional markets in mid-2006.
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SBC COMMUNICATIONS INC.
JUNE 30, 2005MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in Millionsmillions except per share amounts OTHER BUSINESS MATTERS - Continued Pending Acquisition of BellSouthOn March 4, 2006, we agreed to acquire BellSouth in a transaction in which each share of BellSouth common stock will be exchanged for 1.325 shares of AT&T common stock. Based on the average closing price of AT&T shares for the two days prior to, including, and two days subsequent to the public announcement of the merger (March 5, 2006) of $27.32, the total transaction is valued, for purchase accounting purposes, at approximately $65,000. The transaction has been approved by the Board of Directors of each company and also must be approved by the stockholders of AT&T and BellSouth. The transaction is also subject to review by the U.S. Department of Justice (DOJ) and approval by the FCC and various other regulatory authorities. We currently expect the transaction to close by the end of 2006.
Project LightspeedIn June 2004, we announced key advances in developing a network capable of delivering a new generation of integrated digital television, high-speed broadband and VoIP services to our residential and small-business customers, referred to as Project Lightspeed. We have been building out this network in numerous locations and began providing services, including IP video, in one limited market, in late 2005. Our goal in this controlled market entry is to fully apply our new operating and back-office systems, gain information on customer preferences and, if needed, to fine-tune the service. To that end, we have restricted the number of customers and services offered to the necessary minimum. Subject to successful results from this controlled market entry and successful testing of our additional IP video services, we plan to enter 15 to 20 additional markets by the end of 2006. During that expansion, we expect to add additional features to our IP video service offering. We expect to have the capability to offer service to approximately 18 million households by the end of 2008, as part of our initial deployment, and expect to spend approximately $4,400 in network-related deployment costs and capital expenditures beginning in 2006 through 2008, as well as additional success-based customer activation capital expenditures. With respect to our IP video service, we continue to work with our vendors to develop, in a timely manner, the requisite hardware and software technology. Our deployment plans could be delayed if we do not receive required equipment and software on schedule. We also continue to negotiate with programming owners (e.g., movie studios and cable networks) for permission to offer existing television programs and movies and, if applicable, other new interactive services that we could offer in the future using advances in the IP technology we are testing.technology. Our ability to provide an attractive and profitable video offering will depend in large part on the results of these efforts. Also, as discussed in the “Competitive and Regulatory Environment” section, we are supporting legislation at both the federal and state levels that would streamline the regulatory process for new video competitors to enter the market. We believe that our planned deploymentProject Lightspeed is subject to federal oversight as an “informationa “video service” under the Federal Communications Act. However, some cable providers and municipalities have claimed that certain IP serviceservices should be treated as a traditional cable service and therefore subject to the applicable state and local regulation, which could include the requirement to pay fees to obtain local franchises for our IP video service. If the courts were to decide that state and local regulation were applicable to our Project Lightspeed services, it could have a material adverse effect on the cost, timing and extent of our deployment plans. 4639
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in Millionsmillions except per share amounts OTHER BUSINESS MATTERS - Continued Antitrust LitigationIn 2002, two consumer class-action antitrust cases were filed in the United States District Court for the Southern District of New York (District Court) against SBC, Verizon Communications Inc., BellSouth and Qwest Communications International Inc. alleging that they have violated federal and state antitrust laws by agreeing not to compete with one another and acting together to impede competition for local telephone services (Twombly v. Bell Atlantic Corp., et al.). In October 2003, the District Court granted the joint defendants’ motion to dismiss and the plaintiffs appealed. In October 2005, the United States Court of Appeals for the Second Circuit Court (Second Circuit) reversed the District Court, thereby allowing the cases to proceed. The Second Circuit noted in its decision that its ruling was procedural in nature and did not address the merits of the cases. Motions for rehearing and rehearing en banc were denied on January 3, 2006, and the case has now been remanded to the District Court for further proceedings.On remand, we have moved for partial dismissal on alternative grounds. In addition, Defendants filed a Petition for Writ of Certiorari with the Supreme Court of the United States on March 6, 2006. We continue to believe that an adverse outcome having a material effect on our financial statements in these cases is unlikely but will continue to evaluate the potential impact of these suits on our financial results as they progress. AT&T Wireless Litigation Several class-action lawsuits have been filed in the District Court against ATTC asserting claims under the federal securities laws in connection with the offering of AT&T Wireless tracking stock in April 2000 (In re AT&T Corp. Securities Litigation). The plaintiffs have demanded damages in excess of $2,100 related to the offering of AT&T Wireless tracking stock. In April 2006, the parties agreed to settle the litigation for $150, pending approval by the trial court. In connection with the split-off of AT&T Wireless, certain provisions of the separation agreement between AT&T Wireless and ATTC result in Cingular, due to its acquisition of AT&T Wireless, being allocated 70% of any liabilities arising out of these actions to the extent they relate to AT&T Wireless tracking stock, with the remaining liability being allocated equally between ATTC and Comcast Cable Communications, Inc. Accordingly, the settlement, if approved by the court, would not result in any additional expenses being accrued by Cingular or ATTC. Retiree Phone Concession LitigationIn May 2005, we were served with a purported class action in U.S. District Court, Western District of Texas (Stoffels v. SBC Communications Inc.), in which the plaintiffs, who are retirees of Pacific Bell Telephone Company, Southwestern Bell, and Ameritech, contend that the telephone concession provided by the company is, in essence, a “defined benefit plan” within the meaning of the Employee Retirement Income Security Act of 1974 (ERISA). Plaintiffs seek to certify a class of persons that are either (1) retirees of an SBC company who were receiving a telephone concession after they retired from January 1, 2002 to the present and who lived outside the SBC service area; or (2) current or former employees of any SBC participating company with more than five years of service with an SBC participating company as of June 1, 2005 who were eligible or who might become eligible to receive an out-of-franchise telephone concession after they retired; or (3) members of the immediate family of any person in Group 1 or Group 2, including surviving spouses and the retiree dependents (and including registered domestic partners of Pacific Telesis employees and retirees) during the time that SBC had a policy to provide employees of such participating companies with a telephone concession after retirement. Plaintiffs seek reformation of the out-of-region phone concession offered under the postemployment benefits plan (the Plan) and the documents 40 AT&T INC. MARCH 31, 2006 Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in millions except per share amounts OTHER BUSINESS MATTERS - Continued governing it to comply with ERISA, an order requiring us to fund the Plan as reformed, the appointment of an independent fiduciary to administer the Plan, an order requiring the Plan to pay benefits to plaintiffs and other class members consistent with the terms of the plan, civil penalties and attorneys’ fees and costs pursuant to ERISA. We filed a Motion to Dismiss for failure to state a claim, which was denied by the U.S. District Court, Western District of Texas on February 3, 2006. The case has been set for trial on September 25, 2006. We believe that an adverse outcome having a material effect on our financial statements in this case is unlikely, but will continue to evaluate the potential impact of this suit on our financial results as it progresses. Hepting LitigationPlaintiffs filed this purported class action in U.S. District Court in the Northern District of California on behalf of “all individuals in the United States that are current residential subscribers or customers of defendants’ telephone services or internet services, or that were residential telephone or internet subscribers or customers at any time after September 2001,”(Hepting, et al v. AT&T Corp., AT&T Inc. and Does 1-20). They allege that the defendants have provided and continue to provide the U.S. Government with direct access to databases containing its stored telephone and internet records, and have disclosed and are currently disclosing to the U.S. Government records concerning communications to which Plaintiffs and class members were a party. Plaintiffs seek damages, a declaratory judgment, and injunctive relief for violations of the First and Fourth Amendments to the United States Constitution, the Foreign Intelligence Surveillance Act, the Electronic Communications Privacy Act, and other federal and California statutes. In April 2006, we filed a Motion to Dismiss the complaint. 41 AT&T INC. MARCH 31, 2006 Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in millions except per share amounts ACCOUNTING POLICIES AND STANDARDS Pension and Other Postemployment Benefit PlansOn March 31, 2006, the Financial Accounting Standards Board (FASB) issued the exposure draft “Employers’ Accounting for Defined Benefit Pension and Other Postemployment Benefit Plans, an amendment of FASB Statements 87, 88, 106, and 132(R).” The exposure draft is phase one of the FASB’s stated intent to reform the pension and other postretirement accounting and reporting standards and, if adopted in its current form, would (1) require companies to recognize the current economic status on the balance sheet (whether over funded or under funded for GAAP purposes but not for ERISA purposes), (2) require plan obligations to be measured as of the date of the employer’s statement of financial position (which we currently do) and (3) require adoption for fiscal years ending after December 15, 2006, which would affect our year-end 2006 reporting. This exposure draft is subject to a public comment period ending May 31, 2006 and further review and amendment by the FASB; it is uncertain what the requirements of a final statement would be, when issued. However, had this exposure draft been in effect at December 31, 2005, we would have reduced our pension assets approximately $8,700 and increased our postretirement benefit obligation approximately $7,300. The after tax reduction to our stockholders’ equity would have been approximately $10,000. 42 AT&T INC. MARCH 31, 2006 Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in millions except per share amounts LIQUIDITY AND CAPITAL RESOURCES We had $406$1,057 in cash and cash equivalents available at June 30, 2005.March 31, 2006. Cash and cash equivalents included cash of approximately $292,$611, money market funds of $42$335 and other cash equivalents of $72. The decline in cash and cash equivalents of $354 since December 31, 2004$111. Cash was due to cash used to meet the financing needs of the business including, but not limited to, payment of operating expenses, funding capital expenditures, dividends to stockholders, repaymentfunding of debt, increased tax depositsCingular’s capital and operating requirements in accordance with the terms of our agreement with Cingular and BellSouth, tax-related payments and the decrease in cash related to the payment of our liability associated with our discontinued operations. This decline was partially offset primarily by cash receipts from operations and cash received from Cingular.debt repayments. We discuss many of these factors in detail below. Cash fromProvided by Operating Activities During the first six monthsquarter of 20052006, our primary source of funds was cash from operating activities of $5,040 as$2,458 compared to $5,691 for$1,253 in the first six monthsquarter of 2004. This decline was2005. Operating cash flows increased in the first quarter of 2006 compared to 2005 primarily due to increasedlower tax payments in the first quarter of 2006 of approximately $1,041 for$573 and the first six monthsadditional cash from operations related to our acquisition of 2005 reduced by retirement benefit fundingATTC. Included in the lower tax payment amount is a refund received from the completion of $232 in 2004.the ATTC federal income tax audit covering 1997 – 2001. The 2005 and 2006 tax payments includedinclude amounts related to prior year accrued liabilities. The timing of cash payments for income taxes, which is governed by the Internal Revenue Service and other taxing jurisdictions, will differ from the timing of recording tax expense and deferred income taxes, which are reported in accordance with GAAP. We also made advance tax payments in 2005, which we consider to be a refundable deposit, to a certain state jurisdiction. These payments were made in order to avoid potentially onerous interest and penalties. The issues involved are in dispute and we intend to pursue all procedural options available to us in order to obtain refunds of the amounts deposited. For calendar year 2005, weWe do not expect ouranticipate 2006 cash payments for income taxes to exceed our reported income tax expense. During the first six months of 2004 our primary sources of funds were cash from operating activities of $5,691 and proceeds of $5,179 primarily from the sale of non-strategic international investments.
Cash fromUsed in Investing Activities ForIn the first six monthsquarter of 2005,2006, cash used for investing activities consisted of:
$2,3291,821 in construction and capital expenditures; andexpenditures. $169699 of funding of Cingular’s capital and operating requirements in accordance with the terms of our agreement with Cingular and BellSouth. See our “Cingular” section below for details. $62 related to an investment in 2Wire Inc., a privately held company that provides services related to Project Lightspeed. In the first quarter of 2006, cash provided by our investing activities of $27 was related to the acquisitionsale of Yantra Corp., a provider of distributed order managementCovad shares and supply chain fulfillment solutions.other assets. To provide high-quality communications services to our customers, we must make significant investments in property, plant and equipment. The amount of capital investment is influenced by demand for services and products, continued growth and regulatory considerations. Our capital expenditures totaled $1,821 in the first quarter of 2006 and $1,050 in the first quarter of 2005. Capital expenditures in the wireline segment, which represented substantially all of our total capital expenditures, increased by approximately 8.6% for72.0% in the first six monthsquarter of 2005 as2006 compared to the same period in 2004. In response to an improving federal regulatory environmentfirst quarter of 2005 and competition, we announced our Project Lightspeed initiative (see “Other Business Matters”) and expect to spend approximately $4,000 through 2008 in deployment costs and $1,000 in customer-activationwas impacted by the acquisition of ATTC. Our first quarter capital expenditures beginning in 2006 through the first half of 2008. We expect total capital spending for 2005 to be at the low end of our targeted range of $5,400 to $5,700, excluding Cingular, substantially all of which we expect to relate to our wireline segmentwere used primarily for our wireline subsidiaries’ networks (including ATTC), Project Lightspeed and support systems for our long-distance service. We expect to continue to fund these expenditures using cash from operations and incremental borrowings, depending on interest rate levels and overall market conditions. The international segment should be self-funding as it consists 47
43 SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in Millionsmillions except per share amounts LIQUIDITY AND CAPITAL RESOURCES -– Continued Because of opportunities made available by the continued changing regulatory environment and our acquisition of ATTC, we expect that our capital expenditures in 2006, which includes Project Lightspeed and excludes Cingular, will be in the target range of between $8,000 and $8,500. We expect to spend approximately $4,400 on our Project Lightspeed initiative for network related deployment costs and capital expenditures through 2008, as well as additional success-based customer activation capital expenditures. We expect that the business opportunities made available, specifically in the data/broadband area, will allow us to expand our products and services (see “Project Lightspeed” discussed in “Other Business Matters”). substantially
We expect to fund 2006 capital expenditures for our wireline segment, which includes international operations, using cash from operations and incremental borrowings, depending on interest rate levels and overall market conditions. Substantially all of our capital spending in 2006 will relate to our wireline segment and will be used primarily for our subsidiaries’ networks, Project Lightspeed and merger-integration projects. The other segment capital expenditures were less than 2.0% of total capital expenditures in the first quarter of 2006. Included in the other segment are equity investments, andwhich should be self-funding as they are not direct SBCAT&T operations, as well as corporate and Sterling operations. We expect to fund any directory segment capital expenditures using cash from operations. We discuss our Cingular segment below. For the first six months of 2005, cash provided by our investing activities consisted of:
•
| approximately $1,182 in accordance with the terms of our agreement with Cingular and BellSouth. See our “Cingular” section below for details;
| •
| $98 related to maturities of other held-to-maturity securities, which have maturities greater than 90 days;
| •
| $86 primarily from the sale of shares of Amdocs, Yahoo and the sale of our entire interest in SpectraSite; and
| •
| $37 related to the repayment of a note receivable from an international investment.
|
Cash fromUsed in Financing Activities We plan to fund our 2006 financing activities primarily through cash from operations. We will continue to examine opportunities to fund our activities with cash from the disposition of certain assets and other investments as well as issuing debt at favorable rates in order to refinance some of our debt maturities in 2006. We paid cash dividends of $2,130$1,289 in the first quarter of 2006 compared to $1,066 in the first quarter of 2005, reflecting the issuance of additional shares for the first six monthsATTC acquisition and a dividend increase. Dividends declared by our Board of 2005 compared to $2,069 forDirectors totaled $0.3325 per share in the first six monthsquarter of 2004. The $61 increase was due to an2006 and $0.3225 per share in the first quarter of 2005. In December 2005, our Board of Directors approved a 3.1% increase in the regular quarterly dividend from $0.3125 to $0.3225$0.3325 per share approved by our Board of Directors in December 2004. On June 24, 2005, our Board of Directors declared a second quarter dividend of $0.3225 per share, which was paid on August 1, 2005.share. Our dividend policy considers both the expectations and requirements of stockholders, internal requirements of SBCAT&T and long-term growth opportunities. It is our intent to provide the financial flexibility to allow our Board of Directors the opportunity to continue our historical approach to dividend growth. All dividends remain subject to approval by our Board of Directors. DuringOur Board of Directors authorized the repurchase of up to 400 million shares of our common stock; this authorization expires at the end of 2008. Under this repurchase program we expect to purchase approximately $2,000 of additional shares under our repurchase program in the remainder of 2006 and $8,000 during 2007. We did not repurchase any shares in the first halfquarter of 20052006.
At March 31, 2006 we used our available excess cash primarilyhad $5,712 of debt maturing within one year, which includes $4,015 of long-term debt maturities during 2006, $1,627 of commercial paper borrowings and $70 of bank borrowings relating to reduce our debt levels. In the first six monthsforeign subsidiaries of 2005 we repaid $1,037 ofATTC. Included in our long-term debt maturities was the purchase accounting 44 AT&T INC. MARCH 31, 2006 Item 2. Management’s Discussion and Analysis of which approximately $786Financial Condition and Results of Operations Dollars in millions except per share amounts LIQUIDITY AND CAPITAL RESOURCES – Continued fair value debt adjustment applicable to the acquisition of ATTC. All of our commercial paper borrowings are due within 90 days. The bank borrowings availability is contingent on the level of cash held by some of our foreign subsidiaries. We continue to examine our mix of short- and long-term debt in light of interest rate trends. During the first quarter of 2006, debt repayments totaled $261 and consisted of: $254 related to debt maturities with interest rates ranging from 6.25%5.875% to 9.50%; $238 related to the exercise of a put on our 5.95% notes originally maturing in 2038; and $136.96%. $7 related to scheduled principal payments on other debt. Funds from operations were primarily used to repay these notes.debt and short-term borrowings. In July 2005, we redeemed approximately $809At March 31, 2006, our debt ratio was 36.4% compared to our debt ratio of callable debt40.2% at March 31, 2005. The decrease was primarily by issuing commercial paper and with cash from operations. Additionally, we will repay $300due to our acquisition of long-term debt scheduled to mature forATTC in the remainderfourth quarter of 2005, with cash from operations. Forwhich increased stockholders’ equity by more than $14,500 compared to the second halffirst quarter of 2005, partially offset by ATTC debt we expectnow reflect on our balance sheet following the acquisition. Our debt ratio at December 31, 2005 was 35.9%. The increase in the debt ratio from year-end is due to shift our emphasis on using available excess cash from reducing our long-terma net increase in debt of more than $900 in the first quarter of 2006, including net advances to examining opportunities to repurchase sharesCingular and refinancing of SBC common stock under our repurchase program.
Our consolidated commercial paper borrowings totaled approximately $3,515 at June 30, 2005. All of these commercial paper borrowings are due within 90 days.
In June 2005, a subsidiary of SBC received proceeds of approximately $234 from a registered offering of 10,000,000 shares of SBC’s common stock.debt, which was partially offset by an increase in stockholders’ equity.
We have a 3-year credit agreement totaling $6,000 with a syndicate of banks, which expires on October 18, 2007. Advances under this agreement may be used for general corporate purposes, including support of commercial 48
SBC COMMUNICATIONS INC.
JUNE 30, 2005
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Dollars in Millions except per share amounts
LIQUIDITY AND CAPITAL RESOURCES - Continued
paper borrowings and other short-term borrowings. There is no material adverse change provision governing the drawdown of advances under this credit agreement. We are in compliance with all covenants under the agreement. We had no borrowings outstanding under committed lines of credit as of June 30, 2005. At June 30, 2005, our debt ratio was 38.3% compared to our debt ratio of 31% at June 30, 2004. The increase was primarily due to additional debt of $8,750 we issued in the fourth quarter of 2004 to fund our portion of Cingular’s acquisition of AT&T Wireless.
In December 2003, our Board of Directors authorized the repurchase of up to 350 million shares of SBC common stock; this authorization expires at the end of 2008. During the second quarter of 2005, we repurchased 10 million shares at a cost of approximately $235.March 31, 2006.
Pending Acquisition of AT&TBellSouth On January 30, 2005,March 4, 2006, we agreed to acquire AT&TBellSouth in a transaction in which each share of AT&TBellSouth common stock will be exchanged for 0.779421.325 shares of a share of SBCAT&T common stock (equivalent to approximately 19% of SBC’s outstanding shares as of June 30, 2005). In addition, immediately prior to the closing of the transaction, AT&T will pay each AT&T shareholder a special dividend of $1.30 per share.stock. Based on the average closing price of SBC common stock on January 28, 2005,AT&T shares for the exchange ratio equals $18.41 per sharetwo days prior to, including, and two days subsequent to the public announcement of the merger (March 5, 2006) of $27.32, the total transaction is valued, for purchase accounting purposes, at approximately $16,000, including the special dividend. After the acquisition, AT&T will be a wholly owned subsidiary of SBC. The transaction has been approved by the Board of Directors of each company and was also approved on June 30, 2005 by the shareholders of AT&T. The transaction is subject to review by the DOJ and approval by the FCC and various other regulatory authorities. We expect the transaction to close by late 2005. See “Other Business Matters” for more details.$65,000. Cingular The upgrade, integration and expansion of the Cingular and AT&T Wireless networks and the networks acquired in a transaction with Triton PCS Holdings, Inc. will continue to require substantial amounts of capital over the next several years. As of March 31, 2006, Cingular has spent $1,441 primarily for GSM/GPRS/EDGE network upgrades with cash from operations, dispositions and, as needed, advances under the revolving credit agreement mentioned below. Cingular expects to fund its capital requirements in 2006 from existing cash balances, cash generated from operations and, if necessary, drawing under the revolving credit agreement. In 2006, Cingular expects to spend within a target range of between $7,000 and $7,500 primarily for the upgrade, integration and expansion of its networks, the installation of UMTS/HSDPA technology in a number of markets and the construction and upgrade of network facilities in California and Nevada following the sale of duplicate facilities to T-Mobile upon the termination of Cingular’s GSMF network infrastructure joint venture. 4945
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in Millionsmillions except per share amounts LIQUIDITY AND CAPITAL RESOURCES -– Continued Cingular’s cash requirements may increase if they participate in the upcoming FCC spectrum auction and are successful in bidding. Cingular
Effective August 1, 2004, weWe and BellSouth agreed to finance Cingular’s capital and operating cash requirements to the extent Cingular requires funding above the level provided by operations. We and BellSouth also entered into a one-year revolving credit agreement with Cingular to provide short-term financing for operations on a pro rata basis at an interest rate of LIBOR (London Interbank OfferOffered Rate) plus 0.05% and may be renewed annually upon agreement of the parties. In June 2005 this agreement was renewed through, which expires July 31, 2007. This agreement includes a provision for the repayment of our and BellSouth’s shareholder loans made to Cingular in the event there are no outstanding amounts due under the revolving credit agreement and to the extent Cingular has excess cash, as defined by the agreement. During the first six monthsquarter of 2005,2006 we receivedmade net repayments totaling approximately $1,182 fromadvances to Cingular in accordance withof $699 under the terms of this revolving credit agreement. Our shareThese amounts increased the outstanding amount of advances made to Cingular related to this revolving credit agreement was approximately $0a total of $1,006 at June 30, 2005 and $1,002March 31, 2006 from $307 at December 31, 20042005 and wasare reflected in “Investments in and Advances to Cingular Wireless” on our Consolidated Balance Sheet.Sheets.
The remaining $180 of Cingular’s revolving credit repayments, mentioned above, for the first six months of 2005 were applied as a reduction to our shareholder loan to Cingular, which totaled approximately $5,675 at June 30, 2005 and $5,855 at December 31, 2004. In July 2005, we received additional net repayments totaling approximately $1,179 from Cingular in accordance with the terms of this revolving credit agreement. Since there were no outstanding amounts due under this agreement, this $1,179 was also applied as a reduction on our shareholder loan to Cingular in July 2005.
The upgrade, integration and expansion of the Cingular and AT&T Wireless networks and the networks acquired in a transaction with Triton PCS Holdings, Inc. will require substantial amounts of capital over the next several years. Cingular expects to fund its capital requirements for at least the next 12 months from existing cash balances, cash generated from operations and, if necessary, drawing under the revolving credit agreement with us and BellSouth, mentioned previously. As of June 30, 2005, Cingular has spent $3,159 primarily for GSM/GPRS/EDGE network upgrades with cash from operations, dispositions and, as needed, the revolving credit agreement mentioned previously.
5046
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 3. Quantitative and Qualitative Disclosures About Market Risk Dollars in millions At June 30, 2005,March 31, 2006, we had interest rate swaps with a notional value of $4,250 and a fair value liability of approximately $106.$70. Item 4. Controls and Procedures The registrant maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed by the registrant is recorded, processed, summarized, accumulated and communicated to its management, including its principal executive and principal financial officers, to allow timely decisions regarding required disclosure, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. The chief executive officer and chief financial officer have performed an evaluation of the effectiveness of the design and operation of the registrant’s disclosure controls and procedures as of June 30, 2005.March 31, 2006. Based on that evaluation, the chief executive officer and chief financial officer concluded that the registrant’s disclosure controls and procedures were effective as of June 30, 2005.March 31, 2006. 5147
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
CAUTIONARY LANGUAGE CONCERNING FORWARD-LOOKING STATEMENTS Information set forth in this report contains forward-looking statements that are subject to risks and uncertainties, and actual results could differ materially. Many of the factors listed here are discussed in more detail in the “Risk Factors” section in our Annual Report on Form 10-K and updated in the “Risk Factors” section below. We claim the protection of the safe harbor for forward-looking statements provided by the Private Securities Litigation Reform Act of 1995. The following factors could cause our future results to differ materially from those expressed in the forward-looking statements: •
| Adverse economic changes in the markets served by us or in countries in which we have significant investments.
| •
| Changes in available technology and the effects of such changes including product substitutions and deployment costs.
| •
| Increases in our benefit plans’ costs including increases due to adverse changes in the U.S. securities markets, resulting in worse-than-assumed investment returns and discount rates, and adverse medical cost trends.
| •
| The final outcome of Federal Communications Commission proceedings and reopenings of such proceedings and judicial review, if any, of such proceedings, including issues relating to access charges, broadband deployment, availability and pricing of unbundled network elements and platforms (UNE-Ps) and unbundled loop and transport elements (EELs).
| •
| The final outcome of regulatory proceedings in our 13-state area and reopenings of such proceedings, and judicial review, if any, of such proceedings, including proceedings relating to interconnection terms, access charges, universal service, UNE-Ps and resale and wholesale rates, broadband deployment including Project Lightspeed, performance measurement plans, service standards and traffic compensation.
| •
| Enactment of additional state, federal and/or foreign regulatory and tax laws and regulations pertaining to our subsidiaries and foreign investments.
| •
| Our ability to absorb revenue losses caused by increasing competition, including offerings using alternative technologies (e.g., cable, wireless and VoIP) and UNE-P requirements, and to maintain capital expenditures.
| •
| The extent of competition in our 13-state area and the resulting pressure on access line totals and wireline and wireless operating margins.
| •
| Our ability to develop attractive and profitable product/service offerings to offset increasing competition in our wireline and wireless markets.
| •
| The ability of our competitors to offer product/service offerings at lower prices due to lower cost structures and adverse regulatory and legislative actions, including state regulatory proceedings relating to UNE-Ps and nonregulation of comparable alternative technologies (e.g., VoIP).
| •
| The timing, extent and cost of deployment of our Project Lightspeed broadband initiative, the development of attractive and profitable service offerings, the extent to which regulatory, franchise fees and build-out requirements apply to this initiative and the availability and reliability of the various technologies required to provide such offerings.
| •
| The issuance by the Financial Accounting Standards Board or other accounting oversight bodies of new accounting standards or changes to existing standards.
| •
| The issuance by the Internal Revenue Service and/or state tax authorities of new tax regulations or changes to existing standards and actions by federal, state or local tax agencies and judicial authorities with respect to applying applicable tax laws and regulations; and the resolution of disputes with any taxing jurisdictions.
|
Adverse economic changes in the markets served by us or in countries in which we have significant investments. Changes in available technology and the effects of such changes including product substitutions and deployment costs. Increases in our benefit plans’ costs including increases due to adverse changes in the U.S. securities markets, resulting in worse-than-assumed investment returns and discount rates, and adverse medical cost trends. The final outcome of Federal Communications Commission proceedings and reopenings of such proceedings and judicial review, if any, of such proceedings, including issues relating to access charges, broadband deployment, availability and pricing of unbundled network elements and platforms (UNE-Ps) and unbundled loop and transport elements. The final outcome of regulatory proceedings in the states in which we operate and reopenings of such proceedings, and judicial review, if any, of such proceedings, including proceedings relating to interconnection terms, access charges, universal service, UNE-Ps and resale and wholesale rates, broadband deployment including Project Lightspeed, performance measurement plans, service standards and traffic compensation. Enactment of additional state, federal and/or foreign regulatory and tax laws and regulations pertaining to our subsidiaries and foreign investments. Our ability to absorb revenue losses caused by increasing competition, including offerings using alternative technologies (e.g., cable, wireless and VoIP), and our ability to maintain capital expenditures. The extent of competition and the resulting pressure on access line totals and wireline and wireless operating margins. Our ability to develop attractive and profitable product/service offerings to offset increasing competition in our wireline and wireless markets. The ability of our competitors to offer product/service offerings at lower prices due to lower cost structures and regulatory and legislative actions adverse to us, including state regulatory proceedings relating to UNE-Ps and nonregulation of comparable alternative technologies (e.g., VoIP). The timing, extent and cost of deployment of our Project Lightspeed initiative; the development of attractive and profitable service offerings; the extent to which regulatory, franchise fees and build-out requirements apply to this initiative, and; the availability, cost and/or reliability of the various technologies and/or content required to provide such offerings. The issuance by the Financial Accounting Standards Board or other accounting oversight bodies of new accounting standards or changes to existing standards. The issuance by the Internal Revenue Service and/or state tax authorities of new tax regulations or changes to existing standards and actions by federal, state or local tax agencies and judicial authorities 5248
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
CAUTIONARY LANGUAGE CONCERNING FORWARD-LOOKING STATEMENTS - Continued •
| The impact of the wireless joint venture with BellSouth, known as Cingular, including marketing and product-development efforts, customer acquisition and retention costs, access to additional spectrum, network upgrades, technological advancements, industry consolidation including the acquisition of AT&T Wireless and availability and cost of capital.
| •
| Cingular’s failure to achieve, in the amounts and within the timeframe expected, the capital and expense synergies and other benefits expected from its acquisition of AT&T Wireless.
| •
| The impact of our pending acquisition of AT&T, including our ability to obtain governmental approvals of the acquisition on the proposed terms and schedule; the risk that the businesses will not be integrated successfully; the risk that the cost savings and any other synergies from the acquisition may not be fully realized or may take longer to realize than expected; disruption from the acquisition making it more difficult to maintain relationships with customers, employees or suppliers; and competition and its effect on pricing, spending, third-party relationships and revenues.
| •
| Changes in our corporate strategies, such as changing network requirements or acquisitions and dispositions, to respond to competition and regulatory, legislative and technological developments.
|
with respect to applying applicable tax laws and regulations; and the resolution of disputes with any taxing jurisdictions. The impact of the wireless joint venture with BellSouth, known as Cingular, including: marketing and product-development efforts; customer acquisition and retention costs; access to additional spectrum; network upgrades; technological advancements; industry consolidation, including the acquisition of AT&T Wireless, and; availability and cost of capital. Cingular’s failure to achieve, in the amounts and within the time frame expected, the capital and expense synergies and other benefits expected from its acquisition of AT&T Wireless. The impact of our pending acquisition of BellSouth, including our ability to obtain shareholder and governmental approvals of the acquisition on the proposed terms and schedule; the risk that the businesses will not be integrated successfully; the risk that the cost savings and any other synergies from the acquisition may take longer to realize than expected or may not be fully realized; and the disruption from the acquisition making it more difficult to maintain relationships with customers, employees or suppliers. The impact of our acquisition of ATTC, including the risk that the businesses will not be integrated successfully; the risk that the cost savings and any other synergies from the acquisition may not be fully realized or may take longer to realize than expected; disruption from the integration process making it more difficult to maintain relationships with customers, employees or suppliers; and competition and its effect on pricing, spending, third-party relationships and revenues. Changes in our corporate strategies, such as changing network requirements or acquisitions and dispositions, to respond to competition and regulatory, legislative and technological developments. Readers are cautioned that other factors discussed in this report, although not mentionedlisted here, also could materially impactaffect our future earnings. 5349
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
PART II - OTHER INFORMATION Dollars in millions except per share amounts Item 1A. Risk Factors We discuss in our Annual Report on Form 10-K various risks that may materially affect our business. We use this section to update this discussion to reflect material developments since our Form 10-K was filed. The impact of our pending acquisition of BellSouth, including our ability to obtain shareholder and governmental approvals of the acquisition on the proposed terms and schedule; the risk that the businesses will not be integrated successfully; the risk that the cost savings and any other synergies from the acquisition may take longer to realize than expected or may not be fully realized; and disruption from the acquisition making it more difficult to maintain relationships with customers, employees or suppliers. We agreed to acquire BellSouth in order to streamline the ownership and operations of Cingular and combine the Cingular, BellSouth and AT&T IP networks into a single IP network; to speed the deployment, and at lower cost, of next-generation IP video and other services; to provide business customers with the benefits of combining AT&T’s national and international networks and services with BellSouth’s local exchange and broadband services; and to create potential cost savings, technological development and other benefits. Achieving these results will depend in part on successfully integrating three large corporations, which could involve significant management attention and create uncertainties for employees; additionally, we and Cingular are already in the process of integrating previous acquisitions. Uncertainty among employees could adversely affect the ability of AT&T, BellSouth and Cingular to attract and retain key employees. Diversion of attention from ongoing operations on the part of management and employees could adversely affect our customers, suppliers and other parties with whom we have relationships. While the merger is pending, customers and strategic partners may delay or defer decisions to use services of each of the three companies, which could adversely affect the revenues and earnings of each company as well as the market prices of AT&T and BellSouth common shares. We also expect to incur substantial expenses related to the integration of these companies. We must integrate a large number of systems, both operational and administrative. These integration expenses may result in our taking significant charges against earnings, both cash and non-cash, primarily from the amortization of intangibles. Delays in this process could have a material adverse effect on our revenues, expenses, operating results and financial condition. In addition, events outside of our control, including changes in state and federal regulation and laws as well as economic trends, also could adversely affect our ability to realize the expected benefits from this acquisition. Item 2. Unregistered Sales of Securities and Use of Proceeds (a) | During the secondfirst quarter of 2005,2006, non-employee directors acquired from SBCAT&T shares of common stock pursuant to SBC’sAT&T’s Non-Employee Director Stock and Deferral Plan. Under the plan, a director may make an annual election to receive all or part of his or her: (1) annual retainer in the form of SBCAT&T shares or deferred stock units (DSUs) and (2) fees in the form of DSUs. DSUs are convertible into SBCAT&T shares. Also under the plan, each Director will receive an annual grant of DSUs during the second quarter. During this period,In the first quarter an aggregate of 68,080 SBC13,551 AT&T shares and DSUs were acquired by non-employee directors at prices ranging from $23.38$25.95 to $23.80,$27.59, in each case the fair market value of the shares on the date of acquisition. The issuances of shares and DSUs were exempt from registration pursuant to Section 4(2) of the Securities Act. |
(c)
| Issuer Equity Repurchases – In December 2003, our Board of Directors authorized the repurchase of up to 350 million shares of SBC common stock; this authorization expires at the end of 2008. As part of this program, during the second quarter of 2005, we repurchased 10 million shares at a cost of approximately $235, as shown below.
|
Purchase Period | Total
Number of
Shares
Purchased | Average
Price
Paid per
Share | Total Number of
Shares Purchased as
Part of Publicly
Announced Plans or
Programs | Maximum Number of
Shares that May Yet Be
Purchased Under the
Plans or Programs | April 29, 2005 – April 30, 2005 | 2,500,000 | $ 23.30 | 2,500,000 | 330,250,000 | May 2, 2005 – May 4, 2005 | 7,500,000 | $ 23.56 | 7,500,000 | 322,750,000 | Total | 10,000,000 | $ 23.49 | 10,000,000 | 322,750,000 |
5450
SBC COMMUNICATIONSAT&T INC.
JUNE 30, 2005MARCH 31, 2006
Item 4. Submission of Matters to a Vote of Security Holders
Annual Meeting of Stockholders
(a)
| The annual meeting of the stockholders of SBC Communications Inc. (SBC) was held on April 29, 2005, in San Antonio, Texas. Stockholders representing 2,740,587,249, or 82.96%, of the common shares outstanding as of the March 1, 2005 record date were present in person or were represented at the meeting by proxy.
|
(b)
| At the meeting, holders of common shares voted as indicated below to elect the following persons to the Board of Directors for a one-year term:
|
DIRECTOR | SHARES FOR | SHARES WITHHELD* | Edward E. Whitacre Jr. | 2,607,583,080 | 133,004,169 | Gilbert F. Amelio | 2,635,763,699 | 104,823,550 | August A. Busch III | 2,570,269,662 | 170,317,587 | Martin K. Eby, Jr. | 2,626,863,207 | 113,724,042 | James A. Henderson | 2,629,753,067 | 110,834,182 | Charles F. Knight | 2,626,484,442 | 114,102,807 | Lynn M. Martin | 2,631,876,705 | 108,710,544 | John B. McCoy | 2,634,426,468 | 106,160,781 | Mary S. Metz | 2,634,701,672 | 105,885,577 | Toni Rembe | 2,566,908,773 | 173,678,476 | S. Donley Ritchey | 2,634,806,896 | 105,780,353 | Joyce M. Roche | 2,636,346,837 | 104,240,412 | Laura D’Andrea Tyson | 2,637,574,188 | 103,013,061 | Patricia P. Upton | 2,628,743,891 | 111,843,358 |
*Includes shares represented at the meeting by proxy where the shareowner withheld authority to vote for the indicated director or directors, as well as shares present at the meeting which were not voted for such director or directors.
In addition, the following two directors retired from the Board of Directors at the Annual Meeting:
|
The Honorable William P. Clark
|
(c)
| Stockholders ratified the appointment of Ernst & Young LLP as independent auditors of SBC for the year ended December 31, 2005. The vote was 2,652,218,492 FOR and 55,839,717 AGAINST, with 32,529,040 shares ABSTAINING.
|
(d)
| Stockholders approved the creation of a new stock purchase and deferral plan for SBC managers that replaces a similar plan created in 1991. The vote was 2,087,929,830 FOR and 126,214,080 AGAINST, with 47,793,009 ABSTAINING.
|
(e)
| Stockholders defeated a proposal seeking additional disclosure by the company of its corporate political contributions. The vote was 257,197,550 FOR and 1,800,373,769 AGAINST, with 204,365,600 ABSTAINING.
|
55
SBC COMMUNICATIONS INC.
JUNE 30, 2005
(f)
| Stockholders defeated a proposal requesting a review of executive compensation. The vote was 266,455,867 FOR and 1,828,018,350 AGAINST, with 167,462,702 ABSTAINING.
|
(g)
| Stockholders defeated a proposal calling for adoption of a performance and time-based restricted share grant program for senior executives. The vote was 381,505,141 FOR and 1,814,595,780 AGAINST, with 65,835,998 ABSTAINING.
|
(h)
| Stockholders approved a proposal that would require a simple majority vote for matters put to a vote of SBC stockholders. The vote was 1,371,171,459 FOR and 823,202,525 AGAINST, with 67,562,935 ABSTAINING.
|
Item 6. Exhibits Exhibits identified in parenthesisparentheses below, on file with the Securities and Exchange Commission (SEC), are incorporated by reference as exhibits hereto. Unless otherwise indicated, all exhibits so incorporated are from File No. 1-8610. 10-bb2
| Amended And Agreement and Plan of Merger, dated as of March 4, 2006, among BellSouth Corporation, AT&T Inc. and ABC Consolidation Corp. (Exhibit 2.1 to Form 8-K dated March 4, 2006.)
| 3-a | Restated Revolving Credit AgreementCertificate of Incorporation, filed with Cingular Wireless LLCthe Secretary of State of Delaware on November 18, 2005. (Exhibit 3-a to Form 8-K dated November 18, 2005.) | 3-b | Certificate of Amendment to the Restated Certificate of Incorporation, filed with the state of Delaware on May 3, 2006. (Exhibit 3-b to Form 8-K dated April 28, 2006.) | 3-c | Bylaws amended May 3, 2006. (Exhibit 3-c to Form 8-K dated April 28, 2006.) | 10-cc | Stock Purchase and Deferral Plan. | 10-dd | Cash Deferral Plan. | 12 | Computation of Ratios of Earnings to Fixed Charges | | 31 | Rule 13a-14(a)/15d-14(a) Certifications | | | 31.1 | Certification of Principal Executive Officer | | | 31.2 | Certification of Principal Financial Officer | | 32 | Section 1350 Certifications | | | | | | | | | | | |
5651
SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SBC Communications
| AT&T Inc. |
August 4, 2005May 5, 2006
| /s/Richard G. Lindner | | | | Richard G. Lindner | | | Senior Executive Vice President | | | | | |
and Chief Financial Officer |