FORM 10-Q

 

United States

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

(Mark One)

 

 

x

Quarterly Report Pursuant to Section 13 or 15(d) of the

Securities Exchange Act of 1934

 

For the quarterly period ended September 30, 2006

 

or

 

 

o

Transition Report Pursuant to Section 13 or 15(d) of the

Securities Exchange Act of 1934

 

For the transition period from       to     

 

Commission File Number 1-8610

 

AT&T INC.

 

Incorporated under the laws of the State of Delaware

I.R.S. Employer Identification Number 43-1301883

 

175 E. Houston, San Antonio, Texas 78205

Telephone Number: (210) 821-4105

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No [ ]

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12-b2 of the Exchange Act. Large accelerated filer x Accelerated filer [ ] Non-accelerated filer [ ]

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No x

 

At October 31, 2006, common shares outstanding were 3,842,902,194.

 

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

 

 

September 30,

 

September 30,

 

 

2006

 

2005

 

2006

 

2005

Operating Revenues

 

 

 

 

 

 

 

 

Voice

$

8,464

$

5,743

$

25,725

$

17,355

Data

 

4,546

 

2,514

 

13,465

 

7,343

Directory

 

906

 

917

 

2,716

 

2,723

Other

 

1,722

 

1,130

 

5,258

 

3,434

Total operating revenues

 

15,638

 

10,304

 

47,164

 

30,855

Operating Expenses

 

 

 

 

 

 

 

 

Cost of sales (exclusive of depreciation and

 

 

 

 

 

 

 

 

amortization shown separately below)

 

6,664

 

4,364

 

20,641

 

13,153

Selling, general and administrative

 

3,620

 

2,175

 

11,396

 

7,229

Depreciation and amortization

 

2,437

 

1,803

 

7,415

 

5,437

Total operating expenses

 

12,721

 

8,342

 

39,452

 

25,819

Operating Income

 

2,917

 

1,962

 

7,712

 

5,036

Other Income (Expense)

 

 

 

 

 

 

 

 

Interest expense

 

(442)

 

(349)

 

(1,378)

 

(1,051)

Interest income

 

98

 

82

 

278

 

291

Equity in net income of affiliates

 

649

 

219

 

1,438

 

342

Other income (expense) – net

 

11

 

(70)

 

37

 

11

Total other income (expense)

 

316

 

(118)

 

375

 

(407)

Income Before Income Taxes

 

3,233

 

1,844

 

8,087

 

4,629

Income taxes

 

1,068

 

598

 

2,669

 

1,498

Net Income

$

2,165

$

1,246

$

5,418

$

3,131

Earnings Per Common Share:

 

 

 

 

 

 

 

 

Net Income

$

0.56

$

0.38

$

1.40

$

0.95

Earnings Per Common Share - Assuming Dilution:

 

 

 

 

 

 

 

 

Net Income

$

0.56

$

0.38

$

1.39

$

0.95

Weighted Average Number of Common

 

 

 

 

 

 

 

 

Shares Outstanding – Basic (in millions)

 

3,873

 

3,296

 

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.

CONSOLIDATED BALANCE SHEETS

Dollars in millions except per share amounts

 

 

 

 

 

 

 

September 30,

 

 

December 31,

 

 

2006

 

 

2005

Assets

 

(Unaudited)

 

 

 

Current Assets

 

 

 

 

 

Cash and cash equivalents

$

1,251

 

$

1,224

Accounts receivable – net of allowances for

 

 

 

 

 

uncollectibles of $936 and $1,176

 

8,668

 

 

9,351

Prepaid expenses

 

1,038

 

 

1,029

Deferred income taxes

 

1,598

 

 

2,011

Other current assets

 

957

 

 

1,039

Total current assets

 

13,512

 

 

14,654

Property, plant and equipment

 

152,573

 

 

149,238

Less: accumulated depreciation and amortization

 

94,922

 

 

90,511

Property, Plant and Equipment – Net

 

57,651

 

 

58,727

Goodwill

 

13,385

 

 

14,055

Intangible Assets – Net

 

7,728

 

 

8,503

Investments in Equity Affiliates

 

2,222

 

 

2,031

Investments in and Advances to Cingular Wireless

 

33,029

 

 

31,404

Other Assets

 

16,365

 

 

16,258

Total Assets

$

143,892

 

$

145,632

 

 

 

 

 

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

Current Liabilities

 

 

 

 

 

Debt maturing within one year

$

4,713

 

$

4,455

Accounts payable and accrued liabilities

 

14,789

 

 

17,088

Accrued taxes

 

3,122

 

 

2,586

Dividends payable

 

1,281

 

 

1,289

Total current liabilities

 

23,905

 

 

25,418

Long-Term Debt

 

26,799

 

 

26,115

Deferred Credits and Other Noncurrent Liabilities

 

 

 

 

 

Deferred income taxes

 

14,368

 

 

15,713

Postemployment benefit obligation

 

18,150

 

 

18,133

Unamortized investment tax credits

 

188

 

 

209

Other noncurrent liabilities

 

5,081

 

 

5,354

Total deferred credits and other noncurrent liabilities

 

37,787

 

 

39,409

 

 

 

 

 

 

Stockholders’ Equity

 

 

 

 

 

Common shares issued ($1 par value)

 

4,065

 

 

4,065

Capital in excess of par value

 

27,116

 

 

27,499

Retained earnings

 

30,653

 

 

29,106

Treasury shares (at cost)

 

(5,867)

 

 

(5,406)

Additional minimum pension liability adjustment

 

(218)

 

 

(218)

Accumulated other comprehensive income

 

(348)

 

 

(356)

Total stockholders’ equity

 

55,401

 

 

54,690

Total Liabilities and Stockholders’ Equity

$

143,892

 

$

145,632

See Notes to Consolidated Financial Statements.

 

3

 

AT&T INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

Dollars in millions, increase (decrease) in cash and cash equivalents

(Unaudited)

 

Nine months ended

 

September 30,

 

 

2006

 

2005

Operating Activities

 

 

 

 

Net income

$

5,418

$

3,131

Adjustments to reconcile net income to net cash

 

 

 

 

provided by operating activities:

 

 

 

 

Depreciation and amortization

 

7,415

 

5,437

Undistributed earnings from investments in equity affiliates

 

(1,359)

 

(285)

Provision for uncollectible accounts

 

450

 

561

Amortization of investment tax credits

 

(21)

 

(17)

Deferred income tax expense (benefit)

 

(269)

 

(315)

Net gain on sales of investments

 

(10)

 

(104)

Changes in operating assets and liabilities:

 

 

 

 

Accounts receivable

 

249

 

(39)

Other current assets

 

42

 

(249)

Accounts payable and accrued liabilities

 

(1,819)

 

(242)

Stock-based compensation tax benefit

 

(10)

 

(3)

Other - net

 

507

 

508

Total adjustments

 

5,175

 

5,252

Net Cash Provided by Operating Activities

 

10,593

 

8,383

Investing Activities

 

 

 

 

Construction and capital expenditures

 

(6,158)

 

(3,743)

Receipts from (investments in) affiliates – net

 

(633)

 

2,603

Dispositions

 

72

 

126

Acquisitions

 

(115)

 

(169)

Maturities of held-to-maturity securities

 

3

 

98

Proceeds from note repayment

 

-

 

37

Other

 

5

 

-

Net Cash Used in Investing Activities

 

(6,826)

 

(1,048)

Financing Activities

 

 

 

 

Net change in short-term borrowings with original

 

 

 

 

maturities of three months or less

 

2,336

 

(1,656)

Repayment of other short-term borrowings

 

(3)

 

-

Issuance of long-term debt

 

1,491

 

-

Repayment of long-term debt

 

(2,882)

 

(2,123)

Purchase of treasury shares

 

(1,359)

 

(742)

Issuance of treasury shares

 

463

 

362

Dividends paid

 

(3,873)

 

(3,196)

Stock-based compensation tax benefit

 

10

 

3

Other

 

77

 

-

Net Cash Used in Financing Activities

 

(3,740)

 

(7,352)

Net increase (decrease) in cash and cash equivalents from continuing operations

 

27

 

(17)

Net Cash Used in Operating Activities from Discontinued Operations

 

-

 

(310)

Net increase (decrease) in cash and cash equivalents

 

27

 

(327)

Cash and cash equivalents beginning of year

 

1,224

 

760

Cash and Cash Equivalents End of Period

$

1,251

$

433

 

 

 

 

 

Cash paid during the nine months ended September 30 for:

 

 

 

 

Interest

$

1,503

$

1,198

Income taxes, net of refunds

$

2,249

$

1,535

See Notes to Consolidated Financial Statements.

 

4

 

AT&T INC.

 

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

 

 

Dollars and shares in millions, except per share amounts

 

 

(Unaudited)

 

 

 

Nine months ended

 

September 30, 2006

 

Shares

Amount

Common Stock

 

 

 

Balance at beginning of year

4,065

$

4,065

Balance at end of period

4,065

$

4,065

 

 

 

 

Capital in Excess of Par Value

 

 

 

Balance at beginning of year

 

$

27,499

Issuance of shares

 

 

(302)

Stock based compensation

 

 

(81)

Balance at end of period

 

$

27,116

 

 

 

 

Retained Earnings

 

 

 

Balance at beginning of year

 

$

29,106

Net income ($1.39 per diluted share)

 

 

5,418

Dividends to stockholders ($1.00 per share)

 

 

(3,865)

Other

 

 

(6)

Balance at end of period

 

$

30,653

 

 

 

 

Treasury Shares

 

 

 

Balance at beginning of year

(188)

$

(5,406)

Purchase of shares

(45)

 

(1,359)

Issuance of shares

21

 

898

Balance at end of period

(212)

$

(5,867)

 

 

 

 

Additional Minimum Pension Liability Adjustment

 

 

 

Balance at beginning of year

 

$

(218)

Balance at end of period

 

$

(218)

 

 

 

 

Accumulated Other Comprehensive Income, net of tax

 

 

 

Balance at beginning of year

 

$

(356)

Other comprehensive income (loss) (see Note 3)

 

 

8

Balance at end of period

 

$

(348)

See Notes to Consolidated Financial Statements.

 

 

5

AT&T INC.

SEPTEMBER 30, 2006

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Dollars in millions except per share amounts

 

NOTE 1. PREPARATION OF INTERIM 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.

 

We have reclassified certain amounts in prior-period financial statements to conform to the current period’s presentation. As 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; the 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.

 

EITF 06-3 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 Customers and Remitted 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 a gross or a net basis, based on the 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 as an offset to taxes

 

6

AT&T INC.

SEPTEMBER 30, 2006

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued

Dollars in millions except per share amounts

 

owed by a company are not considered taxes collected and remitted. If such taxes are significant, and are presented on a gross basis, the amounts of those taxes should be disclosed. EITF 06-3 will be effective for interim and annual reporting periods beginning after December 15, 2006. We are currently evaluating the impact EITF 06-3 will have, but do not expect a material impact on our financial position and results of operations.

 

FAS 157 In 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 measuring fair value and expands disclosures about fair value measurements. FAS 157 applies under other accounting pronouncements that require or permit 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 current practice. FAS 157 requires prospective application for fiscal years ending after November 15, 2007.

 

FAS 158 In September 2006, the FASB issued Statement of Financial Accounting Standard No. 158, “Employers’ Accounting for Defined 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 funded status of defined benefit pension and postretirement plans as an asset or liability in our statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. This standard will have no effect on our expense or benefit recognition, nor will it affect the funding requirements imposed under the Employee Retirement Income Security Act of 1974, as amended (ERISA). FAS 158 requires prospective application for fiscal years ending after December 15, 2006. 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. We will adopt FAS 158 in the fourth quarter of 2006.

 

Employee Separations In accordance with Statement of Financial Accounting Standards No. 112, “Employers’ Accounting for Postemployment Benefits,” we establish obligations for probable 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 September 30, 2006, for employees not affected by the change-in-control provisions of the ATTC benefit plans, we had severance accruals of $276, of which $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).

 

NOTE 2. ACQUISITIONS

 

AT&T Corp. In November 2005, we acquired ATTC in a transaction accounted for under FAS 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, and operated one of the largest telecommunications networks in the U.S. ATTC also provided domestic and international long-distance and usage-based-communications services to consumer customers. 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. At 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 were subject to adjustment as additional information was 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; any remaining adjustments will be reflected in the fourth 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 nine months of 2006.

 

 

 

Purchase Price Allocation

 

 

As of

 

 

 

As of

 

 

12/31/05

 

Adjustments

 

9/30/06

Assets acquired

 

 

 

 

 

 

Current assets

$

6,295

$

16

$

6,311

Property, plant and equipment

 

10,921

 

(662)

 

10,259

Intangible assets not subject to amortization:

 

 

 

 

 

 

Trade name

 

4,900

 

-

 

4,900

Licenses

 

40

 

-

 

40

Intangible assets subject to amortization:

 

 

 

 

 

 

Customer lists and relationships

 

3,050

 

-

 

3,050

Patents

 

150

 

-

 

150

Brand licensing agreements

 

70

 

-

 

70

Investments in unconsolidated subsidiaries

 

160

 

(90)

 

70

Other assets

 

4,247

 

165

 

4,412

Goodwill

 

12,343

 

(691)

 

11,652

Total assets acquired

 

42,176

 

(1,262)

 

40,914

 

 

 

 

 

 

 

Liabilities assumed

 

 

 

 

 

 

Current liabilities, excluding

current portion of long-term debt

 

6,740

 

63

 

6,803

Long-term debt

 

8,293

 

-

 

8,293

Deferred income taxes

 

531

 

(720)

 

(189)

Postemployment benefit obligation

 

8,807

 

(468)

 

8,339

Other noncurrent liabilities

 

2,288

 

(137)

 

2,151

Total liabilities assumed

 

26,659

 

(1,262)

 

25,397

Net assets acquired

$

15,517

$

-

$

15,517

 

Adjustments 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 pension assets (primarily real estate related) resulted in a $20 reduction of operating expense in the third quarter. In addition to the deferred tax impacts associated with valuation adjustments, a net reduction in deferred taxes was recorded as a result of modifications to various pre-merger tax estimates and the resolution of an ATTC Internal Revenue Service audit (an adjustment of $385 for the years 1997-2001). In total we recorded an increase of $97 in operating income, $70 of which related to periods prior to the third quarter of 2006.

 

8

AT&T INC.

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 if a change-in-control occurred. Included in the liabilities assumed at acquisition, was $1,543 accrued for such enhanced severance and benefits. As part of 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 evaluate this accrual through the end of the allocation period.

 

 

Balance at

12/31/05

Cash Payments 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

 

 

3/31/05

 

6/30/05

 

9/30/05

 

12/31/05

 

2005

Revenues

$

16,619

$

16,554

$

16,414

$

16,202

$

65,789

 

Net Income

 

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.

 

9

AT&T INC.

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 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 was due to exchange rate fluctuations in our foreign affiliates’ local currencies 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

Nine months ended

 

 

September 30,

 

 

September 30,

 

 

2006

 

2005

 

 

2006

 

2005

Net income

$

2,165

$

1,246

 

$

5,418

$

3,131

Other comprehensive income, net of tax:

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustment

 

29

 

(2)

 

 

(16)

 

28

Net unrealized gains (losses) on securities:

 

 

 

 

 

 

 

 

 

Unrealized gains (losses)

 

(17)

 

2

 

 

17

 

(21)

Less reclassification adjustment realized

in net income

 

-

 

(4)

 

 

(8)

 

(37)

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

 

-

 

(2)

 

 

1

 

(2)

Other comprehensive income (loss)

 

16

 

(4)

 

 

8

 

(29)

Total Comprehensive Income 

$

2,181

$

1,242

 

$

5,426

$

3,102

 

 

10

AT&T INC.

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 September 30, 2006 and 2005 is shown in the table below:

 

 

Three months ended

 

Nine months ended

 

September 30,

 

September 30,

 

2006

2005

 

 

2006

 

2005

Numerators

 

 

 

 

 

 

 

 

 

Numerator for basic earnings per share:

 

 

 

 

 

 

 

 

 

Net income

$

2,165

$

1,246

 

$

5,418

$

3,131

Dilutive potential common shares:

 

 

 

 

 

 

 

 

 

Other stock-based compensation

 

2

 

5

 

 

5

 

8

Numerator for diluted earnings per share

$

2,167

$

1,251

 

$

5,423

$

3,139

Denominators (000,000)

 

 

 

 

 

 

 

 

 

Denominator for basic earnings per share:

 

 

 

 

 

 

 

 

 

Weighted-average number of common

 

 

 

 

 

 

 

 

 

shares outstanding

 

3,873

 

3,296

 

 

3,880

 

3,300

Dilutive potential common shares:

 

 

 

 

 

 

 

 

 

Stock options

 

5

 

-

 

 

4

 

1

Other stock-based compensation

 

14

 

10

 

 

16

 

10

Denominator for diluted earnings per share

 

3,892

 

3,306

 

 

3,900

 

3,311

Basic earnings per share

 

 

 

 

 

 

 

 

 

Net income

$

0.56

$

0.38

 

$

1.40

$

0.95

Diluted earnings per share

 

 

 

 

 

 

 

 

 

Net income

$

0.56

$

0.38

 

$

1.39

$

0.95

 

At September 30, 2006, we had issued and outstanding options to purchase approximately 234 million shares of AT&T common stock. The exercise prices of options to purchase a weighted average of 189 million shares in the third quarter and 212 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. At September 30, 2006, the exercise price of 47 million share options were below market price, commonly referred to as “in the money.” Of these options, 11 million will expire by the end of 2007.

 

At 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.

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: (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, 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, which publish Yellow and White Pages directories and 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 (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.

 

 

12

AT&T INC.

SEPTEMBER 30, 2006

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued

Dollars in millions except per share amounts

 

 

For the three months ended September 30, 2006

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Wireline

 

Cingular

 

Directory

 

Other

 

Consolidation
and Elimination

 

Cingular
Elimination

 

Consolidated
Results

Revenues from external customers

$

14,577

$

9,553

$

906

$

155

$

-

$

(9,553)

$

15,638

Intersegment revenues

 

9

 

-

 

15

 

49

 

(73)

 

-

 

-

Total segment operating revenues

 

14,586

 

9,553

 

921

 

204

 

(73)

 

(9,553)

 

15,638

Operations and support expenses

 

9,756

 

6,561

 

439

 

161

 

(72)

 

(6,561)

 

10,284

Depreciation and amortization expenses

 

2,376

 

1,576

 

1

 

60

 

-

 

(1,576)

 

2,437

Total segment operating expenses

 

12,132

 

8,137

 

440

 

221

 

(72)

 

(8,137)

 

12,721

Segment operating income

 

2,454

 

1,416

 

481

 

(17)

 

(1)

 

(1,416)

 

2,917

Interest expense

 

-

 

306

 

-

 

-

 

442

 

(306)

 

442

Interest income

 

-

 

6

 

-

 

-

 

98

 

(6)

 

98

Equity in net income (loss) of affiliates

 

-

 

-

 

(2)

 

651

 

-

 

-

 

649

Other income (expense) – net

 

-

 

(44)

 

-

 

-

 

11

 

44

 

11

Segment income before income taxes

$

2,454

$

1,072

$

479

$

634

$

(334)

$

(1,072)

$

3,233

 

 

 

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.

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 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 $62 in the third quarter and $184 for the first nine months of 2006 and $74 in the third quarter and $248 for the first nine 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 provides 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.

 

Under the revolving credit 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 $931 at September 30, 2006 and $307 at December 31, 2005.

 

We generated revenues of $359 in the third quarter and $1,106 for the first nine months of 2006 and $220 in the third quarter and $607 for the first nine 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 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.

 

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 FAS 87 and FAS 106. In the following table, gains are denoted with parentheses and losses are not.

 

 

Three months ended

 

Nine months ended

 

September 30,

 

September 30,

 

2006

2005

 

 

2006

 

2005

Pension cost:

 

 

 

 

 

 

 

 

 

Service cost – benefits earned during the period

$

262

$

197

 

$

787

$

589

Interest cost on projected benefit obligation

 

627

 

403

 

 

1,881

 

1,210

Expected return on assets

 

(1,008)

 

(636)

 

 

(2,992)

 

(1,908)

Amortization of prior service cost and transition asset

 

37

 

47

 

 

112

 

140

Recognized actuarial loss

 

91

 

39

 

 

271

 

118

Net pension cost

$

9

$

50

 

$

59

$

149

 

 

 

 

 

 

 

 

 

 

Postretirement benefit cost:

 

 

 

 

 

 

 

 

 

Service cost – benefits earned during the period

$

108

$

95

 

$

326

$

290

Interest cost on accumulated postretirement

 

 

 

 

 

 

 

 

 

benefit obligation

 

485

 

355

 

 

1,457

 

1,077

Expected return on assets

 

(234)

 

(189)

 

 

(701)

 

(567)

Amortization of prior service benefit

 

(90)

 

(90)

 

 

(269)

 

(254)

Recognized actuarial loss

 

119

 

110

 

 

354

 

329

Postretirement benefit cost

$

388

$

281

 

$

1,167

$

875

 

 

 

 

 

 

 

 

 

 

Combined net pension and postretirement cost

$

397

$

331

 

$

1,226

$

1,024

 

Our combined net pension and postretirement cost increased $66 in the third quarter and $202 for the first nine months of 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. 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 five years.

 

As part of our acquisition of ATTC, we acquired certain non-U.S. operations. Net pension cost for non-U.S. plans, which is not included in the table above, was $4 in the third quarter and $18 for the first nine 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, which is not included in the table above, was $38 in the third quarter and $113 for the first nine months of 2006, of which $26 and $77 was interest cost, respectively. Net supplemental retirement pension

 

16

AT&T INC.

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 acquisition (March 5, 2006) of $27.32, the total transaction is valued, for purchase accounting purposes, at approximately $66,000.

 

We and BellSouth jointly own Cingular and the internet-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 various other regulatory authorities. In October 2006, the U.S. Department of Justice completed its review of the transaction without imposing any conditions. The acquisition remains subject to approval by the Federal Communications Commission. We expect the transaction to close in the fall of 2006.

 

17

AT&T INC.

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 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 Results We completed our acquisition of AT&T Corp. (ATTC) on November 18, 2005. Consolidated results for the third quarter and nine month period ended 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 the third quarter and nine months ended 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 nine months of 2006 and 2005 are summarized as follows:

 


    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 income As noted above, 2006 revenues and expenses reflect the addition of ATTC’s results while our 2005 results do not include ATTC. Accordingly, the following discussion of changes in our revenues and expenses is significantly affected by the ATTC acquisition. Our operating income increased $955, or 48.7%, in the third quarter and $2,676, or 53.1%, for the first nine months of 2006 and our operating income margin decreased from 19.0% to 18.7% in the third quarter and increased from 16.3% to 16.4% for the first nine months. Operating income increased primarily due to expense reduction through merger synergies, partially offset by additional amortization expense on those intangibles identified at the time of our acquisition of ATTC and 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. Access line trends are further discussed in our Wireline segment discussion.

 

Operating revenues Our operating revenues increased $5,334, or 51.8%, in the third quarter and $16,309, or 52.9%, for the first nine months of 2006 primarily due to our 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

 

18

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 first two quarters of 2006. Operating revenue changes are discussed in greater detail in our “Segment Results” sections.

 

Operating expenses Our operating expenses increased $4,379, or 52.5%, in the third quarter and $13,633, or 52.8%, for the first nine months of 2006 primarily due to our acquisition of ATTC, and also included merger integration costs of $147 in the third quarter and $569 for the first nine months and amortization expense on intangible assets identified at the time of 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 expenses in 2006 also include decreases related to workforce reductions, reflecting a decline of approximately 10,500 employees from December 31, 2005, of which 3,600 were in the third quarter. As of September 30, 2006, we were ahead of schedule with our targeted 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 $93, or 26.6%, in the third quarter and $327, or 31.1%, for the first nine months of 2006. The increase in 2006 was primarily due to interest expense on ATTC’s outstanding debt.

 

Interest income increased $16, or 19.5%, in the third quarter and decreased $13, or 4.5%, for the first nine 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. 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 $430 in the third quarter and $1,096 for the first nine months of 2006. The increase was primarily due to our proportionate share of Cingular’s improved results of $375 in the third quarter and $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 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. Our equity investments are discussed in greater detail in the “Other Segment Results” section.

 

Other income (expense) – net We had other income of $11 in the third quarter and $37 for the first nine months of 2006, as compared to other expense of $70 in the third quarter and other income of $11 for the first nine 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 other expenses of $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, SpectraSite, Inc and 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.

 

19

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

 

Income 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 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: (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, 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 our directory operations, which publish Yellow and White Pages directories and 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.”

 

Wireline

Segment Results

 

 

Third Quarter

 

 

Nine-Month Period

 

 

 

 

 

 

Percent

 

 

 

 

 

 

Percent

 

 

2006

 

2005

 

Change

 

 

2006

 

2005

 

Change

Segment operating revenues

 

 

 

 

 

 

 

 

 

 

 

 

 

Voice

$

8,464

$

5,743

 

47.4%

 

$

25,725

$

17,355

 

48.2%

Data

 

4,546

 

2,514

 

80.8

 

 

13,465

 

7,343

 

83.4

Other

 

1,576

 

972

 

62.1

 

 

4,805

 

2,970

 

61.8

Total Segment Operating Revenues

 

14,586

 

9,229

 

58.0

 

 

43,995

 

27,668

 

59.0

Segment operating expenses

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of sales

 

6,399

 

4,096

 

56.2

 

 

19,830

 

12,358

 

60.5

Selling, general and administrative

 

3,357

 

1,891

 

77.5

 

 

10,592

 

6,375

 

66.1

Depreciation and amortization

 

2,376

 

1,747

 

36.0

 

 

7,233

 

5,277

 

37.1

Total Segment Operating Expenses

 

12,132

 

7,734

 

56.9

 

 

37,655

 

24,010

 

56.8

Segment Income

$

2,454

$

1,495

 

64.1%

 

$

6,340

$

3,658

 

73.3%

 

Operating Margin Trends

Our wireline segment operating income margin was 16.8% in the third 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. Operating income and margins increased primarily due to lower expenses as a result of merger synergies partially offset by additional amortization expense on those intangibles identified at the time of our acquisition of ATTC and lower voice revenue as a result of continued in-region access line declines due to increased competition, as customers disconnected both primary and additional lines and switched to competitors’ alternative technologies, such as wireless, VoIP and cable for voice and data.

 

Wireline Operating Results

All changes other than those specifically stated as being due to the ATTC acquisition are related to in-region wireline operations.

 

Voice revenues increased $2,721, or 47.4%, in the third quarter and $8,370, or 48.2%, for the first nine 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. Voice revenues 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).

 

 

Long-distance revenues increased $2,579 in the third quarter and $8,044 for the first nine months of 2006 driven almost entirely by the increase in long-distance customers due to the acquisition of ATTC. Also contributing to the increases were higher long-distance penetration levels. However, our long-distance revenue growth continued to slow, 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 late 2003 and a continuing decline in ATTC’s mass-market customers.

 

21

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

 

 

Local voice revenues increased $273 in the third quarter and $783 for the first nine months of 2006 primarily reflecting our acquisition of ATTC. However, 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 to continue to be negatively affected 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. Partially offsetting these demand-related declines were revenue increases related to pricing increases for regional telephone service and calling features.

 

Lower demand for local wholesale services, primarily due to the decline in Unbundled Network Element-Platform (UNE-P) lines provided to competitors, decreased revenue $131 in the third quarter and $457 for the first nine 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 who represented a majority of our UNE-P lines have signed commercial agreements with us and therefore remain our wholesale customers. 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.

 

Data revenues increased $2,032, or 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 and $2,346 for the first nine months, increases in transport of $651 in the third quarter and $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 increased almost entirely due to the acquisition of ATTC. Data revenues accounted for approximately 29% of our operating revenues in the third quarter and for the first nine months of 2006 and 24% of revenues in the third quarter and for the first nine months of 2005.

 

Included in IP data revenues are DSL, 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 $109 in the third quarter and $313 for the first nine months of 2006, reflecting an increase in DSL lines in service, which was partially driven by lower-priced promotional offerings as a response to competitive pricing 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 approximately 49% of total data revenues in the third quarter and 50% for the first nine months of 2006, and 63% of total data revenues in the third quarter and 64% for the first nine 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.

 

Other operating revenues increased $604, or 62.1%, in the third quarter and $1,835, or 61.8%, for the first nine months of 2006, primarily due to incremental revenue from our acquisition of ATTC. Major items included in other operating revenues are integration services and customer premises equipment, outsourcing, directory and operator assistance services and government-related services, which account for over 72% of total revenue for all periods. Our co-branded AT&T | DISH Network satellite TV service increased revenue $8 in the third quarter and $33 for the first nine months of 2006. Revenue also increased $70 from an intellectual property license for the first nine months of 2006.

 

22

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

 

 

Cost of sales expenses increased $2,303, or 56.2%, in the third quarter and $7,472, or 60.5%, for the first nine months of 2006, primarily related to the acquisition of 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.

 

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, 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 net losses on plan assets in prior years. In addition, expenses increased $20 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. Nonemployee-related expenses such as contract services, agent commissions and materials and supplies costs, increased $102 in 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 $110 for the first nine months of 2006, due primarily to growth in long-distance service, and as a result of decreased costs recorded in the first quarter of 2005 related to a carrier settlement. Salary and wage merit increases and other employee related expenses increased $29 in the third quarter and $58 for the first nine months of 2006.

 

Partially offsetting these increases were lower costs associated with equipment sales and related network integration services, which decreased $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 for 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-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 administrative expenses increased $1,466, or 77.5%, in the third quarter and $4,217, or 66.1%, for the first nine months of 2006, primarily due to the ATTC 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 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 $164 in the third quarter and $800 for the first nine months of 2006 primarily due to advertising costs related to promotion of the AT&T brand name. In addition, other advertising expenses increased $13 in the third quarter and $70 for the first nine months of 2006. Salary and wage merit increases and other employee related expenses increased $42 in the third quarter and $56 for the first nine months of 2006. Nonemployee related expenses, such as contract services, agent commissions and materials and supplies costs,

 

23

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

 

increased $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, $67 in the third quarter and $201 for the first nine months of 2006. Our provision for uncollectible accounts decreased slightly 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 amortization expenses increased $629, or 36.0%, in the third quarter and 1,956, or 37.1%, for the first nine months of 2006 primarily due to higher depreciable and amortizable asset bases as a result of the ATTC merger.

 

24

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

 

Supplemental Information

 

Access Line Summary

Our in-region switched access lines at September 30, 2006 and 2005 are shown below and access line trends are addressed throughout this segment discussion:

 

In-Region 1

 

 

 

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 CLECs 2

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 Connections 3

8,155

6,496

25.5%

1 In-region represents access lines served by AT&T’s ILECs.

2 Competitive local exchange carriers (CLECs)

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.

 

25

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

 

Cingular

Segment Results

 

 

Third Quarter

 

 

Nine-Month Period

 

 

 

 

 

 

Percent

 

 

 

 

 

 

Percent

 

 

2006

 

2005

 

Change

 

 

2006

 

2005

 

Change

Segment operating revenues

 

 

 

 

 

 

 

 

 

 

 

 

 

Service revenues

$

8,661

$

7,721

 

12.2%

 

$

24,961

$

22,859

 

9.2%

Equipment revenues

 

892

 

1,025

 

(13.0)

 

 

2,790

 

2,725

 

2.4

Total Segment Operating Revenues

 

9,553

 

8,746

 

9.2

 

 

27,751

 

25,584

 

8.5

Segment operating expenses

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of services and equipment sales

 

3,725

 

3,667

 

1.6

 

 

11,218

 

10,629

 

5.5

Selling, general and administrative

 

2,836

 

2,881

 

(1.6)

 

 

8,439

 

8,835

 

(4.5)

Depreciation and amortization

 

1,576

 

1,541

 

2.3

 

 

4,854

 

4,845

 

0.2

Total Segment Operating Expenses

 

8,137

 

8,089

 

0.6

 

 

24,511

 

24,309

 

0.8

Segment Operating Income

 

1,416

 

657

 

-

 

 

3,240

 

1,275

 

-

Interest Expense

 

306

 

304

 

0.7

 

 

901

 

968

 

(6.9)

Equity in Net Income of Affiliates

 

-

 

1

 

-

 

 

-

 

4

 

-

Other – net

 

(38)

 

(28)

 

(35.7)

 

 

(107)

 

(32)

 

-

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. 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. 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.”

 

Cingular’s Customer and Operating Trends

As of September 30, 2006, Cingular served 58.7 million cellular/PCS (wireless) customers compared to 52.3 million at September 30, 2005. Cingular’s increase in customer gross additions in the third quarter and for the first nine months of 2006 compared to 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 net subscriber additions increased 56.6% in the third quarter and 42.3% for the first nine months of 2006.

 

Competition and the slowing rate of new wireless users as the wireless market matures will continue to impact Cingular’s gross additions, 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. However, in the past quarter Cingular’s ARPU improved slightly reflecting increased use of data services by customers. Cingular expects continued pressure on ARPU notwithstanding increasing revenue from data services.

 

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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

 

ARPU increased 0.2% in the third quarter and declined 1.8% for the first nine 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 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, customer shifts to all-inclusive rate plans that offer lower monthly charges, Cingular’s free mobile-to-mobile plans that allow Cingular customers to call other Cingular customers at no charge and to a lesser extent “rollover” 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 1.8% in the third quarter and for the first nine months of 2006, down from 2.3% in the third quarter and 2.2% for the first nine months of 2005. The churn rate for Cingular’s postpaid customers was 1.5% in the third quarter and for the first nine months of 2006, down from 2.0% in the third quarter and 1.9% for the first nine 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 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 14.8% in the third quarter and 11.7% for the first nine months of 2006, which improved over margins of 7.5% in the third quarter and 5.0% for the first nine months of 2005. The higher margin in 2006 was primarily due to revenue

 

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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

 

growth of $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.

 

Service revenues are comprised of local voice and data services, roaming, long-distance and other revenue. Service revenues increased $940, or 12.2%, in the third quarter and $2,102, or 9.2%, for the first nine months of 2006 and consisted of:

 

Local voice revenues increased $449, or 7.1%, in the third quarter and $1,083, or 5.8%, for the first nine months, primarily due to 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 4.4% in the third quarter and 5.0% for the first nine months.

 

Data service revenues increased $417, or 60.5%, in the third quarter and $1,055, or 55.1%, for the first nine months, due to 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 12.8% of Cingular’s service revenues in the third quarter and 11.9% for the first nine months.

 

Roaming revenues from Cingular customers and other wireless carriers for use of Cingular’s network increased $57, or 10.8%, in the third quarter and decreased $45, or 2.9%, for the first nine months.

 

Long-distance and other revenue increased $17, or 8.9%, in the third quarter and $9, or 1.6%, for the first nine months primarily as a result of increased international long-distance usage partially offset by a decline in other revenue attributed to property management fees.

 

Equipment revenues decreased $133, or 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 was 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 as a result of increased handset sales related to the higher gross customer additions and higher prices on handset upgrades and accessories, partially offset by increased rebate activity.

 

Cost of services and equipment sales expenses increased $58, or 1.6%, in the third quarter and $589, or 5.5%, for the first nine months of 2006 primarily due to increases in network usage and associated network system expansion.

 

Cost of services increased $63, or 2.6%, in the third quarter and $443, or 6.4%, for the first nine months of 2006 primarily due to the following:

 

Increases in network usage with an increase in minutes of use of 21.3% in the third quarter and 21.0% for the first nine months.

 

Higher roaming and long-distance costs were partially offset by a decline in reseller expenses. The reseller decrease resulted from a decrease in minutes of use on the T-Mobile 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 decreased $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 was primarily due to a decline in the average cost per handset sold. The increase for the first nine months was due to increased handset unit sales (including upgrades) associated with the higher gross additions, partially offset by the decline in the average cost per handset sold. Total equipment costs continue to be higher than equipment revenues due to Cingular’s sale of handsets below cost, through direct sales sources, to customers who committed to one-year or two-year contracts or in connection with other promoti