PART I - FINANCIAL INFORMATION | Item 1. Financial Statements | | AT&T INC. | CONSOLIDATED STATEMENTS OF INCOME | Dollars in millions except per share amounts | (Unaudited) | | | Three months ended | | Nine months ended | | | March 31,September 30,
| | September 30, | | | 2006 | | 2005 | | 2006 | | 2005 | Operating Revenues | | | | | | | | | Voice | $ | 8,7228,464
| $ | 5,8525,743
| $ | 25,725 | $ | 17,355 | Data | | 4,4424,546
| | 2,3912,514
| | 13,465 | | 7,343 | Directory | | 901906
| | 905917
| | 2,716 | | 2,723 | Other | | 1,7701,722
| | 1,1001,130
| | 5,258 | | 3,434 | Total operating revenues | | 15,83515,638
| | 10,24810,304
| | 47,164 | | 30,855 | Operating Expenses | | | | | | | | | Cost of sales (exclusive of depreciation and amortization | | | | | | | | | amortization shown separately below) | | 7,1286,664
| | 4,3884,364
| | 20,641 | | 13,153 | Selling, general and administrative | | 4,0243,620
| | 2,4792,175
| | 11,396 | | 7,229 | Depreciation and amortization | | 2,4922,437
| | 1,8251,803
| | 7,415 | | 5,437 | Total operating expenses | | 13,64412,721
| | 8,6928,342
| | 39,452 | | 25,819 | Operating Income | | 2,1912,917
| | 1,5561,962
| | 7,712 | | 5,036 | Other Income (Expense) | | | | | | | | | Interest expense | | (464)(442)
| | (353)(349)
| | (1,378) | | (1,051) | Interest income | | 8598
| | 10982
| | 278 | | 291 | Equity in net income (loss) of affiliates | | 334649
| | (58)219
| | 1,438 | | 342 | Other income (expense) – net | | 11 | | 47(70)
| | 37 | | 11 | Total other income (expense) | | (34)316
| | (255)(118)
| | 375 | | (407) | Income Before Income Taxes | | 2,1573,233
| | 1,3011,844
| | 8,087 | | 4,629 | Income taxes | | 7121,068
| | 416598
| | 2,669 | | 1,498 | Net Income | $ | 1,4452,165
| $ | 8851,246
| $ | 5,418 | $ | 3,131 | Earnings Per Common Share: | | | | | | | | | Net Income | $ | 0.370.56
| $ | 0.270.38
| $ | 1.40 | $ | 0.95 | Earnings Per Common Share - Assuming Dilution: | | | | | | | | | Net Income | $ | 0.370.56
| $ | 0.270.38
| $ | 1.39 | $ | 0.95 | Weighted Average Number of Common | | | | | | | | | Shares Outstanding– Basic (in millions) | | 3,8823,873
| | 3,3033,296
| | 3,880 | | 3,300 | Dividends Declared Per Common Share | $ | 0.3325 | $ | 0.3225 | $ | 0.9975 | $ | 0.9675 |
See Notes to Consolidated Financial Statements. 2 AT&T INC. | AT&T INC. | AT&T INC. | CONSOLIDATED BALANCE SHEETS | CONSOLIDATED BALANCE SHEETS | CONSOLIDATED BALANCE SHEETS | Dollars in millions except per share amounts | | | | | | | | | | | | | March 31, | | | December 31, | | September 30, | | | December 31, | | | 2006 | | | 2005 | | 2006 | | | 2005 | Assets | | (Unaudited) | | | | | (Unaudited) | | | | Current Assets | | | | | | | | | | | Cash and cash equivalents | $ | 1,057 | | $ | 1,224 | $ | 1,251 | | $ | 1,224 | Accounts receivable – net of allowances for | | | | | | | | | | | uncollectibles of $1,131 and $1,176 | | 8,647 | | | 9,351 | | uncollectibles of $936 and $1,176 | | | 8,668 | | | 9,351 | Prepaid expenses | | 1,215 | | | 1,029 | | 1,038 | | | 1,029 | Deferred income taxes | | 1,874 | | | 2,011 | | 1,598 | | | 2,011 | Other current assets | | 1,057 | | | 1,039 | | 957 | | | 1,039 | Total current assets | | 13,850 | | | 14,654 | | 13,512 | | | 14,654 | Property, plant and equipment | | 150,516 | | 149,238 | | 152,573 | | 149,238 | Less: accumulated depreciation and amortization | | 92,149 | | | 90,511 | | 94,922 | | | 90,511 | Property, Plant and Equipment – Net | | 58,367 | | 58,727 | | 57,651 | | 58,727 | Goodwill | | 13,402 | | | 14,055 | | 13,385 | | | 14,055 | Intangible Assets – Net | | 8,214 | | | 8,503 | | 7,728 | | | 8,503 | Investments in Equity Affiliates | | 2,090 | | | 2,031 | | 2,222 | | | 2,031 | Investments in and Advances to Cingular Wireless | | 32,316 | | 31,404 | | 33,029 | | 31,404 | Other Assets | | 16,198 | | | 16,258 | | 16,365 | | | 16,258 | Total Assets | $ | 144,437 | | $ | 145,632 | $ | 143,892 | | $ | 145,632 | | | | | | | | | | | | Liabilities and Stockholders’ Equity | | | | | | | | | | | Current Liabilities | | | | | | | | | | | Debt maturing within one year | $ | 5,712 | | $ | 4,455 | $ | 4,713 | | $ | 4,455 | Accounts payable and accrued liabilities | | 15,510 | | 17,088 | | 14,789 | | 17,088 | Accrued taxes | | 2,240 | | 2,586 | | 3,122 | | 2,586 | Dividends payable | | 1,293 | | 1,289 | | 1,281 | | 1,289 | Total current liabilities | | 24,755 | | 25,418 | | 23,905 | | 25,418 | Long-Term Debt | | 25,829 | | 26,115 | | 26,799 | | 26,115 | Deferred Credits and Other Noncurrent Liabilities | | | | | | | | | Deferred income taxes | | 14,902 | | 15,713 | | 14,368 | | 15,713 | Postemployment benefit obligation | | 18,278 | | 18,133 | | 18,150 | | 18,133 | Unamortized investment tax credits | | 202 | | 209 | | 188 | | 209 | Other noncurrent liabilities | | 5,382 | | 5,354 | | 5,081 | | 5,354 | Total deferred credits and other noncurrent liabilities | | 38,764 | | 39,409 | | 37,787 | | 39,409 | | | | | | | | | | | | Stockholders’ Equity | | | | | | | | | Common shares issued ($1 par value) | | 4,065 | | 4,065 | | 4,065 | | 4,065 | Capital in excess of par value | | 27,262 | | 27,499 | | 27,116 | | 27,499 | Retained earnings | | 29,257 | | 29,106 | | 30,653 | | 29,106 | Treasury shares (at cost) | | (4,927) | | (5,406) | | (5,867) | | (5,406) | Additional minimum pension liability adjustment | | (218) | | (218) | | (218) | | (218) | Accumulated other comprehensive income | | (350) | | (356) | | (348) | | (356) | Total stockholders’ equity | | 55,089 | | 54,690 | | 55,401 | | 54,690 | Total Liabilities and Stockholders’ Equity | $ | 144,437 | | $ | 145,632 | $ | 143,892 | | $ | 145,632 |
See Notes to Consolidated Financial Statements. 3 AT&T INC. | AT&T INC. | AT&T INC. | CONSOLIDATED STATEMENTS OF CASH FLOWS | CONSOLIDATED STATEMENTS OF CASH FLOWS | CONSOLIDATED STATEMENTS OF CASH FLOWS | Dollars in millions, increase (decrease) in cash and cash equivalents | Dollars in millions, increase (decrease) in cash and cash equivalents | Dollars in millions, increase (decrease) in cash and cash equivalents | (Unaudited) | (Unaudited) | (Unaudited) | | Three Months Ended | Nine months ended | | March 31, | September 30, | | | 2006 | | 2005 | | 2006 | | 2005 | Operating Activities | | | | | | | | | Net income | $ | 1,445 | $ | 885 | $ | 5,418 | $ | 3,131 | Adjustments to reconcile net income to net cash | | | | | | | | | provided by operating activities: | | | | | | | | | Depreciation and amortization | | 2,492 | | 1,825 | | 7,415 | | 5,437 | Undistributed earnings from investments in equity affiliates | | (313) | | 74 | | (1,359) | | (285) | Provision for uncollectible accounts | | 193 | | 239 | | 450 | | 561 | Amortization of investment tax credits | | (7) | | (6) | | (21) | | (17) | Deferred income tax expense (benefit) | | 66 | | (37) | | (269) | | (315) | Net gain on sales of investments | | (8) | | (66) | | (10) | | (104) | Changes in operating assets and liabilities: | | | | | | | | | Accounts receivable | | 509 | | 128 | | 249 | | (39) | Other current assets | | (189) | | (97) | | 42 | | (249) | Accounts payable and accrued liabilities | | (2,057) | | (1,624) | | (1,819) | | (242) | Stock-based compensation tax benefit | | (8) | | (3) | | (10) | | (3) | Other - net | | 335 | | (65) | | 507 | | 508 | Total adjustments | | 1,013 | | 368 | | 5,175 | | 5,252 | Net Cash Provided by Operating Activities | | 2,458 | | 1,253 | | 10,593 | | 8,383 | Investing Activities | | | | | | | | | Construction and capital expenditures | | (1,821) | | (1,050) | | (6,158) | | (3,743) | Receipts from (investments in) affiliates – net | | (699) | | 596 | | (633) | | 2,603 | Maturities of held-to-maturity securities | | - | | 64 | | Dispositions | | 27 | | 73 | | 72 | | 126 | Acquisitions | | (62) | | (169) | | (115) | | (169) | Maturities of held-to-maturity securities | | | 3 | | 98 | Proceeds from note repayment | | - | | 37 | | - | | 37 | Other | | | 5 | | - | Net Cash Used in Investing Activities | | (2,555) | | (449) | | (6,826) | | (1,048) | Financing Activities | | | | | | | | | Net change in short-term borrowings with original | | | | | | | | | maturities of three months or less | | 1,271 | | 761 | | 2,336 | | (1,656) | Repayment of other short-term borrowings | | (2) | | - | | (3) | | - | Issuance of long-term debt | | | 1,491 | | - | Repayment of long-term debt | | (259) | | (572) | | (2,882) | | (2,123) | Purchase of treasury shares | | | (1,359) | | (742) | Issuance of treasury shares | | 201 | | 47 | | 463 | | 362 | Dividends paid | | (1,289) | | (1,066) | | (3,873) | | (3,196) | Stock-based compensation tax benefit | | 8 | | 3 | | 10 | | 3 | Other | | | 77 | | - | Net Cash Used in Financing Activities | | (70) | | (827) | | (3,740) | | (7,352) | Net increase (decrease) in cash and cash equivalents from continuing operations | | (167) | | (23) | | 27 | | (17) | Net Cash Used in Operating Activities from Discontinued Operations | | - | | (310) | | - | | (310) | Net increase (decrease) in cash and cash equivalents | | (167) | | (333) | | 27 | | (327) | Cash and cash equivalents beginning of year | | 1,224 | | 760 | | 1,224 | | 760 | Cash and Cash Equivalents End of Period | $ | 1,057 | $ | 427 | $ | 1,251 | $ | 433 | | | | | | | | | | Cash paid during the three months ended March 31 for: | | | | | | Cash paid during the nine months ended September 30 for: | | | | | | Interest | $ | 449 | $ | 413 | $ | 1,503 | $ | 1,198 | Income taxes, net of refunds | $ | 853 | $ | 1,426 | $ | 2,249 | $ | 1,535 |
See Notes to Consolidated Financial Statements. 4 AT&T INC. | AT&T INC. | AT&T INC. | | CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY | CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY | CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY | | Dollars and shares in millions, except per share amounts | Dollars and shares in millions, except per share amounts | Dollars and shares in millions, except per share amounts | | (Unaudited) | (Unaudited) | (Unaudited) | | | | Three months ended | | Nine months ended | | | March 31, 2006 | | September 30, 2006 | | | Shares | Amount | | Shares | Amount | Common Stock | Common Stock | | | | Common Stock | | | | Balance at beginning of year | Balance at beginning of year | 4,065 | $ | 4,065 | Balance at beginning of year | 4,065 | $ | 4,065 | Balance at end of period | Balance at end of period | 4,065 | $ | 4,065 | Balance at end of period | 4,065 | $ | 4,065 | | | | | | | | | | Capital in Excess of Par Value | Capital in Excess of Par Value | | | | Capital in Excess of Par Value | | | | Balance at beginning of year | Balance at beginning of year | | $ | 27,499 | Balance at beginning of year | | $ | 27,499 | Issuance of shares | Issuance of shares | | | (191) | Issuance of shares | | | (302) | Stock based compensation | Stock based compensation | | | (46) | Stock based compensation | | | (81) | Balance at end of period | Balance at end of period | | $ | 27,262 | Balance at end of period | | $ | 27,116 | | | | | | | | | | Retained Earnings | Retained Earnings | | | | Retained Earnings | | | | Balance at beginning of year | Balance at beginning of year | | $ | 29,106 | Balance at beginning of year | | $ | 29,106 | Net income ($0.37 per share) | | | 1,445 | | Dividends to stockholders ($0.3325 per share) | | | (1,292) | | Net income ($1.39 per diluted share) | | Net income ($1.39 per diluted share) | | | 5,418 | Dividends to stockholders ($1.00 per share) | | Dividends to stockholders ($1.00 per share) | | | (3,865) | Other | Other | | | (2) | Other | | | (6) | Balance at end of period | Balance at end of period | | $ | 29,257 | Balance at end of period | | $ | 30,653 | | | | | | | | | | Treasury Shares | Treasury Shares | | | | Treasury Shares | | | | Balance at beginning of year | Balance at beginning of year | (188) | $ | (5,406) | Balance at beginning of year | (188) | $ | (5,406) | Purchase of shares | | Purchase of shares | (45) | | (1,359) | Issuance of shares | Issuance of shares | 11 | | 479 | Issuance of shares | 21 | | 898 | Balance at end of period | Balance at end of period | (177) | $ | (4,927) | Balance at end of period | (212) | $ | (5,867) | | | | | | | | | | Additional Minimum Pension Liability Adjustment | Additional Minimum Pension Liability Adjustment | | | | Additional Minimum Pension Liability Adjustment | | | | Balance at beginning of year | Balance at beginning of year | | $ | (218) | Balance at beginning of year | | $ | (218) | Balance at end of period | Balance at end of period | | $ | (218) | Balance at end of period | | $ | (218) | | | | | | | | | | Accumulated Other Comprehensive Income, net of tax | Accumulated Other Comprehensive Income, net of tax | | | | Accumulated Other Comprehensive Income, net of tax | | | | Balance at beginning of year | Balance at beginning of year | | $ | (356) | Balance at beginning of year | | $ | (356) | Other comprehensive income (loss) (see Note 3) | Other comprehensive income (loss) (see Note 3) | | | 6 | Other comprehensive income (loss) (see Note 3) | | | 8 | Balance at end of period | Balance at end of period | | $ | (350) | Balance at end of period | | $ | (348) | See Notes to Consolidated Financial Statements. | | See Notes to Consolidated Financial Statements. | | See Notes to Consolidated Financial Statements. | | | | | |
5 AT&T INC. MARCH 31,SEPTEMBER 30, 2006
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Dollars in millions except per share amounts NOTE 1. SUMMARYPREPARATION OF SIGNIFICANT ACCOUNTING POLICIESINTERIM FINANCIAL STATEMENTS Basis of Presentation Throughout this document, AT&T Inc. is referred to as “AT&T,” “we” or 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, 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 internationally providing wireline and wireless telecommunications services and equipment as well as directory advertising and publishing services. 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 Board of Directors 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. ReclassificationsWe have reclassified certain amounts in prior-period financial statements to conform to the current period’s presentation. InAs a result of our November 2005 acquisition of AT&T Corp. (ATTC), in 2006, we revised our segment reporting (see Note 5). In addition, we revised the product categories reported in operating revenue as follows: long-distance voice is now reported in voice revenue; integration services andthe majority of customer premises equipment and integration services revenue, previously reported as voice and data revenue are now reported in other revenue; and directory revenues now reflect our traditional directory segment revenues. Additionally, in assessing fair value of contracts in conjunction with the acquisition of ATTC (see Note 2) we reduced revenues and operating expenses by $18 in the post-acquisition 2005 period and by $79 for the first six months of 2006 to reflect settlements with foreign carriers for transport/carrying calls at the contract incremental/cash settlement rates rather than contract swap rates. Operating Income remained unchanged.
FIN 48 In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48), an interpretation of Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (FAS 109). FIN 48 clarifies the accounting for uncertainty in income taxes by prescribing a recognition threshold for tax positions taken or expected to be taken in a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact FIN 48 will have on our financial position and results of operations. Revenue RecognitionEITF 06-3Revenues derived In June 2006, the Emerging Issues Task Force (EITF), a task force established to assist the FASB on significant emerging accounting issues, ratified the consensus on EITF 06-3, “How Taxes Collected from local telephone, long-distanceCustomers and data services are recognized when services are provided. This is based uponRemitted to Governmental Authorities Should Be Presented in the Income Statement”(EITF 06-3).EITF 06-3 provides that taxes imposed by a governmental authority on a revenue producing transaction between a seller and a customer should be shown in the income statement on either usage (e.g. minutes of traffic processed), period of time (e.g. monthly service fees)a gross 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 time revenue is recognizednet basis, based on historical experience. Cash incentives giventhe entity’s accounting policy, which should be disclosed pursuant to Accounting Principles Board Opinion No. 22, “Disclosure of Accounting Policies.” Amounts that are allowed to be charged to customers are recorded as a reduction of revenue. When required as part of providing service, revenues and associated expenses relatedan offset to nonrefundable, upfront service activation and set-up fees are deferred and recognized over the associated service contract period. If no service contract exists, thosetaxes
6 AT&T INC. MARCH 31,SEPTEMBER 30, 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 acceptedowed by customers. For agreements involving the resale of third party services in which wea company are not considered taxes collected and remitted. If such taxes are significant, and are presented on a gross basis, the primary obligoramounts 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.
We recognize revenuesthose taxes should be disclosed. EITF 06-3 will be effective for interim and expenses related to publishing directories on the amortization method, which recognizes revenues and expenses ratably over the life of the directory title, typically 12 months.
Traffic Compensation Expenseannual reporting periods beginning after December 15, 2006.We use various estimatesare currently evaluating the impact EITF 06-3 will have, but do not expect a material impact on our financial position and assumptions to determine the amountresults 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 number of circuits and the average projected circuit costs, based on historical data adjusted for rate changes. These costs are adjusted to reflect actual expenses over the three months following the end of the reporting period as bills are received.operations.
Advertising CostsFAS 157Advertising costsIn September 2006, the FASB issued Statement of Financial Accounting Standard No. 157, “Fair Value Measurements” (FAS 157). FAS 157 defines fair value, establishes a framework for advertising productsmeasuring fair value and servicesexpands disclosures about fair value measurements. FAS 157 applies under other accounting pronouncements that require or promotingpermit fair value measurement. FAS 157 does not require any new fair value measurements and we do not expect the application of this standard to change our corporate image are expensed as incurred.current practice. FAS 157 requires prospective application for fiscal years ending after November 15, 2007.
Income TaxesFAS 158Deferred income taxes are providedIn September 2006, the FASB issued Statement of Financial Accounting Standard No. 158, “Employers’ Accounting for temporary differences betweenDefined Benefit Pension and Other Postretirement Plans” (FAS 158), an amendment of Statement of Financial Accounting Standard No. 87 “Employers’ Accounting for Pensions” (FAS 87), Statement of Financial Accounting Standard No. 88 “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” Statement of Financial Accounting Standard No. 106 “Employers’ Account for Postretirement Benefits Other Than Pensions” (FAS 106) and Statement of Financial Accounting Standard No. 132(R) “Employers’ Disclosures about Pensions and Other Postretirement Benefits.” FAS 158 will require us to recognize the carrying amountsfunded status of assetsdefined benefit pension and liabilities forpostretirement plans as an asset or liability in our statement of financial reporting purposesposition and the amounts used for tax purposes. To 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 ofto recognize changes in tax laws and court rulings at both federal and state levels.
Our income tax returns are regularly audited and reviewed bythat funded status in the Internal Revenue Service (IRS) and state taxing authorities. The IRS is expected to complete fieldwork for its audit ofyear in which the 2000-2002 traditional SBC tax returns during 2006.changes occur through comprehensive income. This is not expected tostandard will have an adverse impactno effect on our expense or benefit recognition, nor will it affect the financial statements.
The IRS is also reviewingfunding requirements imposed under 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 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 ReformEmployee Retirement Income Security Act of 1986 are amortized1974, 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 March 31, 2006, we held $611 in cash, $335 in money market funds and $111 in other cash equivalents.
Allowanceamended (ERISA). FAS 158 requires prospective application 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.
Property, Plant and EquipmentProperty, plant and equipment 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 property, 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 depreciated 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 on the disposition of this plant and equipment.
Property, plant and equipment is reviewed for recoverability whenever events or changes in circumstances 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 exceeds its fair value. The carrying amount of a long-lived asset is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset.
8
AT&T INC.
MARCH 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 ratesfiscal years ending after December 15, 2006. Had FAS 158 been in effect at the balance sheet dates.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. 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 incomewill adopt FAS 158 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 riskfourth quarter 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 Instruments2006.We 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 fair 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 amortized 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 net investment hedges, along with the changes in the fair value of the hedged asset or liability that is attributable to the hedged risk, in “Accumulated other comprehensive income,” which is a component of Stockholders’ Equity. The settlement gains or costs on our cash flow hedges are amortized as interest expense over the term of the interest payments of the related debt issuances.
Changes in the fair value of undesignated derivatives are recorded in other income (expense) – net, along with the change 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 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.
Employee SeparationsIn accordance with Statement of Financial Accounting Standards No. 112, “Employers’ Accounting for Postemployment Benefits,” we establish obligations for expectedprobable 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,September 30, 2006, for employees not affected by the change-in-control provisions of the ATTC benefit plans, we had severance accruals for traditional SBC employees of approximately $383,$276, of which $274$241 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 preliminary purchase 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 141.141, issuing 632 million shares. 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. ATTCagencies, and operated one of the largest telecommunications networks in the U.S. ATTC was also a provider ofprovided 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 received 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 transaction was valued, for accounting purposes, at $15,517 and the assets and liabilities of ATTC were recorded at their respective fair values as of the date of the acquisition. WeAt the time of the acquisition, we obtained preliminary third-party valuations of property, plant and equipment, intangible assets (including the AT&T trade name), debt 7 AT&T INC. SEPTEMBER 30, 2006 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts 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 arewere subject to adjustment as additional information iswas 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. As of September 30, 2006, we have obtained additional information on many of the outstanding issues relating to the preliminary valuation, resulting in the adjustment of certain assets and liabilities, offset by a change to goodwill. 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 valuationvaluations; any remaining adjustments will be recordedreflected 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 amountsfourth quarter.
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 quarternine months of 2006. | | Purchase Price Allocation | | Purchase Price Allocation | | | As of | | | | As of | | As of | | | | As of | | | 12/31/05 | | Adjustments | | 3/31/06 | | 12/31/05 | | Adjustments | | 9/30/06 | Assets acquired | | | | | | | | | | | | | Current assets | $ | 6,295 | $ | 19 | $ | 6,314 | $ | 6,295 | $ | 16 | $ | 6,311 | Property, plant and equipment | | 10,921 | | - | | 10,921 | | 10,921 | | (662) | | 10,259 | Intangible assets not subject to amortization | | | | | | | | Intangible assets not subject to amortization: | | | | | | | | Trade name | | 4,900 | | - | | 4,900 | | 4,900 | | - | | 4,900 | Licenses | | 40 | | - | | 40 | | 40 | | - | | 40 | Intangible assets subject to amortization | | | | | | | | Intangible assets subject to amortization: | | | | | | | | Customer lists and relationships | | 3,050 | | - | | 3,050 | | 3,050 | | - | | 3,050 | Patents | | 150 | | - | | 150 | | 150 | | - | | 150 | Brand licensing agreements | | 70 | | - | | 70 | | 70 | | - | | 70 | Investments in unconsolidated subsidiaries | | 160 | | - | | 160 | | 160 | | (90) | | 70 | Other assets | | 4,247 | | - | | 4,247 | | 4,247 | | 165 | | 4,412 | Goodwill | | 12,343 | | (653) | | 11,690 | | 12,343 | | (691) | | 11,652 | Total assets acquired | | 42,176 | | (634) | | 41,542 | | 42,176 | | (1,262) | | 40,914 | | | | | | | | | | | | | | Liabilities assumed | | | | | | | | | | | | | Current liabilities, excluding current portion of long-term debt | | 6,740 | | 39 | | 6,779 | | 6,740 | | 63 | | 6,803 | Long-term debt | | 8,293 | | - | | 8,293 | | 8,293 | | - | | 8,293 | Deferred income taxes | | 531 | | (673) | | (142) | | 531 | | (720) | | (189) | Postemployment benefit obligation | | 8,807 | | - | | 8,807 | | 8,807 | | (468) | | 8,339 | Other noncurrent liabilities | | 2,288 | | - | | 2,288 | | 2,288 | | (137) | | 2,151 | Total liabilities assumed | | 26,659 | | (634) | | 26,025 | | 26,659 | | (1,262) | | 25,397 | Net assets acquired | $ | 15,517 | $ | - | $ | 15,517 | $ | 15,517 | $ | - | $ | 15,517 |
Purchase accounting rules require thatAdjustments were primarily related to property, plant and equipment, head-count assumptions associated with payments for involuntary employee separations, pension asset valuations and the adjustment for certain tax items. Reductions in the value of property, plant and equipment primarily reflects the reduction of estimated real estate values of property in use as well as a more comprehensive look at our fixed asset portfolio. Included in our third-quarter 2006 operating results is a $71 reduction of depreciation expense related to the revaluation of these assets. The timing lag in valuation of certain pre-merger issues are identified, modified or resolved, resulting increases or decreasespension assets (primarily real estate related) resulted in a $20 reduction of operating expense in the third quarter. In addition to the deferred tax liabilities are offset byimpacts associated with valuation adjustments, a changenet reduction in goodwill. During the first quarterdeferred taxes was recorded as a result of 2006, modifications to various pre-merger tax estimates and the resolution of an ATTC Internal Revenue Service audit (for(an adjustment of $385 for the years 1997-2001) resulted. In total we recorded an increase of $97 in a reduction in goodwilloperating income, $70 of $653 and are reflected inwhich related to periods prior to the adjustments column above.third quarter of 2006.
12
8 AT&T INC. MARCH 31,SEPTEMBER 30, 2006
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts The completion of the final valuation of the assets and liabilities may result in further adjustments to goodwill. Additionally, as ATTC stock options that were converted at the time of the merger are exercised, the tax effect on those options may further reduce goodwill. As of September 30, 2006, we had recorded $11 in related reductions. ATTC maintained change-in-control provisions with its employees that required enhanced severance and benefit payments be paid to employees of ATTC whenif a change-in-control occurred. Included in the liabilities assumed at acquisition, were employee-related accrualswas $1,543 accrued for such enhanced severance and benefits. As part of approximately $1,543.the opening balance sheet adjustments, a revised number of expected employee separations that will result in payments resulted in a decline in the change-in-control severance and benefit accrual of $477. Following is a summary of the accrual recorded at December 31, 2005, cash payments made during the first nine months of 2006 and the purchase accounting adjustments thereto. We will continue to be paid byevaluate this accrual through the Company, from ATTC's pension plans and from ATTC's postemployment benefit plans.end of the allocation period. | | 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 | |
|
| Balance at 12/31/05 | CashPayments for the Quarter Ended | | Balance at | | 3/31/06 | 6/30/06 | 9/30/06 | Adjustments | 9/30/06 | Paid out of: | | | | | | | | | | | | | Company funds | $ | 870 | $ | (46) | $ | (59) | $ | (86) | $ | (97) | $ | 582 | Pension and Postemployment benefit plans | | 673 | | (5) | | (27) | | (18) | | (380) | | 243 | Total | $ | 1,543 | $ | (51) | $ | (86) | $ | (104) | $ | (477) | $ | 825 | | | | | | | | | | | | | | |
The following unaudited pro forma consolidated results of operations assume that the acquisition of ATTC was completed as of January 1, 2005. | | For the Quarter Ended | | For the Year Ended | | For the Quarter Ended | | For the Year Ended | | | Mar 31, | | Jun 30, | | Sep 30, | | Dec 31, | | 2005 | | 3/31/05 | | 6/30/05 | | 9/30/05 | | 12/31/05 | | 2005 | Revenues | $ | 16,670 | $ | 16,602 | $ | 16,468 | $ | 16,279 | $ | 66,019 | $ | 16,619 | $ | 16,554 | $ | 16,414 | $ | 16,202 | $ | 65,789 | | Net Income | | 1,319 | | 1,257 | | 1,729 | | 1,862 | | 6,167 | | 1,319 | | 1,257 | | 1,729 | | 1,862 | | 6,167 | |
As part of the process of coordinating benefits, we changed our management vacation pay policy for legacy SBC employees so vacation is earned ratably throughout the year rather than at the end of the preceding year. As a result, we recognized a decrease in operating expenses of $246 in the third quarter of 2006. We anticipate the expense reduction for the fourth quarter of 2006 to be approximately $80. 13
9 AT&T INC. MARCH 31,SEPTEMBER 30, 2006
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts NOTE 3. COMPREHENSIVE INCOME The components of our comprehensive income for the three and nine months ended March 31,September 30, 2006 and 2005 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 iswas due to exchange rate fluctuations in our foreign affiliates’ local currencies. Thecurrencies and 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 | Three months ended | Nine months ended | | March 31, | | September 30, | | September 30, | | 2006 | 2005 | | 2006 | | 2005 | | 2006 | | 2005 | Net income | $ | 1,445 | $ | 885 | $ | 2,165 | $ | 1,246 | | $ | 5,418 | $ | 3,131 | Other comprehensive income, net of tax: | | | | | | | | | | | | | Foreign currency translation adjustment | | (20) | | (2) | | 29 | | (2) | | (16) | | 28 | Net unrealized gains (losses) on securities: | | | | | | | | | | | | | Unrealized gains (losses) | | 27 | | (16) | | (17) | | 2 | | 17 | | (21) | Less reclassification adjustment realized in net income | | (6) | | (27) | | - | | (4) | | (8) | | (37) | Reclassification adjustment for losses on cash flow hedges included in net income | | 4 | | 1 | | Net unrealized gains on cash flow hedges: Unrealized gains, net of taxes | | | - | | - | | 2 | | - | Reclassification adjustment for losses | | | | | | | | | | on cash flow hedges included in net income | | | 4 | | 2 | | 12 | | 3 | Other | | 1 | | - | | - | | (2) | | 1 | | (2) | Other comprehensive income (loss) | | 6 | | (44) | | 16 | | (4) | | 8 | | (29) | Total comprehensive income | $ | 1,451 | $ | 841 | | Total Comprehensive Income | | $ | 2,181 | $ | 1,242 | | $ | 5,426 | $ | 3,102 |
14
10 AT&T INC. MARCH 31,SEPTEMBER 30, 2006
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts NOTE 4. EARNINGS PER SHARE A reconciliation of the numerators and denominators of basic earnings per share and diluted earnings per share for net income for the three and nine months ended March 31,September 30, 2006 and 2005 areis shown in the table below: | Three months ended | Three months ended | | Nine months ended | | March 31, | September 30, | | September 30, | | 2006 | 2005 | 2006 | 2005 | | | 2006 | | 2005 | Numerators | | | | | | | | | | | | | | Numerator for basic earnings per share: | | | | | | | | | | | | | | Net income | $ | 1,445 | $ | 885 | $ | 2,165 | $ | 1,246 | | $ | 5,418 | $ | 3,131 | Dilutive potential common shares: | | | | | | | | | | | | | | Other stock-based compensation | | 3 | | 2 | | 2 | | 5 | | | 5 | | 8 | Numerator for diluted earnings per share | $ | 1,448 | $ | 887 | $ | 2,167 | $ | 1,251 | | $ | 5,423 | $ | 3,139 | Denominators (000,000) | | | | | | | | | | | | | | Denominator for basic earnings per share: | | | | | | | | | | | | | | Weighted-average number of common | | | | | | | | | | | | | | shares outstanding | | 3,882 | | 3,303 | | 3,873 | | 3,296 | | | 3,880 | | 3,300 | Dilutive potential common shares: | �� | | | | | | | | | | | | | Stock options | | 3 | | 1 | | 5 | | - | | | 4 | | 1 | Other stock-based compensation | | 17 | | 11 | | 14 | | 10 | | | 16 | | 10 | Denominator for diluted earnings per share | | 3,902 | | 3,315 | | 3,892 | | 3,306 | | | 3,900 | | 3,311 | Basic earnings per share | | | | | | | | | | �� | | | | Net income | $ | 0.37 | $ | 0.27 | $ | 0.56 | $ | 0.38 | | $ | 1.40 | $ | 0.95 | Diluted earnings per share | | | | | | | | | | | | | | Net income | $ | 0.37 | $ | 0.27 | $ | 0.56 | $ | 0.38 | | $ | 1.39 | $ | 0.95 |
At March 31,September 30, 2006, and 2005, we had issued and outstanding options to purchase approximately 264 and 209234 million shares of AT&T common stock. The exercise prices of options to purchase a weighted average of 231189 million shares in the third quarter and 196212 million sharesfor the first nine months exceeded the average market price of AT&T stock for the three months ended March 31, 2006 and 2005.stock. Accordingly, we did not include these amounts in determining the dilutive potential common shares for the respective periods. At March 31,September 30, 2006, the exercise price of 3547 million share options were below market price.price, commonly referred to as “in the money.” Of these options, 511 million will expire by the end of 2007. 15At September 30, 2005, we had issued and outstanding options to purchase 202 million shares of AT&T common stock. The exercise prices of options to purchase a weighted average of 191 million shares in the third quarter and 195 million for the first nine months exceeded the average market price of AT&T stock. Accordingly, we did not include these amounts in determining the dilutive potential common shares for the respective periods.
11 AT&T INC. MARCH 31,SEPTEMBER 30, 2006
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts NOTE 5. SEGMENT INFORMATION Our segments are strategic business units that offer different products and services and are managed accordingly. We analyze our various operating segments based on segment income. Interest expense, interest income and other income (expense) – net 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 four reportable segments that reflect the current management of our business:segments: (1) wireline, (2) Cingular, (3) directory and (4) other. The wireline segment provides both retail and wholesale landline telecommunications services, including local and long-distance voice, switched access, internet protocol and internet access data, and messaging services, managed networking to business customers, our U-versesm video service 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. 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. The directory segment includes our directory operations, includingwhich publish Yellow and White Pages advertisingdirectories and electronic publishing.sell directory and internet-based advertising. Our portion of the results from YELLOWPAGES.COM (YPC), a joint venture with BellSouth Corporation (BellSouth), is recorded in this segment as equity in net income of affiliates. The other segment includes results from Sterling Commerce Inc. and all corporate and other operations. This segment also includes our portion of the results from our international equity investments and from Cingular as equity in net income of affiliates, as discussed above. 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 and Other columns represent the segment results of each such operating segment. The Wireline column includes revenues from services sold to Cingular of $382 in the first quarter of 2006 and $182 in the first quarter of 2005 (see Note 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. 16
12 AT&T INC. MARCH 31,SEPTEMBER 30, 2006
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts At March 31, 2006 or for the three months ended | | | | | | | | | | | | | | For the three months ended September 30, 2006 | | For the three months ended September 30, 2006 | | | | | | | | | | | | | | | | | | | | | | | Consolidation | | Cingular | | Consolidated | | | | | | | | | | | | | | | | | Wireline | | Cingular | | Directory | | Other | | and Elimination | | Elimination | | Results | | Wireline | | Cingular | | Directory | | Other | | Consolidation and Elimination | | Cingular Elimination | | Consolidated Results | Revenues from external customers | $ | 14,731 | $ | 8,980 | $ | 901 | $ | 203 | $ | - | $ | (8,980) | $ | 15,835 | $ | 14,577 | $ | 9,553 | $ | 906 | $ | 155 | $ | - | $ | (9,553) | $ | 15,638 | Intersegment revenues | | 8 | | - | | 22 | | - | | (30) | | - | | - | | 9 | | - | | 15 | | 49 | | (73) | | - | | - | Total segment operating revenues | | 14,739 | | 8,980 | | 923 | | 203 | | (30) | | (8,980) | | 15,835 | | 14,586 | | 9,553 | | 921 | | 204 | | (73) | | (9,553) | | 15,638 | Operations and support expenses | | 10,557 | | 6,493 | | 447 | | 178 | | (30) | | (6,493) | | 11,152 | | 9,756 | | 6,561 | | 439 | | 161 | | (72) | | (6,561) | | 10,284 | Depreciation and amortization expenses | | 2,430 | | 1,680 | | 1 | | 61 | | - | | (1,680) | | 2,492 | | 2,376 | | 1,576 | | 1 | | 60 | | - | | (1,576) | | 2,437 | Total segment operating expenses | | 12,987 | | 8,173 | | 448 | | 239 | | (30) | | (8,173) | | 13,644 | | 12,132 | | 8,137 | | 440 | | 221 | | (72) | | (8,137) | | 12,721 | Segment operating income | | 1,752 | | 807 | | 475 | | (36) | | - | | (807) | | 2,191 | | 2,454 | | 1,416 | | 481 | | (17) | | (1) | | (1,416) | | 2,917 | Interest expense | | - | | 297 | | - | | - | | 464 | | (297) | | 464 | | - | | 306 | | - | | - | | 442 | | (306) | | 442 | Interest income | | - | | 4 | | - | | - | | 85 | | (4) | | 85 | | - | | 6 | | - | | - | | 98 | | (6) | | 98 | Equity in net income (loss) of affiliates | | - | | - | | (5) | | 339 | | - | | - | | 334 | | - | | - | | (2) | | 651 | | - | | - | | 649 | Other income (expense) – net | | - | | (36) | | - | | - | | 11 | | 36 | | 11 | | - | | (44) | | - | | - | | 11 | | 44 | | 11 | Segment income before income taxes | $ | 1,752 | $ | 478 | $ | 470 | $ | 303 | $ | (368) | $ | (478) | $ | 2,157 | $ | 2,454 | $ | 1,072 | $ | 479 | $ | 634 | $ | (334) | $ | (1,072) | $ | 3,233 | | | | | | | | | | | | | | | | | Segment Assets | $ | 104,409 | $ | 79,344 | $ | 3,950 | $ | 130,809 | $ | (94,731) | $ | (79,344) | $ | 144,437 | |
For the three months ended March 31, 2005 | | | | | | | | | | | | | | | | | | | | | | | Consolidation | | Cingular | | Consolidated | | | Wireline | | Cingular | | Directory | | Other | | and Elimination | | Elimination | | Results | Revenues from external customers | $ | 9,174 | $ | 8,229 | $ | 905 | $ | 169 | $ | - | $ | (8,229) | $ | 10,248 | Intersegment revenues | | 8 | | - | | 24 | | - | | (32) | | - | | - | Total segment operating revenues | | 9,182 | | 8,229 | | 929 | | 169 | | (32) | | (8,229) | | 10,248 | Operations and support expenses | | 6,293 | | 6,440 | | 444 | | 160 | | (30) | | (6,440) | | 6,867 | Depreciation and amortization expenses | | 1,773 | | 1,675 | | 2 | | 52 | | (2) | | (1,675) | | 1,825 | Total segment operating expenses | | 8,066 | | 8,115 | | 446 | | 212 | | (32) | | (8,115) | | 8,692 | Segment operating income | | 1,116 | | 114 | | 483 | | (43) | | - | | (114) | | 1,556 | Interest expense | | - | | 338 | | - | | - | | 353 | | (338) | | 353 | Interest income | | - | | 18 | | - | | - | | 109 | | (18) | | 109 | Equity in net income (loss) of affiliates | | - | | 2 | | (1) | | (58) | | 1 | | (2) | | (58) | Other income (expense) – net | | - | | (14) | | - | | - | | 47 | | 14 | | 47 | Segment income before income taxes | $ | 1,116 | $ | (218) | $ | 482 | $ | (101) | $ | (196) | $ | 218 | $ | 1,301 |
17
At September 30, 2006 or for the nine months ended | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | Wireline | | Cingular | | Directory | | Other | | Consolidation and Elimination | | Cingular Elimination | | Consolidated Results | Revenues from external customers | $ | 43,970 | $ | 27,751 | $ | 2,716 | $ | 478 | $ | - | $ | (27,751) | $ | 47,164 | Intersegment revenues | | 25 | | - | | 53 | | 126 | | (204) | | - | | - | Total segment operating revenues | | 43,995 | | 27,751 | | 2,769 | | 604 | | (204) | | (27,751) | | 47,164 | Operations and support expenses | | 30,422 | | 19,657 | | 1,321 | | 497 | | (203) | | (19,657) | | 32,037 | Depreciation and amortization expenses | | 7,233 | | 4,854 | | 2 | | 181 | | (1) | | (4,854) | | 7,415 | Total segment operating expenses | | 37,655 | | 24,511 | | 1,323 | | 678 | | (204) | | (24,511) | | 39,452 | Segment operating income | | 6,340 | | 3,240 | | 1,446 | | (74) | | - | | (3,240) | | 7,712 | Interest expense | | - | | 901 | | - | | - | | 1,378 | | (901) | | 1,378 | Interest income | | - | | 13 | | - | | - | | 278 | | (13) | | 278 | Equity in net income (loss) of affiliates | | - | | - | | (13) | | 1,451 | | - | | - | | 1,438 | Other income (expense) – net | | - | | (120) | | - | | - | | 37 | | 120 | | 37 | Segment income before income taxes | $ | 6,340 | $ | 2,232 | $ | 1,433 | $ | 1,377 | $ | (1,063) | $ | (2,232) | $ | 8,087 | | | | | | | | | | | | | | | | Segment Assets | $ | 103,791 | $ | 80,292 | $ | 4,718 | $ | 135,078 | $ | (99,695) | $ | (80,292) | $ | 143,892 |
13 AT&T INC. MARCH 31,SEPTEMBER 30, 2006
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts For the three months ended September 30, 2005 | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | Wireline | | Cingular | | Directory | | Other | | Consolidation and Elimination | | Cingular Elimination | | Consolidated Results | Revenues from external customers | $ | 9,222 | $ | 8,746 | $ | 917 | $ | 165 | $ | - | $ | (8,746) | $ | 10,304 | Intersegment revenues | | 7 | | - | | 15 | | 17 | | (39) | | - | | - | Total segment operating revenues | | 9,229 | | 8,746 | | 932 | | 182 | | (39) | | (8,746) | | 10,304 | Operations and support expenses | | 5,987 | | 6,548 | | 425 | | 168 | | (41) | | (6,548) | | 6,539 | Depreciation and amortization expenses | | 1,747 | | 1,541 | | 1 | | 54 | | 1 | | (1,541) | | 1,803 | Total segment operating expenses | | 7,734 | | 8,089 | | 426 | | 222 | | (40) | | (8,089) | | 8,342 | Segment operating income | | 1,495 | | 657 | | 506 | | (40) | | 1 | | (657) | | 1,962 | Interest expense | | - | | 304 | | - | | - | | 349 | | (304) | | 349 | Interest income | | - | | 8 | | - | | - | | 82 | | (8) | | 82 | Equity in net income (loss) of affiliates | | - | | 1 | | - | | 219 | | - | | (1) | | 219 | Other income (expense) – net | | - | | (36) | | - | | - | | (70) | | 36 | | (70) | Segment income before income taxes | $ | 1,495 | $ | 326 | $ | 506 | $ | 179 | $ | (336) | $ | (326) | $ | 1,844 |
For the nine months ended September 30, 2005 | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | Wireline | | Cingular | | Directory | | Other | | Consolidation and Elimination | | Cingular Elimination | | Consolidated Results | Revenues from external customers | $ | 27,645 | $ | 25,584 | $ | 2,723 | $ | 487 | $ | - | $ | (25,584) | $ | 30,855 | Intersegment revenues | | 23 | | - | | 63 | | 42 | | (128) | | - | | - | Total segment operating revenues | | 27,668 | | 25,584 | | 2,786 | | 529 | | (128) | | (25,584) | | 30,855 | Operations and support expenses | | 18,733 | | 19,464 | | 1,301 | | 475 | | (127) | | (19,464) | | 20,382 | Depreciation and amortization expenses | | 5,277 | | 4,845 | | 4 | | 157 | | (1) | | (4,845) | | 5,437 | Total segment operating expenses | | 24,010 | | 24,309 | | 1,305 | | 632 | | (128) | | (24,309) | | 25,819 | Segment operating income | | 3,658 | | 1,275 | | 1,481 | | (103) | | - | | (1,275) | | 5,036 | Interest expense | | - | | 968 | | - | | - | | 1,051 | | (968) | | 1,051 | Interest income | | - | | 44 | | - | | - | | 291 | | (44) | | 291 | Equity in net income (loss) of affiliates | | - | | 4 | | (1) | | 343 | | - | | (4) | | 342 | Other income (expense) – net | | - | | (76) | | - | | - | | 11 | | 76 | | 11 | Segment income before income taxes | $ | 3,658 | $ | 279 | $ | 1,480 | $ | 240 | $ | (749) | $ | (279) | $ | 4,629 |
14 AT&T INC. SEPTEMBER 30, 2006 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts NOTE 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 $4,108 at March 31,September 30, 2006 and December 31, 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$62 in the third quarter and $184 for the first quarternine months of 2006 and $87$74 in the third quarter and $248 for the first quarternine months of 2005. We 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 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 Offered Rate) plus 0.05%, which expires July 31, 2007. This agreement includes a provisionprovides 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. In the first quarter of 2006, our net advances to Cingular totaled $699 underUnder the revolving credit agreement.agreement we received net repayments from Cingular totaling $91 in the third quarter and had net advances of $624 for the first nine months of 2006. Our share of advances to Cingular under the revolving credit agreement is reflected in “Investments in and Advances to Cingular Wireless” on our Consolidated Balance Sheets and totaled $1,006$931 at March 31,September 30, 2006 and $307 at December 31, 2005.
We generated revenues of $382$359 in the third quarter and $1,106 for the first quarternine months of 2006 and $182$220 in the third quarter and $607 for the first quarternine months of 2005 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 AT&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 on our Consolidated Statements of Income when we report our 60% proportionate share of Cingular’s results. 15 AT&T INC. SEPTEMBER 30, 2006 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts NOTE 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),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 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.FAS 87 “Employers’ Accounting for Pensions” and Statement of Financial Accounting Standards No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.”FAS 106. In the following table, gains are denoted with parentheses and losses are not. | Three months ended | | Three months ended | | Nine months ended | | March 31, | | September 30, | | September 30, | | 2006 | 2005 | | 2006 | 2005 | | | 2006 | | 2005 | Pension cost: | | | | | | | | | | | | | | | Service cost – benefits earned during the period | $ | 260 | $ | 196 | | $ | 262 | $ | 197 | | $ | 787 | $ | 589 | Interest cost on projected benefit obligation | | 628 | | 403 | | | 627 | | 403 | | | 1,881 | | 1,210 | Expected return on assets | | (991) | | (636) | | | (1,008) | | (636) | | | (2,992) | | (1,908) | Amortization of prior service cost and transition asset | | 37 | | 47 | | | 37 | | 47 | | | 112 | | 140 | Recognized actuarial loss | | 93 | | 39 | | | 91 | | 39 | | | 271 | | 118 | Net pension cost | $ | 27 | $ | 49 | | $ | 9 | $ | 50 | | $ | 59 | $ | 149 | | | | | | | | | | | | | | | | Postretirement benefit cost: | | | | | | | | | | | | | | | Service cost – benefits earned during the period | $ | 109 | $ | 99 | | $ | 108 | $ | 95 | | $ | 326 | $ | 290 | Interest cost on accumulated postretirement | | | | | | | | | | | | | | | benefit obligation | | 494 | | 367 | | | 485 | | 355 | | | 1,457 | | 1,077 | Expected return on assets | | (234) | | (189) | | | (234) | | (189) | | | (701) | | (567) | Amortization of prior service benefit | | (90) | | (80) | | | (90) | | (90) | | | (269) | | (254) | Recognized actuarial loss | | 126 | | 114 | | | 119 | | 110 | | | 354 | | 329 | Postretirement benefit cost | $ | 405 | $ | 311 | | $ | 388 | $ | 281 | | $ | 1,167 | $ | 875 | | | | | | | | | | | | | | | | Combined net pension and postretirement cost | $ | 432 | $ | 360 | | $ | 397 | $ | 331 | | $ | 1,226 | $ | 1,024 |
Our combined net pension and postretirement cost increased $72$66 in the third quarter and $202 for the first quarternine months of 2006.2006 compared with the same periods in 2005. 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,For development of the expected return on assets, 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 for non-U.S. plans, was $8which is not included in the table above, was $4 in the third quarter and $18 for the first quarternine months of 2006. We also provide senior- and middle-management employees with nonqualified, unfunded supplemental retirement and savings plans. Net supplemental retirement pension benefits cost, werewhich is not included in the table above, was $38 in the third quarter and $113 for the first quarternine months of 2006, and $27 in the first quarter of 2005, of which $26 and $17$77 was interest cost, respectively. Net supplemental retirement pension 19
16 AT&T INC. MARCH 31,SEPTEMBER 30, 2006
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions except per share amounts benefits cost was $27 in the third quarter and $81 for the first nine months of 2005, of which $17 and $51 was interest cost, respectively. NOTE 8. PENDING ACQUISITION OF BELLSOUTH On 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 mergeracquisition (March 5, 2006) of $27.32, the total transaction is valued, for purchase accounting purposes, at approximately $65,000.$66,000. We and BellSouth jointly own Cingular and the internet directoryinternet-based publisher YPC. In the Cingular joint venture, we hold a 60 percent economic interest and BellSouth holds a 40 percent economic interest and in the YPC joint venture we hold a 66 percent economic interest and BellSouth holds a 34 percent economic 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, BellSouth, Cingular and YPC will be wholly-owned subsidiaries of AT&T. Upon consolidation, the asset and liabilities of BellSouth and Cingular will be appraised, based on third-party valuations, for inclusion on the opening balance sheet, adjusting 100% of BellSouth’s and 40% of Cingular’s values. Long-lived assets such as property, plant and equipment will reflect a value of replacing the assets, which takes into account changes in technology, usage, and relative obsolescence and depreciation of the assets, sometimes referred to as a Greenfield approach. This approach often results in differences, sometimes material, from recorded book values even if, absent the acquisition, the assets would be neither increased in value nor impaired. In addition, assets and liabilities that would not normally be recorded in ordinary operations will be recorded at their acquisition values (e.g., customer relationships that were developed by the acquired company). Debt instruments and investments are valued in relation to current market conditions and other assets and liabilities are valued based on the acquiring company’s estimates. After all identifiable assets and liabilities are valued, the remainder of the purchase price is recorded as goodwill. These values are subject to adjustment for one year after the close of the transaction as additional information is obtained. The transaction has been approved by the Board of Directors and the stockholders of each company and also must be approved by the stockholders of AT&T and BellSouth. The transaction also is subject to review byvarious other regulatory authorities. In October 2006, the U.S. Department of Justice andcompleted its review of the transaction without imposing any conditions. The acquisition remains subject to approval by the Federal Communications Commission and various other regulatory authorities.Commission. We currently expect the transaction to close byin the endfall of 2006. 20
17 AT&T INC. MARCH 31,SEPTEMBER 30, 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 For ease of reading, AT&T Inc. is referred to as “we,” “AT&T,” or the “Company” throughout this document and the names of the particular subsidiaries and affiliates providing the services generally have been omitted. AT&T is a holding company; AT&T does not provide communications services, rather, itscompany whose subsidiaries and affiliates operate in the 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, 2005. In the 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 threethird quarter and nine month period ended March 31,September 30, 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 threethird quarter and nine months ended March 31,September 30, 2005, are not included in our operating results and are therefore not discussed. Our financial results in the third quarter and for the first quarternine months of 2006 and 2005 are summarized as follows: | | First Quarter | | | Percent | | | 2006 | | 2005 | | Change | Operating revenues | $ | 15,835 | $ | 10,248 | | 54.5% | Operating expenses | | 13,644 | | 8,692 | | 57.0 | Operating income | | 2,191 | | 1,556 | | 40.8 | Income before income taxes | | 2,157 | | 1,301 | | 65.8 | Net income | | 1,445 | | 885 | | 63.3 |
| | | Third Quarter | Nine-Month Period |
| | 2006 | | 2005 | | Percent Change | 2006 | | 2005 | | Percent Change |
| Operating revenues | | $15,638 | | $10,304 | | 51 | .8% | $47,164 | | $30,855 | | 52 | .9% | Operating expenses | | 12,721 | | 8,342 | | 52 | .5 | 39,452 | | 25,819 | | 52 | .8 | Operating income | | 2,917 | | 1,962 | | 48 | .7 | 7,712 | | 5,036 | | 53 | .1 | Income before income taxes | | 3,233 | | 1,844 | | 75 | .3 | 8,087 | | 4,629 | | 74 | .7 | Net Income | | 2,165 | | 1,246 | | 73 | .8 | 5,418 | | 3,131 | | 73 | .0 |
|
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 beis significantly affected by the ATTC acquisition. Our operating income increased $635,$955, or 40.8%48.7%, in the third quarter and $2,676, or 53.1%, for the first quarternine months of 2006 and our operating income margin decreased from 15.2%19.0% to 13.8%. The decline18.7% in operatingthe third quarter and increased from 16.3% to 16.4% for the first nine months. Operating income margin reflects additionalincreased primarily due to expense associated withreduction through merger and integration costs andsynergies, partially offset by 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 primarily due to growth in data revenues, which accounted for approximately 28% of our operating revenues in the first quarter of 2006 and 23% for the quarter ended March 31, 2005, slightly offset by the negative effects of a continued decline in access lines. Since our merger with ATTC, our operating income margin has grown from 13.9% in the first quarter to 16.5% in the second quarter and 18.7% in the third quarter of 2006, reflecting realized merger synergies and a merger-related change in our vacation policy (see Note 2). Retail access lines continued to decline due to increased competition, as customers disconnected both primary and additional lines and began using wireless and Voice over Internet Protocol (VoIP) technology offered by competitors and cable instead of phone lines for voice and data. This was also a contributing factorAccess line trends are further discussed in our Wireline segment discussion. Operating revenues Our operating revenues increased $5,334, or 51.8%, in the year-ago period. Retail access lines also declinedthird quarter and $16,309, or 52.9%, for both periodsthe first nine months of 2006 primarily due to customers disconnecting their additionalour acquisition of ATTC. The increase was slightly offset by continued pressure in voice, reflecting access line decreases in our traditional SBC Communications (SBC) 13-state region (“in-region”) and decreased demand for wholesale services. (We changed our name to AT&T from SBC after our acquisition of ATTC.) Operating revenues in the third quarter were down about 1% from 21
18 AT&T INC. MARCH 31,SEPTEMBER 30, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued 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 or wholesale product, we lose all revenue when a wireline customer shifts to a competitor using an alternative technology such as cable, wireless or VoIP or their own network facilities. Increasing shifts 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 stabilized, reflecting in part our ability to offer retail nationwide long-distance service as well as 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 $5,587, or 54.5%, in the first quartertwo quarters 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 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 year-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, 2005.2006. Operating revenue changes are discussed in greater detail in our “Segment Results” sections.
Operating expenses Our operating expenses increased $4,952,$4,379, or 57.0%52.5%, in the third quarter and $13,633, or 52.8%, for the first quarternine months of 2006 primarily due to our acquisition of ATTC, and also included merger integration costs of $266$147 in the third quarter and $569 for the first nine months and amortization expense on intangible assets identified at the time of $266.the ATTC merger of $233 in the third quarter and $740 for the first nine months. Operating expenses in the third quarter and for the first nine months of 2006 were $246 lower than prior periods due to a change in our vacation policy (see Note 2). Our first quarterexpenses in 2006 expenses also include decreases related to workforce reductions, reflecting a decline of 3,390approximately 10,500 employees from December 31, 2005.2005, of which 3,600 were in the third quarter. As of March 31,September 30, 2006, we were ahead of schedule with our scheduledtargeted workforce reductions associated with the ATTC acquisition. Sequentially, expenses for the quarter decreased 2.9% in the second quarter and 3.4% in the third quarter, reflecting progress with the integration of ATTC and other cost-reduction initiatives, as well as the merger-related change in our vacation policy. Our significant expense changes are discussed in greater detail in our “Segment Results” sections. Interest expense increased $111,$93, or 31.4%26.6%, in the third quarter and $327, or 31.1%, for the first quarternine months 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
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
Interest incomedecreased $24, increased $16, or 22%19.5%, in the third quarter and decreased $13, or 4.5%, for the first quarternine months of 2006. The increase in the quarter was primarily due to increased interest income from marketable securities. The decrease in interest income for the first nine months of 2006 was primarily due to the pay-down by Cingular Wireless (Cingular) of our shareholder loan to them; thisthem. This decrease was partially 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 affiliates. Equity in net income of affiliates increased $392$430 in the third quarter and $1,096 for the first quarternine months of 2006. The increase was primarily due to an increase of approximately $357 in our proportionate share of Cingular’s improved results of $375 in the third quarter and an increase of $51 in results from our international holdings.$968 for the first nine months. 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 on our Consolidated Statements of Income. Cingular’s operating results are discussed in detail in the “Cingular Segment Results” section. Our accounting for Cingular is described in more detail in Note 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 holdingsinvestments are discussed in greater detail in ourthe “Other Segment Results” section.
Other income (expense) – net We had other income of $11 in the third quarter and $37 for the first quarternine months of 2006, and $47as compared to other expense of $70 in the third quarter and other income of $11 for the first quarternine months of 2005. Results in the third quarter of 2006 primarily consisted of $14 related to leveraged lease and royalty income and other expenses of $5 related to fair value adjustments on financial instruments. Results for the first nine months of 2006 primarily consisted of royalty income of $15, gains on the sale of Covad Communications Group Inc. shares of $10 and leveraged lease income of $8. These gains were partially offset by other expenses of $20 related to fair value adjustments on financial instruments and net exchange rate losses. Results in the third quarter of 2005 primarily consisted of gainsother expenses of $68$82 due to an increase in value of a third-party minority holder’s interest in an SBC subsidiary’s preferred stock and $21 due to a call premium on early debt retirement, partially offset by a gain of $24 on the sale of a lease partnership. Other income for the first nine months of 2005 primarily included a gain of approximately $82 on the sale of shares of Amdocs Limited, (Amdocs)SpectraSite, Inc and SpectraSite, Inc. (SpectraSite)Yahoo!, a gain of $24 from the sale of a lease partnership and gains of $24 related to the transfer of wireless properties to Cingular. These gains were partially offset by other expenses of $82 and $21 mentioned above and a charge of $21 related to the other-than-temporary decline in the value of various cost investments. Income 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
19 AT&T INC. MARCH 31,SEPTEMBER 30, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued Dollars in millions except per share amounts RESULTS OF OPERATIONS - ContinuedIncome taxes increased $470, or 78.6%, in the third quarter and $1,171, or 78.2%, for the first nine months of 2006. The increase in income taxes in the third quarter and for the first nine months of 2006 was due to higher income before income taxes. Our effective tax rates were 33.0% in the third quarter and for the first nine months of 2006 compared to 32.4% in the third quarter and for the first nine months of 2005.
Selected Financial and Operating Data | September 30, | | 2006 | | 2005 | Debt ratio1 | 36.3% | | 36.6% | In-region network access lines in service (000)2 | 47,087 | | 50,217 | In-region wholesale lines (000)2 | 3,972 | | 5,423 | In-region broadband connections (000)2, 3 | 8,155 | | 6,496 | Number of AT&T employees4 | 179,420 | | 154,500 | Cingular Wireless customers (000)5 | 58,666 | | 52,292 |
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 Broadband connections include DSL lines of 8,148 in 2006 and 6,496 in 2005, U-verse high-speed internet access and satellite broadband. 4 Number of employees at December 31, 2005 was 189,950. 5 Amounts represent 100% of the wireless customers of Cingular. Segment Results Our segments represent strategic business units that offer different products and services and are managed accordingly. Our operating segment results presented in Note 5 and discussed below for each segment follow our internal management reporting. We analyze our various operating segments based on segment income. Interest expense, interest income and other income (expense) – net, 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 four reportable segments that reflect the current management of our business:segments: (1) wireline; (2) Cingular; (3) directory; and (4) other. The wireline segment provides both retail and wholesale landline telecommunications services, including local and long-distance voice, switched access, internet protocol (IP) and internet access data, and messaging services, managed networking to business customers, our U-versesm video service and satellite television services through our agreement with EchoStar Communications Corp.
(“ (“AT&T | DISH Network” offering). 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. The directory segment includes allour directory operations, includingwhich publish Yellow and White Pages advertisingdirectories and electronic publishing.sell directory and internet-based advertising. Our portion of the results from YELLOWPAGES.COM (YPC) is recorded in this segment as equity in net income of affiliates. The other segment includes results from Sterling Commerce Inc. (Sterling) and all corporate and other operations. The other segment also includes our portion of the results from our international equity investments and from Cingular as equity in 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 in the other segment. 20 AT&T INC. SEPTEMBER 30, 2006 Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued Dollars in millions except per share amounts 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.” 24
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
Wireline Segment Results | First Quarter | | | Third Quarter | | | Nine-Month Period | | | | | Percent | | | | | | Percent | | | | | | | Percent | | 2006 | 2005 | | Change | | 2006 | | 2005 | | Change | | | 2006 | | 2005 | | Change | Segment operating revenues | | | | | | | | | | | | | | | | | | | | | Voice | $ | 8,722 | $ | 5,852 | | 49.0% | | $ | 8,464 | $ | 5,743 | | 47.4% | | $ | 25,725 | $ | 17,355 | | 48.2% | Data | | 4,442 | | 2,391 | | 85.8 | | | 4,546 | | 2,514 | | 80.8 | | | 13,465 | | 7,343 | | 83.4 | Other | | 1,575 | | 939 | | 67.7 | | | 1,576 | | 972 | | 62.1 | | | 4,805 | | 2,970 | | 61.8 | Total Segment Operating Revenues | | 14,739 | | 9,182 | | 60.5 | | | 14,586 | | 9,229 | | 58.0 | | | 43,995 | | 27,668 | | 59.0 | Segment operating expenses | | | | | | | | | | | | | | | | | | | | | Cost of sales | | 6,856 | | 4,123 | | 66.3 | | | 6,399 | | 4,096 | | 56.2 | | | 19,830 | | 12,358 | | 60.5 | Selling, general and administrative | | 3,701 | | 2,170 | | 70.6 | | | 3,357 | | 1,891 | | 77.5 | | | 10,592 | | 6,375 | | 66.1 | Depreciation and amortization | | 2,430 | | 1,773 | | 37.1 | | | 2,376 | | 1,747 | | 36.0 | | | 7,233 | | 5,277 | | 37.1 | Total Segment Operating Expenses | | 12,987 | | 8,066 | | 61.0 | | | 12,132 | | 7,734 | | 56.9 | | | 37,655 | | 24,010 | | 56.8 | Segment Income | $ | 1,752 | $ | 1,116 | | 57.0% | | $ | 2,454 | $ | 1,495 | | 64.1% | | $ | 6,340 | $ | 3,658 | | 73.3% |
Operating Margin Trends Our wireline segment operating income increased $636, or 57.0%,margin was 16.8% in the firstthird quarter of 2006, compared to 16.2% in the third quarter of 2005, and 14.4% for the first nine months of 2006, compared to 13.2% for the first nine months of 2005. Our wireline segment operating income increased $959 in the third quarter of 2006 and $2,682 for the first nine months of 2006 primarily reflecting incremental revenue and expenses from our acquisition of ATTC, while our operatingATTC. 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 incomeand margins increased primarily due to growth in data revenue. The decrease in operating income margin reflects additional expense associated withlower expenses as a result of merger and integration costs andsynergies partially offset by additional amortization expense on those intangibles identified at the time of our acquisition of ATTC. WhileATTC and lower voice revenue increasedas a result of continued in-region access line declines due to the acquisition of ATTC, in-region retail access lines continued to decline due toincreased competition, as customers continuing to disconnectdisconnected both primary and additional lines and switchingswitched 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 offerings combining multiple services for one fixed price (bundles).
25
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
Wireline Operating Results All varianceschanges other than those specifically stated as being due to the ATTC acquisition are related to the operations of traditional SBC.in-region wireline operations. Voicerevenues increased $2,870,$2,721, or 49.0%47.4%, in the third quarter and $8,370, or 48.2%, for the first quarternine months of 2006 primarily due to the acquisition of ATTC. 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. InVoice revenues previously reported for the first quartersix months of 2006 revenue increased $2,852 in long-distance and $194 in local voice, partially offsetwere reduced by revenue declines$79 based on a review 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.certain international billing arrangements (see Note 1). The increaseLong-distance revenues increased $2,579 in long-distance revenues werethe third quarter and $8,044 for the first nine months of 2006 driven almost entirely driven by the increase in long-distance customers due to the acquisition of ATTC. Additionally, in-region retail long-distance revenues increased $99 inAlso contributing to the first quarter of 2006, reflecting ourincreases were higher long-distance penetration levels. Sales of combinedHowever, our long-distance and local calling fixed-fee offerings (referred to as “bundling”) also contributed to the increased long-distance revenues and customers. Long-distance revenuesrevenue growth continued to increaseslow, decreasing approximately 4.0% from second-quarter 2006 results, reflecting continuing market maturity since we began providing service to all of our in-region states in our traditional SBC Midwest, Westlate 2003 and Southwest regions.a continuing decline in ATTC’s mass-market customers.
21 AT&T INC. SEPTEMBER 30, 2006 The increaseItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued
Dollars in localmillions except per share amounts Local voice revenues of $194increased $273 in the third quarter and $783 for the first quarternine months of 2006 primarily reflectsreflecting our acquisition of ATTC. OurHowever, we expect that revenues from ATTC’s mass-market customers will continue to decline on a sequential quarterly basis. Local voice revenues were also negatively impacted by continued declines in customer demand, calling features (e.g., Caller ID and voice mail), inside wire and retail payphone revenues. We expect our local voice revenue growth willto continue to be negatively impacted due toaffected by increased competition, including customers shifting to competitors’ wireless, VoIP technology and cable offerings for voice, 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 decline in customer demand decreased revenues $88. A decline in demand for calling features (e.g., Caller ID and voice mail), due primarily to the access line declines, decreased revenues approximately $47 in the first quarter of 2006. Lower demand for inside wire and retail payphone services decreased revenues approximately $38 in the first quarter 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 regional telephone service and calling features in the first quarter of 2006.features.
Lower demand for local wholesale services, primarily due to the decline in UNE-PUnbundled Network Element-Platform (UNE-P) lines provided to competitors, decreased revenue approximately $176$131 in the third quarter and $457 for the first quarternine months of 2006. Lines provided under the former UNE-P rules (which ended in March 2006) declined, as competitors moved to alternate arrangements to serve their customers or their customers chose an alternative technology. These lines are classified as wholesale in the “Access Line Summary” table. Competitors representingwho represented a majority of our UNE-P lines have signed commercial agreements with us and therefore remain our wholesale customers. 26
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
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. While we lose some revenue when a wireline customer shifts from one of our retail lines to a competitor that relies on a resale or wholesale product, we lose all revenue when a wireline customer shifts to a competitor using an alternative technology such as cable, wireless or VoIP, or their own network facilities. Datarevenues increased $2,051,$2,032, or 85.8%80.8%, in the third quarter and $6,122, or 83.4%, for the first nine months of 2006. The increase in data revenues was due to increases in IP data of $792 in the third quarter of 2006, withand $2,346 for the first nine months, increases of $779 in Internet Protocol (IP) data, $666 in transport of $651 in the third quarter and $606$1,998 for the first nine months and increases in packet switched services of $589 in the third quarter and $1,778 for the first nine months, all of which wereincreased almost entirely due to the acquisition of ATTC. Revenues fromData revenues accounted for approximately 29% of our traditional SBC regions increased approximately 9.0% compared tooperating revenues in the third quarter and for the first nine months of 2006 and 24% of revenues in the third quarter of 2005 and 2.0% sequentially, while pro forma revenues from ATTC’s traditional enterprise categories declined slightly compared tofor the first quarternine months of 2005 and sequentially.2005. Included in IP data revenues are services forDSL, dedicated internet access, virtual private network and other 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 $103$109 in the third quarter and $313 for the first quarternine months of 2006, reflecting an increase in DSL lines in service, which was partially driven by lower-priced promotional offerings andas a response to competitive pricing responses to competitors. The number of DSL lines in service grew to approximately 7.4 million, a 32.5% increase from March 31, 2005.pressures. Our 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 50%approximately 49% of total data revenues in the third quarter and 50% for the first quarternine months of 2006, and 65%63% of total data revenues in the third quarter and 64% for the first quarternine months of 2005. Our packet switched services includes frame relay, asynchronous transfer mode (ATM) and managed packet services. As customers continue to shift from this traditional technology to IP-based technology, we expect these services to decline as a percentage of our overall data revenues. Otheroperating revenues increased $636$604, or 62.1%, in the third quarter and $1,835, or 61.8%, for the first quarternine months of 2006, primarily due to incremental revenue of $601 from our acquisition of ATTC. The majorMajor items included in other operating revenues are integration services and customer premises equipment, outsourcing, directory and operator assistance services and government-related services.services, which account for over 72% of total revenue for all periods. Our co-branded AT&T | DISH Network satellite TV service increased revenue $15$8 in the third quarter and $33 for the first nine months of 2006. Partially offsetting these revenue increases were reduced demandRevenue also increased $70 from an intellectual property license for directorythe first nine months of 2006. 22 AT&T INC. SEPTEMBER 30, 2006 Item 2. Management’s Discussion and operator assistance, billingAnalysis of Financial Condition and collection services provided to other carriers, wholesale and other miscellaneous products and services, which decreased revenue $42Results of Operations - Continued Dollars in 2006.millions except per share amounts Cost of salesexpenses increased $2,733$2,303, or 56.2%, in the third quarter and $7,472, or 60.5%, for the first quarternine months of 2006, primarily related to the acquisition of ATTC, which increased expenses approximately $2,800.ATTC. 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. 27
AT&T INC.
MARCH 31,In-region benefit expenses, consisting primarily of our combined net pension and postretirement cost, increased $47 in the third quarter and $106 for the first nine months of 2006,
Item 2. Management’s Discussion primarily due to changes in our actuarial assumptions, which included the reduction of our discount rate from 6.00% to 5.75% (which increases expense), and Analysisnet losses on plan assets in prior years. In addition, expenses increased $20 for the first nine months of Financial Condition2006 related to changes in 2005 to phone concessions for out-of region retirees which reduced expenses in 2005. Nonemployee-related expenses such as contract services, agent commissions and Results of Operations
Dollarsmaterials and supplies costs, increased $102 in millions except per share amounts
RESULTS OF OPERATIONS - Continued
the third quarter and $67 for the first nine months. Traffic compensation expense (for access to another carrier’s network), up slightly in the third quarter, increased $113 in$110 for the first nine months of 2006, due primarily to growth in Yahoo! Inc. and long-distance service, and as a result of decreased costs recorded in the first quarter of 2005 related to a carrier settlement. Benefit expenses, consisting primarily of our combined net pension and postretirement 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 adjustmentsemployee related expenses increased expense $31$29 in the third quarter and $58 for the first nine months of 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 quarter of 2006. Lower employee levels decreased expenses, primarily salary and wages, $39 in 2006. Costs associated with equipment sales and related network integration services, which decreased $34$137 in the third quarter and $317 for the first nine months of 2006 primarily due to lower demand and 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, satellite video) typically are greater than costs associated with services that are provided over multiple years.
Lower employee levels decreased expenses, primarily salary and wages, $83 in the third quarter and $203 for the first nine months of 2006. Expenses in the third quarter and for the first nine months of 2006 were $165 lower than prior periods due to a change in our policy regarding the timing for earning vacation days. Expenses also decreased infor the first nine months of 2006 resulting from repair costs of approximately $100 incurred in the first quarter of 2005 related to severe weather in our traditional SBC regions.in-region. Expenses previously reported for the first six months of 2006 were reduced by $79 based on a review of certain international billing arrangements (see Note 1). Selling, general and administrativeexpenses increased $1,531$1,466, or 77.5%, in the third quarter and $4,217, or 66.1%, for the first quarternine months of 2006, primarily due to the ATTC acquisition, which increased expenses approximately $1,250.acquisition. Selling, general and administrative expenses consist of our provision for uncollectible accounts; advertising costs; sales and marketing functions, including our retail and wholesale customer service centers; centrally managed real estate costs, including maintenance and utilities on all owned and leased buildings; credit and collection functions, and;functions; and 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. Other in-region wireline segment costs increased $274$164 in the third quarter and $800 for the first nine months of 2006 most of which wasprimarily due to advertising costs related to promotion of the new AT&T brand name. In addition, other advertising expenseexpenses increased $25$13 in 2006 primarily driven by our promotionthe third quarter and $70 for the first nine months of the Home Turf campaign and sponsorship of the Winter Olympics.2006. Salary and wage merit increases and other bonus accrual adjustmentsemployee related expenses increased expenses $22$42 in 2006. Benefit expenses, consisting primarilythe third quarter and $56 for the first nine months of our combined net pension and postretirement cost, increased $19 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.2006. Nonemployee related expenses, such as contract services, agent commissions and materials and supplies costs, increased $30 in 2006. 28
23 AT&T INC. MARCH 31,SEPTEMBER 30, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued Dollars in millions except per share amounts RESULTS OF OPERATIONS - Continuedincreased $26 in the third quarter and $14 for the first nine months of 2006. Benefit expenses, consisting primarily of our combined net pension and postretirement cost, increased $23 in the third quarter and $47 for the first nine months of 2006. In addition, expenses increased $57 in the third quarter and $73 for the first nine months of 2006 related to changes in 2005 to phone concessions for out-of region retirees which reduced expenses in 2005.
Partially offsetting these increases were lower employee levels, which decreased expenses, primarily salary and wages, $69$67 in the third quarter and $201 for the first quarternine months of 2006. Our provision for uncollectible accounts decreased $28slightly in the third quarter and $55 for the first nine months of 2006 as we experienced fewer losses from our retail customers and a decrease in bankruptcy filings by our wholesale customers. Expenses in the third quarter and for the first nine months of 2006 were $70 lower than prior periods due to a change in our policy regarding the timing for earning vacation days. Expenses also decreased $236 for the first nine months of 2006 due to a charge we incurred in the second quarter of 2005 to terminate existing agreements with WilTel Communications, which will continue to provide transitional and out-of-market long distance services under an agreement that commenced in November 2005 as a result of our acquisition of ATTC. Depreciation and amortizationexpenses increased $657$629, or 36.0%, in 2006. Expenses increased $734the third quarter and 1,956, or 37.1%, for the first nine months of 2006 primarily due to the acquisition of ATTC, of which $266 related to amortization of intangible assets, primarily customer listshigher depreciable and relationships, identified at the timeamortizable asset bases as a result of the ATTC merger. Expenses related to traditional SBC decreased $77 in the first quarter of 2006, due primarily to significantly lower capital expenditures since 2001. Supplemental Information24
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
AT&T INC. MARCH 31,SEPTEMBER 30, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued Dollars in millions except per share amounts RESULTS OF OPERATIONS - ContinuedSupplemental Information
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 totalAccess Line Summary
Our in-region switched access lines at March 31,September 30, 2006 compared to 86.7% a year earlier. Duringand 2005 are shown below and access line trends are addressed throughout this same period, wholesale lines decreased 28.2% and at March 31, 2006 represented 9.6% of totalsegment discussion: In-Region1 | | | | Switched Access Lines | September 30, | | | | | % Increase | (in 000’s) | 2006 | 2005 | (Decrease) | | | | | Retail Consumer | | | | Primary | 22,068 | 22,922 | (3.7)% | Additional | 3,571 | 3,989 | (10.5) | Retail Consumer Subtotal | 25,639 | 26,911 | (4.7) | | | | | Retail Business | 17,212 | 17,511 | (1.7) | Retail Subtotal | 42,851 | 44,422 | (3.5) | Percent of total switched access lines | 91.0% | 88.5% | | | | | | Sold to ATTC | 1,216 | 1,790 | (32.1) | Sold to other CLECs2 | 2,756 | 3,633 | (24.1) | Wholesale Subtotal | 3,972 | 5,423 | (26.8) | Percent of total switched access lines | 8.4% | 10.8% | | | | | | Payphone (Retail and Wholesale) | 264 | 372 | (29.0) | Percent of total switched access lines | 0.6% | 0.7% | | | | | | Total Switched Access Lines | 47,087 | 50,217 | (6.2)% | | | | | Broadband Connections3 | 8,155 | 6,496 | 25.5% | | | | | |
1 In-region represents access lines down from 12.5% a year earlier.served by AT&T’s ILECs. 2Competitive local exchange carriers (CLECs) 3Broadband connections include DSL lines of 8,148 in 2006 and 6,496 in 2005, U-verse high-speed internet access and satellite broadband. The decline25
AT&T INC. SEPTEMBER 30, 2006 Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued Dollars 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 servicemillions 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.per share amounts Cingular Segment Results | First Quarter | | | Third Quarter | | | Nine-Month Period | | | | | Percent | | | | | | Percent | | | | | | | Percent | | 2006 | 2005 | | Change | | 2006 | | 2005 | | Change | | | 2006 | | 2005 | | Change | Segment operating revenues | | | | | | | | | | | | | | | | | | | | | Service revenues | $ | 8,005 | $ | 7,419 | | 7.9% | | $ | 8,661 | $ | 7,721 | | 12.2% | | $ | 24,961 | $ | 22,859 | | 9.2% | Equipment revenues | | 975 | | 810 | | 20.4 | | | 892 | | 1,025 | | (13.0) | | | 2,790 | | 2,725 | | 2.4 | Total Segment Operating Revenues | | 8,980 | | 8,229 | | 9.1 | | | 9,553 | | 8,746 | | 9.2 | | | 27,751 | | 25,584 | | 8.5 | Segment operating expenses | | | | | | | | | | | | | | | | | | | | | Cost of services and equipment sales | | 3,647 | | 3,439 | | 6.0 | | | 3,725 | | 3,667 | | 1.6 | | | 11,218 | | 10,629 | | 5.5 | Selling, general and administrative | | 2,846 | | 3,001 | | (5.2) | | | 2,836 | | 2,881 | | (1.6) | | | 8,439 | | 8,835 | | (4.5) | Depreciation and amortization | | 1,680 | | 1,675 | | 0.3 | | | 1,576 | | 1,541 | | 2.3 | | | 4,854 | | 4,845 | | 0.2 | Total Segment Operating Expenses | | 8,173 | | 8,115 | | 0.7 | | | 8,137 | | 8,089 | | 0.6 | | | 24,511 | | 24,309 | | 0.8 | Segment Operating Income | | 807 | | 114 | | - | | | 1,416 | | 657 | | - | | | 3,240 | | 1,275 | | - | Interest Expense | | 297 | | 338 | | (12.1) | | | 306 | | 304 | | 0.7 | | | 901 | | 968 | | (6.9) | Equity in Net Income of Affiliates | | - | | 2 | | - | | | - | | 1 | | - | | | - | | 4 | | - | Other – net | | (32) | | 4 | | - | | | (38) | | (28) | | (35.7) | | | (107) | | (32) | | - | Segment Income (Loss) | $ | 478 | $ | (218) | | - | | | Segment Income | | $ | 1,072 | $ | 326 | | - | | $ | 2,232 | $ | 279 | | - |
Accounting for Cingular We account for our 60% economic interest in our Cingular joint venture 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 Board of Directors that controls Cingular.statements. 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 our segment 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. We discuss Cingular’s liquidity and capital expenditures under the heading “Cingular” within “Liquidity and Capital Resources.” 30
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
Cingular’s Customer and Operating Trends As of March 31,September 30, 2006, Cingular served approximately 55.858.7 million cellular/PCS (wireless) customers compared to 54.152.3 million at December 31, 2005 and 50.4 million at March 31,September 30, 2005. Cingular’s increase in customer gross additions in the third quarter and for the first quarternine months of 2006 compared to the first quarter of 2005 was primarily driven by an increase in reseller and prepaid customer growth, combined with its larger distribution network, broad range of service offerings and advertising over the past year. This growth was partially offset by a decline in postpaid customer growth due to the streamlining of operations, such as the reduction of retail stores and agents, and higher wireless market penetration. Cingular’s recent customer activity is listed below:net subscriber additions increased 56.6% in the third quarter and 42.3% for the first nine months of 2006. Wireless Customer Activity
| | 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 impact Cingular’s gross additions, and revenue growth, expenses and put pressure on margins. Cingular expects that future revenue growth will become increasingly dependent on minimizing customer turnover (customer churn) and increasing service 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. WhileHowever, in the past quarter Cingular’s ARPU has somewhat stabilized recently,improved slightly reflecting increased use of data services by customers. Cingular 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, which includes the costs Cingular is now paying T-Mobile USA (T-Mobile) for the use of its network in California and Nevada, higher costs associated with integrating AT&T Wireless’ network and operations, and, to a lesser extent, increased expenses related to operating, maintaining and decommissioning Time Division Multiple Access (TDMA) networks 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.
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26 AT&T INC. MARCH 31,SEPTEMBER 30, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued Dollars in millions except per share amounts RESULTS OF OPERATIONS - Continued
ARPU declined 2.3%increased 0.2% in the third quarter and declined 1.8% for the first quarternine months of 2006. The slight increase in ARPU in the third quarter was primarily due to an increase of 46.0% in average data revenue per customer, which was almost entirely offset by decreases in local service, net roaming revenue and other revenue per customer. The decline in ARPU for the first nine months was due to a decrease in local service, net roaming revenue and other revenue per customer partially offset by an increase in average data revenue per customer, which increased 41.1%.42.0% for the first nine months, and long-distance revenue per customer. Local service revenue per customer declined primarily due to an 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 whichthat 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 month 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.minutes. The effective management of wireless customer churn is critical to Cingular’s ability to maximize revenue growth and to maintain and improve margins. Cingular’s wireless customer churn rate is calculated by dividing the aggregate number of wireless 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%1.8% in the third quarter and for the first quarternine months of 2006, down from 2.2%2.3% in the third quarter and 2.2% for the first quarternine months of 2005. The churn rate for Cingular’s postpaid customers was 1.6%1.5% in the third quarter and for the first quarternine months of 2006, down from 1.9%2.0% in the third quarter and 1.9% for the first quarternine months of 2005. The decline in postpaid churn reflects benefits from the acquisition of AT&T Wireless Service Inc. (AT&T Wireless), including more affordable rate plans, broader network coverage, higher network quality, exclusive devices and free mobile-to-mobile calling among Cingular customers. Cingular’s 55.8 million customers.customer churn of 1.8% in the third quarter increased 10 basis points sequentially from the second quarter of 2006. The sequential increase resulted from normal seasonality patterns, the phasing out of AT&T Wireless prepaid plans and from certain actions Cingular made to recover increased costs associated with serving the diminishing base of its Time Division Multiple Access (TDMA) customers and migration of these customers to the Cingular Global System for Mobile Communication (GSM) network. While Cingular anticipates continued improvements to its network and customer care and more compelling customer products and services, they continue to expect higher disconnects from the continued phase out of the AT&T Wireless prepaid platform and from Cingular’s analog and TDMA service which is planned to discontinue in early 2008. Cingular expects its cost of services to continue increasing due to higher network system usage, which includes the costs Cingular is now paying T-Mobile USA (T-Mobile) for the use of its network in California and Nevada, higher costs associated with integrating the AT&T Wireless network and operations, and, to a lesser extent, increased expenses related to operating, maintaining and decommissioning TDMA networks that duplicated GSM networks while integrating the networks acquired from AT&T Wireless. Cingular’s remaining purchase commitment to T-Mobile was $243 at September 30, 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 as of September 30, 2006, more than 85% of Cingular’s customers in California and Nevada were on the Cingular network. In June 2006, the Federal Communications Commission (FCC) increased the safe harbor for contributions to the Universal Service Fund (USF) by wireless carriers, which establishes a presumption that a specific percentage of a wireless carrier’s revenues are derived from providing interstate telecommunications services, and thus are subject to USF contributions. Cingular previously has contributed to the fund based on the wireless safe harbor, but likely will begin to contribute based on its actual interstate revenues in light of the increase in the wireless safe harbor. Cingular’s Operating Results Our Cingular segment operating income margin was 9.0%14.8% in the third quarter and 11.7% for the first quarternine months of 2006, which improved over margins of 6.2%7.5% in the fourththird quarter of 2005 and 1.4% in5.0% for the first quarternine months of 2005. The higher margin in the first quarter of 2006 compared to the first quarter of 2005 was primarily due to revenue 27 AT&T INC. SEPTEMBER 30, 2006 Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued Dollars in millions except per share amounts growth of $751.$807 in the third quarter and $2,167 for the first nine months. Cingular’s revenue growth reflects the impact of service credits to customers affected by Hurricane Katrina of $31 in the third quarter of 2005. Servicerevenues are comprised of local voice and data services, roaming, long-distance and other revenue. Service revenues increased $586,$940, or 7.9%12.2%, in the third quarter and $2,102, or 9.2%, for the first quarternine months of 2006 and consisted of: Local voice revenues increased $339,$449, or 5.5%7.1%, in the third quarter and $1,083, or 5.8%, for the first quarternine months, primarily due to a 10.5%an increase in Cingular’s average number of wireless customers of 12.1% in the third quarter and 11.3% for the first nine months, partially offset by a decline in local service ARPU of 4.5%.4.4% in the third quarter and 5.0% for the first nine months. Data service revenues increased $303,$417, or 53.2%60.5%, in the third quarter and $1,055, or 55.1%, for the first nine months, due to a 41.1%an increase in average data revenue per customer of 46.0% in the third quarter and 42.0% for the first nine months, which was related to increased use of text messaging and internet access services. Data service revenues represented 9.7%12.8% of Cingular’s totalservice revenues in the third quarter and 11.9% for the first quarter.nine months. Roaming revenues from Cingular customers and other wireless carriers for use of Cingular’s network decreased $32,increased $57, or 6.9%10.8%, in the third quarter and decreased $45, or 2.9%, for the first quarter.nine months. Long-distance and other revenue decreased $24,increased $17, or 11.8%8.9%, in the third quarter and $9, or 1.6%, for the first quarternine months primarily as a result of increased international long-distance usage partially offset by a decline in other revenue attributed to property management revenues, which were partially offset by increased domestic long-distance revenue.fees. 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,decreased $133, or 20.4%13.0%, in the third quarter and increased $65, or 2.4%, for the first nine months of 2006. The decline in the third quarter of 2006was primarily due to an increase in rebate activity and reduced handset pricing, partially offset by increased accessory pricing and upgrade volume. The increase for the first nine months was due to increased handset revenues primarily as a result of increased handset sales related to the higher priced handsets,gross customer additions and higher prices on handset upgrades and accessories, partially offset by a decline in gross prepaid customer additions.increased rebate activity. Cost of services and equipment sales expenses increased $208,$58, or 6.0%1.6%, in the third quarter and $589, or 5.5%, for the first quarternine months of 2006 primarily due to increases in network usage and associated network system expansion. Cost of services increased $176,$63, or 8.2%2.6%, in the third quarter and $443, or 6.4%, for the first quarternine months of 2006 primarily due to the following: Increases in network usage with an increase in minutes of use of 22.8%21.3% in the third quarter and 21.0% for the first quarter of 2006.nine months. Higher roaming and long-distance cost,costs were partially offset by declinesa decline 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.network of 60.1% in the third quarter and 50.1% for the first nine months. Cost of services includes integration costs, primarily for network integration, of $65 in the third quarter and $150 for the first nine months of 2006 compared to $101 in the third quarter and $123 in the first nine months of 2005. Cost of services in the third quarter of 2005 also includes $78 in hurricane costs. Equipment sales expense increased slightlydecreased $5, or 0.4%, in the third quarter and increased $146, or 3.9%, for the first nine months of 2006. The decrease in the third quarter of 2006 by $32, or 2.5%,was primarily due to handset unit sales associated an increasea decline in the average cost per unit sold of 13.3%handset sold. The increase for the first nine months was due to increased handset unit sales of(including upgrades) associated with the higher quality handsets for gross customer additions, including exclusive devices, partially offset by athe decline in gross prepaid customer additions.the average cost per handset sold. Total equipment costs continue to be higher than equipment revenues due to Cingular’s salessale 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, though this difference narrowed compared to the first quarter of 2005.promotions. Selling, general and administrative expenses decreased $155, or 5.2%, in the first quarter of 2006 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 employee costs and employee-related benefits due to a decrease in headcount.
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 advertising 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 equipment maintenance expenses.
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28 AT&T INC. MARCH 31,SEPTEMBER 30, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued Dollars in millions except per share amounts RESULTS OF OPERATIONS - ContinuedSelling, general and administrative expenses decreased $45, or 1.6%, in the third quarter and $396, or 4.5%, for the first nine months of 2006. The decline in the third quarter was due to decreases in general and administrative expenses of $85, partially offset by increased selling expenses of $40. The decline for the nine months was due to decreases in general and administrative expenses of $347 and selling expenses of $49.
Selling, general and administrative expenses included the following: Billing and bad debt expense decreased $131 in the third quarter and $283 for the first nine months primarily due to fewer account write-offs and cost savings related to transitioning to one billing system. Other administrative expenses decreased $60 in the third quarter and $140 for the first nine months of 2006. The decrease in the third quarter was due to a decline in spending related to IT and other professional services and a benefit related to a settlement of a dispute. The decrease for the first nine months was due to a decline in litigation related expenses, lower employee costs and employee-related benefits due to a decrease in headcount, lower IT and other professional services expense and a federal excise tax refund accrual. Customer service expenses decreased $3 in the third quarter and $90 for the first nine months of due to a decline in the number of call center outsourced professional services and lower billing expenses. Other expenses increased $109 in the third quarter and $166 for the first nine months due to increased prepaid card replenishment costs and higher migration and upgrade transaction costs. Selling expenses increased $40 in the third quarter and decreased $49 for the first nine months of 2006. The increase in the third quarter was due to increased direct commissions related to changes to the sales compensation plan. The decrease for the first nine months was due to lower indirect commissions and advertising expenses, partially offset the increased direct commissions expense mentioned previously. The decline in indirect commissions was due to reductions in average activation and agent branding expense. Depreciation and amortization expenses increased $5,$35, or 0.3%2.3%, in the third quarter and $9, or 0.2%, for the first quarternine months of 2006. Depreciation expense increased $146$129, or 11.4%, in the third quarter and $364, or 10.5%, for the first quarternine months of 2006, primarily due to depreciation associated with the property, plant and equipment related to Cingular’s ongoing 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. Substantially all of Cingular’s TDMA assets are anticipated to be fully depreciated by the end of 2007. Amortization expense decreased $141$94, or 22.9%, in the third quarter and $355, or 25.8%, for the first quarternine months of 2006 primarily due to the declining amortization of the AT&T Wireless customer contracts and other intangible assets acquired, which are amortized using the sum of the months digits method of amortization. 29 AT&T INC. SEPTEMBER 30, 2006 Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued Dollars in millions except per share amounts Directory Segment Results | First Quarter | | | Third Quarter | | | Nine-Month Period | | | | | Percent | | | | | | Percent | | | | | | | Percent | | 2006 | 2005 | | Change | | 2006 | | 2005 | | Change | | | 2006 | | 2005 | | Change | Total Segment Operating Revenues | $ | 923 | $ | 929 | | (0.6)% | | $ | 921 | $ | 932 | | (1.2)% | | $ | 2,769 | $ | 2,786 | | (0.6)% | Segment operating expenses | | | | | | | | | | | | | | | | | | | | | Cost of sales | | 288 | | 280 | | 2.9 | | | 277 | | 271 | | 2.2 | | | 853 | | 827 | | 3.1 | Selling, general and administrative | | 159 | | 164 | | (3.0) | | | 162 | | 154 | | 5.2 | | | 468 | | 474 | | (1.3) | Depreciation and amortization | | 1 | | 2 | | (50.0) | | | 1 | | 1 | | - | | | 2 | | 4 | | (50.0) | Total Segment Operating Expenses | | 448 | | 446 | | 0.4 | | | 440 | | 426 | | 3.3 | | | 1,323 | | 1,305 | | 1.4 | Segment Operating Income | | 475 | | 483 | | (1.7) | | | 481 | | 506 | | (4.9) | | | 1,446 | | 1,481 | | (2.4) | Equity in Net Income (Loss) of Affiliates | | (5) | | (1) | | - | | | (2) | | - | | - | | | (13) | | (1) | | - | Segment Income | $ | 470 | $ | 482 | | (2.5)% | | $ | 479 | $ | 506 | | (5.3)% | | $ | 1,433 | $ | 1,480 | | (3.2)% |
Our directory operating income margin was 51.5%52.2% in the firstthird quarter of 2006, compared to 52.0%54.3% in the firstthird quarter of 2005. See further discussion2005 and 52.2% for the first nine months of 2006 compared to 53.2% for the detailsfirst nine months of our directory segment revenue and expense fluctuations below.2005. Operating revenues decreased $6,$11, or 1.2%, in the third quarter and decreased $17, or 0.6%, for the first nine months of 2006. Decreases in print advertising revenues of $34 in the third quarter and $63 for the first quarter of 2006. Revenues in 2006 decreased primarily as a result of decreased demand for local Yellow Pages advertising which wasnine months were partially offset by increased internet advertising revenues.revenues of $20 in the third quarter and $52 for the first nine months of 2006, which do not include the revenues of YPC. These results in the third quarter and for the first nine months reflect the impact of competition from other publishers, other advertising media and continuing economic pressures on advertising customers. 34
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
Cost of salesincreased $8,$6, or 2.9%2.2%, in the third quarter of 2006 and increased $26, or 3.1%, for the first quarternine months of 2006. The increase was primarily driven by higher costs for internet traffic publishing and commissions. Selling, general and administrative expenses decreased $5,increased $8, or 3%5.2%, in the firstthird quarter of 2006 and decreased $6, or 1.3%, for the first nine months of 2006. The increase in the third quarter was primarily due to increased other directory segment costs, including benefits, partially offset by lower bad debt expense. The decline for the first nine months was primarily due to lower bad debt expense, partially offset by increased other directory segment costs, including benefits. Other Segment Results | First Quarter | | Third Quarter | | | Nine-Month Period | | | | | Percent | | | | | | | Percent | | | | | | | Percent | | 2006 | 2005 | | Change | | | 2006 | | 2005 | | Change | | | 2006 | | 2005 | | Change | Total Segment Operating Revenues | $ | 203 | $ | 169 | | 20.1% | $ | 204 | $ | 182 | | 12.1% | | $ | 604 | $ | 529 | | 14.2% | Total Segment Operating Expenses | | 239 | | 212 | | 12.7 | | 221 | | 222 | | (0.5) | | | 678 | | 632 | | 7.3 | Segment Operating Income (Loss) | | (36) | | (43) | | 16.3 | | (17) | | (40) | | 57.5 | | | (74) | | (103) | | 28.2 | Equity in Net Income (Loss) of Affiliates | | 339 | | (58) | | - | | Segment Income (Loss) | $ | 303 | $ | (101) | | - | | | Equity in Net Income of Affiliates | | | 651 | | 219 | | - | | | 1,451 | | 343 | | - | Segment Income | | $ | 634 | $ | 179 | | - | | $ | 1,377 | $ | 240 | | - |
Our other segment operating results in the third quarter and for the first quarternine months of 2006 and 2005 consist primarily of Sterling, corporate and other operations. Sterling provides business integration software and services. 30 AT&T INC. SEPTEMBER 30, 2006 Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued Dollars in millions except per share amounts Operating revenues increased $34$22, or 12.1%, in the third quarter and $75, or 14.2%, for the first quarternine months of 2006 primarily due to increased intercompany revenue from our captive insurance company (shown as intersegment revenue in Note 5) and improved operating revenue at Sterling.Sterling, partially offset by revenue earned by our paging subsidiary in 2005. Our paging subsidiary was sold in November of 2005. Operating expenses increased $27were flat in the third quarter and increased $46, or 7.3%, for the first quarternine months of 2006 primarily due to increased corporate expenses (including) advertising costs and incremental ATTC corporate expenses)expense from our captive insurance company 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 60% proportionate share of Cingular’s results as equity in net income of affiliates. Our other segment also includes our equity investments in international companies, the income from which we report as equity in net income of affiliates. 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. Our other segment also includes our 60% proportionate share of Cingular’s results as equity in net income of affiliates. Our equity in net income of affiliates by major investment is listed below: | | First Quarter | | Third Quarter | | Nine-Month Period | | | 2006 | | 2005 | | 2006 | | 2005 | | 2006 | | 2005 | Cingular | $ | 213 | $ | (144) | $ | 508 | $ | 133 | $ | 1,045 | $ | 77 | América Móvil | | | 79 | | 27 | | 200 | | 104 | Telmex | | 61 | | 51 | | 54 | | 59 | | 167 | | 157 | América Móvil | | 55 | | 27 | | Other | | 10 | | 8 | | 10 | | - | | 39 | | 5 | Other Segment Equity in Net Income (Loss) of Affiliates | $ | 339 | $ | (58) | | Other Segment Equity in Net Income of Affiliates | | $ | 651 | $ | 219 | $ | 1,451 | $ | 343 | |
Equity in net income of affiliates increased $397$432 in the third quarter and $1,108 for the first quarternine months of 2006. The increase was primarily due to an increase of $357$375 in the third quarter and $968 for the first nine months in our proportionate share of Cingular’s results. Also contributing to the increase for the first nine months was increasedan increase in equity income of $38$106 from Telmex and América Móvil S.A. de C.V. and Teléfonos de México, S.A. de C.V. reflecting higher revenue levelsimproved operating results at both companies including significant increases in wireless subscribers at América Móvil.companies. 36
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
COMPETITIVE AND REGULATORY ENVIRONMENT OverviewAT&T subsidiaries operating within the U.S. are subject to federal and state regulatory authorities. AT&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 Federal Communications Commission (FCC)FCC and some state regulatory commissions have maintained many of the extensive regulatory requirements applicable to our traditional wireline subsidiaries. We are actively pursuing additional legislative and regulatory measures to reduce or eliminate regulatory requirements that inhibit our ability to provide the full 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 KansasSeveral states have passed legislation that enables new video entrants to acquire a state-wide franchise to offer video services, see “Video Legislation” below.services. 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 31 AT&T INC. SEPTEMBER 30, 2006 Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued Dollars in millions except per share amounts of legislation is uncertain and depends on many factors, but we believe that the increasing pace of technological change and competition in our industry will encourage lawmakers to remove artificial barriers to competition. Triennial Review Remand Order Effective March 11, 2005,In December 2004, the FCC adopted its fourth set of rules concerning an ILEC’s obligation to make elements of its network available to other local service providers.Each of its previous three sets of rules had been overturned by the federal courts. These new rules, known as the Triennial Review Remand Order (TRRO) eliminated, became effective on March 11, 2005. The TRRO provided significant relief from unbundling by eliminating our remaining 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 majoritywhich ended on March 11, 2006. At the same time, the TRRO largely retained unbundling requirements for many of our UNE-P lines have signed commercial agreementshigh-capacity loop and transport facilities. We and other parties filed appeals with us. For the remaining UNE-P lines, we believe, based on marketing research, that customers primarily converted to competitors using alternative technologies or their own networks as opposed to returning as our retail customers. AtUnited States Court of Appeals for the March 11,District of Columbia Circuit (D.C. Circuit) challenging various portions of the TRRO. In June 2006, transition deadline we re-priced to market-based or resale-like rates any UNE-P lines that had not been converted, exceptthe D.C. Circuit issued a decision upholding the FCC’s order in the state of Illinois where competitive local exchange carriers have the right under state law to retain the lines that areall respects. The D.C. Circuit’s decision became final and non-appealable in service at UNE-P equivalent rates. We had less than 100,000 UNE-P lines in Illinois as of March 11,September 2006. Video LegislationIn March 2006, Indiana During the third quarter, California passed video franchise reform legislation that ends disputes over the need for municipal video franchises. While the California Public Utility Commission (CPUC) is the state franchising authority, the law specifically clarified that the CPUC has no authority over rates, terms and conditions of video service. Additionally, as part of this law, there will be a state telecommunications deregulation bill that will make it easier for telecommunications companies to offer television service. The law prohibits the regulation of advanced services, broadband services, information services and retail IP enabled service, commercial mobile service and new services (any service not commercially availablefreeze on March 28, 2006), and deregulates pricesrates for basic telecommunicationstelephone services, generally capping residential primary line basic service afteruntil January 1, 2009. The new law provides for certain nondiscrimination obligations as well as build-out obligations, the latter of which generally requires AT&T and other large telephone companies providing video service using a three-year transition period. It also creates statewidetechnology other than fiber to the premises to make video franchisingservice available to replace individual local agreements. In April 2006, Kansas passed35% of California households in their telephone service areas within three years and to 50% within five years of obtaining a new 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,
37
AT&T INC.franchise.
MARCH 31, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Dollars in Millions except per share amounts
COMPETITIVE 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
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 Pending Acquisition of BellSouthOn March 4, 2006, we agreed to acquire BellSouth Corporation (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 mergeracquisition (March 5, 2006) of $27.32, the total transaction is valued, for purchase accounting purposes, at approximately $65,000.$66,000. The transaction has been approved by the Board of Directors and the stockholders of each company, and also must be approved by the stockholders of AT&T and BellSouth. The transaction is also subject to review byvarious other regulatory authorities. In October 2006, the U.S. Department of Justice (DOJ) andcompleted its review of the transaction without imposing any conditions. The acquisition remains subject to approval by the FCC.
On October 13, 2006, the Chairman of the FCC issued a letter addressing the concerns posed by two members of the FCC in reviewing this transaction. In response to those concerns, the Chairman has allowed 10 days for further review and various other regulatory authorities. We currently expectevaluation of the transactionproposals submitted by AT&T to closeaddress those concerns and any additional concerns raised by the end of 2006.two members regarding this transaction. The FCC has scheduled an open meeting for November 3, 2006 where they intend to consider the application. Project LightspeedAcquisition of USiOn October 20, 2006, we acquired an independent application service provider, USinternetworking, Inc. (USi) for approximately $300 in cash and assumed debt. The transaction is designed to enhance our enterprise service offerings.
U-verse Services (Project Lightspeed)In 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.customers. We have been building out this network in numerous locations and began providing AT&T U-verse services, including IPU-verse TV (IPTV) video, in one market (San Antonio) in a limited market,manner, in late 2005. Our goal inDuring this controlled market entry is to fully applywe implemented our new operating 32 AT&T INC. SEPTEMBER 30, 2006 Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued Dollars in millions except per share amounts and back-office systems gain information on customer preferences and if needed,gained marketing experience. In June 2006, we began marketing to fine-tune the service. To that end, we have restricted the numberadditional areas of customersSan Antonio while continuing to monitor our systems and services offered to the necessary minimum.market reaction. Subject to successful results from this controlled market entry and successful testingimplementation of our additional IP video services and deployment schedule, we planexpect to enteroffer U-verse services in a total of approximately 15 to 20 additional markets (defined as metropolitan statistical areas) within our traditional 13-state wireline area by the end of 2006.2006, with the additional markets beyond San Antonio to be launched late in the fourth quarter. We expect to follow the plan used in San Antonio, namely, to initially enter only a limited area within each market and then expand to additional areas within each market. During that expansion,our launch into these additional markets, we expect to add additional features to our IP video service offering. We expect to have the capability to offer service to approximately 1819 million householdsliving units by the end of 2008, as part of our initial deployment, and expect to spend approximately $4,400$4,600 in network-related deployment costs and capital expenditures beginning in 2006 through 2008, as well as additional success-based customer activation capital expenditures. These expenditures may increase slightly if the programming and features of the video offering expand or if additional network conditioning is required. 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 negotiatehave completed most negotiations, and within our programming profitability assumptions, 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. 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 Project LightspeedIPTV is subject to federal oversight as a “video service” under the Federal Communications Act. However, some cable providers and municipalities have claimed that certain IP services 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. Certain municipalities also have refused us permission to use our existing right-of-ways to deploy or activate our U-verse-related services and products, resulting in litigation. Pending negotiations and current or threatened litigation involving municipalities could delay our deployment plans in those areas for 2006 and future years. If the courts were to decide that state and local regulation were applicable to our Project LightspeedU-verse services, it could have a material adverse effect on the cost, timing and extent of our deployment plans. 39
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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
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,In March 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 Petitionpetition for Writ of Certiorari withcertiorari requesting the Supreme Court of the United States (Supreme Court) to review the Second Circuit’s decision. In June 2006, the Supreme Court announced its decision to review the case. The District Court has stayed further proceedings pending a decision by the Supreme Court. The case is set for argument on March 6,November 27, 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 seekOn October 3, 2006, the Court certified two classes. On October 18, 2006, we filed a Petition for Permission to certify aAppeal the class certification with the U.S. Court of persons that are either (1) retirees of an SBC company who were receiving a telephone concession after they retired from January 1, 2002 toAppeals for 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 documentsFifth District. On October 24, 2006, 4033
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued 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. Thestayed the case has been set for trial on September 25, 2006.pending the resolution of the appeal. 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.
HeptingNSA LitigationPlaintiffsThere are 21 pending lawsuits that allege that AT&T and other telecommunications carriers unlawfully provided assistance to the National Security Agency (NSA) in connection with intelligence activities that were initiated following the events of September 11, 2001. In the first filed case,Hepting et al v. AT&T Corp., AT&T Inc. and Does 1-20, plaintiffs 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 2001,2001.”(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.party, including providing access to stored telephone and Internet records databases and permitting interception of telephone and Internet communications. 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 Motionmotion to dismiss the complaint. In May, the United States requested leave to intervene in this litigation, asserted the “state secrets privilege” and related statutory privileges, and filed a motion asking the court to either dismiss the complaint or issue a summary judgment in favor of the defendants on the grounds that adjudication of the claims may put at risk the disclosure of privileged national security information. On July 20, 2006, the Court denied the Motions to Dismiss of both parties. Specifically, the complaint.Court ruled that the state secrets privilege does not prevent AT&T from asserting any statutory defense it may have, as appropriate, regarding allegations that it assisted the government in monitoring communication content. However, with regard to the calling records allegations, the Court noted that it would not require AT&T to disclose what relationship, if any, it has with the government. Both AT&T and the U.S. government filed interlocutory appeals on July 31, 2006. The U.S. Court of Appeals for the Ninth Circuit has not yet accepted these appeals.
41Since the filing of this complaint, 20 additional class action lawsuits have been filed in various jurisdictions that allege substantially the same claims. All 21 pending lawsuits have been consolidated under the jurisdiction of a single court, namely the U.S. District Court in the Northern District of California, before the judge presiding over theHepting case. To date, a small number of plaintiffs have objected to this consolidation and their objections are pending before the joint panel on multidistrict litigation.
In one of these 21 cases,Terkel v. AT&T Corp. and Illinois Bell (filed with the U.S. District Court in the Northern District of Illinois), a purported class action filed on behalf of defendants’ Illinois customers, the Court, on July 25, 2006, dismissed the case, acknowledging that the U.S. government’s state secrets privilege prohibited the plaintiffs’ case from proceeding. TheTerkel case involved allegations that the defendants supplied the U.S. government with calling records data in violation of the Electronic Communications Privacy Act but did not allege interception of communications. Management believes these actions are without merit and intends to vigorously defend these matters. 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 had 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. The Court gave final approval of the settlement in October 2006. 34 AT&T INC. MARCH 31,SEPTEMBER 30, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued Dollars in millions except per share amounts ACCOUNTING POLICIES AND STANDARDS Pension and Other Postemployment Benefit PlansFAS 158On March 31,In September 2006, the FASB issued Statement of Financial Accounting Standards Board (FASB) issued the exposure draftStandard No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postemployment Benefit Plans,Postretirement Plans” (FAS 158), an amendment of FASB StatementsStatement of Financial Accounting Standard No. 87 “Employers’ Accounting for Pensions,” Statement of Financial Accounting Standard No. 88 “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” Statement of Financial Accounting Standard No. 106 “Employers’ Account for Postretirement Benefits Other Than Pensions” and Statement of Financial Accounting Standard No. 132(R). “Employers’ Disclosures about Pensions and Other Postretirement Benefits.” 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)FAS 158 will require companiesus to recognize the current economicfunded status on the balance sheet (whether over fundedof defined benefit pension and postretirement plans as an asset 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’sliability in our statement of financial position (which we currently do) and (3) require adoptionto recognize changes in that funded status in the year in which the changes occur through comprehensive income, it will have no effect on our expense or benefit recognition. FAS 158 requires prospective application 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 draft2006. Had FAS 158 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.
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Item 2. Management’s Discussion and Analysis We will adopt FAS 158 in the fourth quarter of Financial Condition and Results of Operations2006.
Dollars in millions except per share amounts
LIQUIDITY AND CAPITAL RESOURCES We had $1,057$1,251 in cash and cash equivalents available at March 31,September 30, 2006. Cash and cash equivalents included cash of $611,$744 and money market funds of $335 and other cash equivalents of $111.$507. Cash was used to meet the financing needs of the business including, but not limited to, payment of operating expenses, funding capital expenditures, payment of dividends to stockholders, debt repayments, tax-related payments, share repurchases and funding of Cingular’s capital and operating requirements in accordance with the terms of our agreement with Cingular and BellSouth, tax-related payments and debt repayments.BellSouth. We discuss many of these factors in detail below. Once the acquisition of BellSouth is complete, our liquidity will reflect the results of BellSouth, Cingular and YPC as consolidated subsidiaries. Cash Provided by or Used in Operating Activities During the first quarternine months of 2006, our primary source of funds was cash from operating activities of $2,458$10,593 compared to $1,253 in$8,383 for the first quarternine months of 2005. Operating cash flows increased in the first quarter of 2006 compared to 2005 primarily due to loweran increase in net income of more than $2,200 and additional cash provided by the ATTC merger, partially offset by increased tax payments of $714 in the first quarter of2006. Tax payments were higher primarily due to increased income before income taxes. Tax payments in 2006 of approximately $573 and the additional cash from operations related to our acquisition of ATTC. Included in the lower tax payment amount isinclude a refund received from the completion of the ATTC federal income tax audit covering 1997 – 2001. The 2005 and 2006 tax payments include 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. We do not anticipate 2006 cash payments for income taxes to exceed reported income tax expense. Cash Provided by or Used in Investing Activities InFor the first quarternine months of 2006, cash used for investing activities consisted of:
$1,8216,158 in construction and capital expenditures. $699624 of funding offor 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. In35
AT&T INC. SEPTEMBER 30, 2006 Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued Dollars in millions except per share amounts $50 related to the acquisition of Nistevo Corporation, which provides internet-based services related to services offered by our subsidiary Sterling. During the first quarternine months of 2006, cash provided by our investing activitiesfrom dispositions of $27 was$72 related to the sale of Covad sharessecurities and 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$6,158 for the first quarternine months of 2006 and $1,050 in$3,743 for the first quarternine months of 2005. Capital expenditures in the wireline segment, which represented substantially all of our capital expenditures, increased 72.0% in65.5% for the first quarternine months of 2006 compared to the first quarternine months of 2005 and was impacted by the acquisition of ATTC.2005. Our first quarter capital expenditures were usedare primarily for our wireline subsidiaries’ networks (including ATTC), Project Lightspeed, merger-integration projects and support systems for our long-distance service. 43
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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
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 includesinclude Project Lightspeed and excludesexclude Cingular, will be inat or slightly above the high end of our target range of between $8,000 andto $8,500. We expect to spend approximately $4,400$4,600 on our Project Lightspeed initiative for network related deployment costs and capital expenditures beginning in 2006 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” “U-verse Services (Project Lightspeed)” discussed in “Other Business Matters”). 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 infor the first quarternine months of 2006. Included in the other segment are equity investments, which should be self-funding as they are not direct AT&T operations, as well as corporate and Sterling operations, which we expect to fund using cash from operations. We expect to fund any directory segment capital expenditures using cash from operations. We discuss our Cingular segment below. Cash Provided by or Used 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 asby issuing debt at favorable rates in order to refinance some of our debt maturities in 2006.and with cash from the disposition of certain other non-strategic investments. We paid dividends of $1,289 in$3,873 for the first quarternine months of 2006 compared to $1,066 in$3,196 for the first quarternine months of 2005, reflecting the issuance of additional shares for the ATTC acquisition and a dividend increase. Dividends declared by our Board of Directors totaled $0.3325 per share in the firstthird quarter of 2006 and $0.3225 per share in the firstthird quarter of 2005. In December 2005, our Board of Directors approved a 3.1% increase in the regular quarterly dividend to $0.3325 per share. Our dividend policy considers both the expectations and requirements of stockholders, internal requirements of AT&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. Our Board of Directors has authorized the repurchase of up to 400 million shares of ourAT&T common stock; this authorization expires at the end of 2008. Under this repurchase programDuring the first nine months of 2006, we repurchased 45 million shares at a cost of $1,359. We expect to purchase approximatelyrepurchase between $2,000 and $3,000 in shares during 2006, with a total buyback of additional shares under our repurchase program in$10,000 through the remainderend of 2006 and $8,000 during 2007. We did nothave repurchased, and intend to continue to repurchase, any shares inpursuant to plans that comply with the first quarterrequirements of 2006.Rule 10b5-1(c) under the Securities Exchange Act of 1934. We will fund our share repurchases through a combination of cash from operations, borrowings, dependent upon market conditions, and cash from the disposition of certain non-strategic investments. At March 31, 2006 we had $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 foreign subsidiaries of ATTC. Included in our long-term debt maturities was the purchase accounting
44
36 AT&T INC. MARCH 31,SEPTEMBER 30, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued Dollars in millions except per share amounts LIQUIDITY AND CAPITAL RESOURCES – Continued
At September 30, 2006, we had $4,713 of debt maturing within one year, which included $1,952 of long-term debt maturities, $2,636 of commercial paper borrowings and $125 of bank borrowings relating to foreign subsidiaries of ATTC. Included in our long-term debt maturities was the fair value debt adjustment (required under purchase accounting rules) applicable to the acquisition of ATTC. All of our commercial paper borrowings are due within 90 days. The availability of 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 quarternine months of 2006, debt repayments totaled $261$2,885 and consisted of: $2542,858 related to debt maturitiesrepayments with interest rates ranging from 5.875%5.75% to 6.96%9.50%. $727 related to scheduled principal payments on other debt and short-term borrowings. In May 2006, we received net proceeds of $1,491 from the issuance of $1,500 of long-term debt consisting of $900 of two-year floating rate notes and $600 of 6.80%, 30-year bonds maturing in 2036. At March 31,September 30, 2006, our debt ratio was 36.4%36.3% compared to our debt ratio of 40.2%36.6% at March 31,September 30, 2005. The decrease was primarily due to an increase in stockholders’ equity by more than $15,200 compared to the first nine months of 2005 and includes our acquisition of ATTC in the fourth quarter of 2005, which increased stockholders’ equity by more than $14,500 compared to the first quarter of 2005,and debt repayments, partially offset by ATTC debt we now 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 a net increase in debt of more than $900 in the first quarter of 2006, including net advances to Cingular and refinancing of debt, which was partially offset by an increase in stockholders’ equity. We have a 3-yearIn July 2006, we replaced our three-year $6,000 credit agreement totalingwith a five-year $6,000 credit agreement with a syndicate of banks,investment and commercial banks. The current agreement will expire in July 2011. The available credit under this agreement will increase by an additional $4,000 in the event AT&T completes its pending acquisition of BellSouth before March 6, 2007. This incremental available credit is intended to replace BellSouth’s existing credit facility, which expires on October 18, 2007.would terminate upon completion of the acquisition. We have the right to request the lenders to further increase their commitments (i.e., raise the available credit) up to an additional $2,000 provided no event of default under the credit agreement has occurred. We also have the right to terminate, in whole or in part, amounts committed by the lenders under this agreement in excess of any outstanding advances; however, any such terminated commitments may not be reinstated. Advances under this agreement may be used for general corporate purposes, including support of commercial paper borrowings and other short-term borrowings. There is no material adverse change provision governing the drawdown of advances under this credit agreement. This agreement contains a negative pledge covenant, which requires that, if at any time we or a subsidiary pledge assets or otherwise permits a lien on its properties, advances under this agreement will be ratably secured, subject to specified exceptions. We must maintain a debt-to-EBITDA (earnings before interest, income taxes, depreciation and amortization, and other modifications described in the agreement) financial ratio covenant of not more than three-to-one as of the last day of each fiscal quarter for the four quarters then ended. We are in compliance with all covenants under the agreement. WeAs of November 1, 2006, we had no borrowings outstanding under committed lines of credit as of March 31, 2006.
Pending Acquisition of BellSouth
On 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.this agreement.
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,September 30, 2006, Cingular has spent $1,441$4,851 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 GSMFGSM Facilities, LLC (GSMF) network infrastructure joint venture. Cingular participated in the recent FCC spectrum auction and made successful bids totaling approximately $1,300. 45
37 AT&T INC. MARCH 31,SEPTEMBER 30, 2006
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued Dollars in millions 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.
We and BellSouth agreed to finance Cingular’s capital and operating cash requirements through a revolving credit agreement, to the extent Cingular requires funding above the level provided by operations. We and BellSouth also entered into a revolving creditdescribe the terms of this agreement with Cingular to provide short-term financing for operations on a pro rata basis at an interest rate of LIBOR (London Interbank Offered Rate) plus 0.05%, 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.Note 6. During the first quarternine months of 2006, we made net advances to Cingular of $699$624 under the revolving credit agreement. These amounts increased the outstanding amount of advances made to Cingular to a total of $1,006$931 at March 31,September 30, 2006 from $307 at December 31, 2005 and are reflected in “Investments in and Advances to Cingular Wireless” on our Consolidated Balance Sheets. 46
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Item 3. Quantitative and Qualitative Disclosures About Market Risk Dollars in millions
At March 31,September 30, 2006, we had interest rate swaps with a notional value of $4,250$3,250 and a fair value liability of approximately $70.$35. We had $1,000 of swaps mature in 2006 related to our repayment of the underlying security. In May 2006, we entered into an interest rate forward contract with a notional amount of $750 to partially hedge interest expense related to our debt issuance in 2006. We utilized a notional amount of $600 of this forward contract and incurred settlement gains of $4. 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 March 31,September 30, 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 March 31,September 30, 2006. 47
AT&T INC.
MARCH 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. 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. 38 AT&T INC. SEPTEMBER 30, 2006 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 outcome of pending or threatened litigation including patent claims against third parties doing business with us or Cingular. 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 48
AT&T INC.
MARCH 31, 2006
CAUTIONARY LANGUAGE CONCERNING FORWARD-LOOKING STATEMENTS - Continued
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;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 approvalsFCC approval 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 listed here, also could materially affect our future earnings. 49
39 AT&T INC. MARCH 31,SEPTEMBER 30, 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 We updated this discussion in our Form 10-Q for the quarter ended June 30, 2006 to discuss our pending acquisition of BellSouth, including our ability to obtain shareholder and governmental approvalsBellSouth. On October 13, 2006, the Chairman of the acquisition onFCC issued a letter addressing the proposed termsconcerns posed by two members of the FCC in reviewing this transaction. In response to those concerns, the Chairman has allowed 10 days for further review and schedule;evaluation of the risk that the businesses will not be integrated successfully; the risk that the cost savingsproposals submitted by AT&T to address those concerns and any other synergies fromadditional concerns raised by the acquisition may take longertwo members regarding this transaction. The FCC has scheduled an open meeting for November 3, 2006 where they intend to realize than expected or may not be fully realized; and disruption fromconsider the acquisition making it more difficult to maintain relationships with customers, employees or suppliers.application.
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 firstthird quarter of 2006, non-employee directors acquired from AT&T shares of common stock pursuant to AT&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 AT&T shares or deferred stock units (DSUs) and (2) fees in the form of DSUs. DSUs are convertible into AT&T shares. Also under the plan, each Director will receive an annual grant of DSUs during the secondthird quarter. In the firstthird quarter an aggregate of 13,55112,942 AT&T shares and DSUs were acquired by non-employee directors at prices ranging from $25.95$29.99 to $27.59,$32.56, 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 – On March 4, 2006, our Board of Directors authorized the repurchase of up to 400 million shares of AT&T common stock; this authorization expires at the end of 2008. During the third quarter of 2006, we repurchased 39.3 million shares at a cost of $1,211. Under this purchase plan, we expect to repurchase between $2,000 and $3,000 in shares during 2006, with a total buyback of $10,000 through the end of 2007. We will fund our share repurchases through a combination of cash from operations, borrowings, dependent upon market conditions, and cash from the disposition of certain non-strategic investments. |
50
Purchase Period | Total Number of Shares Purchased | Average Price Paid per Share1 | 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 | July 31, 2006 | 1,700,000 | $ 29.34 | 1,700,000 | 392,580,000 | August 1, 2006 – August 31, 2006 | 23,300,000 | $ 30.34 | 23,300,000 | 369,280,000 | September 1, 2006 – September 29, 2006 | 14,250,000 | $ 31.80 | 14,250,000 | 355,030,000 | Total | 39,250,000 | $ 30.83 | 39,250,000 | 355,030,000 |
| 1Average Price Paid per Share excludes transaction costs. |
We repurchased 10.6 million shares at an average per share price of $32.77 under our share repurchase program between October 2, 2006 and October 25, 2006. We have 344,430,000 remaining shares authorized to be repurchased under our repurchase program. 40 AT&T INC. MARCH 31,SEPTEMBER 30, 2006
Item 4. Submission of Matters to a Vote of Security Holders Special Meeting of Shareowners (shares in millions) (a) | A special meeting of stockholders of AT&T was held on July 21, 2006, in San Antonio, Texas. Shareowners representing 2,792, or 71.8%, of the common shares outstanding as of the June 1, 2006 record date were present in person or were represented at the meeting by proxy. |
(b) | Holders of common shares voted at this meeting on the following matter, which was set forth in our proxy statement and prospectus dated June 2, 2006. |
| For | % For | Against | % Against | Abstain | Non-Vote | Issuance of AT&T common shares | | | | | | | required pursuant to the Agreement and Plan of Merger dated March 4, 20061 | 2,720 | 98.7% | 37 | 1.3% | 35 | - |
1 Percentages are based on the total common shares voted. Approval of this proposal required a majority vote. Item 6. Exhibits Exhibits identified in parentheses 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. 2
| 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-a3
| Restated Certificate of Incorporation, filed with the Secretary of State of Delaware on November 18, 2005.July 28, 2006 (Exhibit 3-a3 to Form 8-K dated November 18, 2005.)10-Q for June 30, 2006) | 3-b10-ff
| 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.)2005 Supplemental Employee Retirement Plan
| 3-c10-ii
| Bylaws amended May 3, 2006. (Exhibit 3-c to Form 8-K dated April 28, 2006.)
| 10-cc
| Stock Purchase andAT&T Corp. Senior Management Incentive Award Deferral Plan.
| 10-dd
| Cash Deferral Plan.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 |
41 51
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. May 5,November 2, 2006
| /s/Richard G. Lindner | | | Richard G. Lindner | | | Senior Executive Vice President | | and Chief Financial Officer | | | | | | | |
and Chief Financial Officer 42 |