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BellSouth Corporation (BLS)

Q2 2006 Earnings Conference Call

July 24, 2006 10:00 am ET

Executives

Pat Shannon - Chief Financial Officer

Nancy Davis - Vice President, Investor Relations

Analysts

Simon Flannery - Morgan Stanley Dean Witter

David Barden - Banc of America Securities

Michael Rollins - Citigroup

David Janazzo - Merrill Lynch

Jonathan Chaplin - JPMorgan Chase & Co.

Christopher Larsen - Credit Suisse First Boston

Jason Armstrong - Goldman Sachs

Frank Louthan - Raymond James & Associates

Michael Bowen - Friedman, Billings, Ramsey Group, Inc.

Michael McCormack - Bear, Stearns & Co.

Qaisar Hasan - Buckingham Research Group

Richard Klugman - Provincial

Presentation

Operator

Good morning, my name is Judy and I will be your conference facilitator today. At this time, I would like to welcome everyone to the BellSouth second quarter 2006 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer period.

(Operator Instructions)

As a reminder, ladies and gentlemen, this call is being recorded today, Monday, July 24, 2006. Should anyone need assistance at any time during the conference, please press star, then zero and an operator will assist you. Thank you.

At this time, I would like to turn the call over to Nancy Davis. You may begin your conference.

Nancy Davis

Thank you, Judy. Good morning. Thank you for joining BellSouth’s second quarter 2006 earnings conference call. During this conference call, we will refer to a slide presentation. The presentation, earnings press release, investor news, and our financial statements are posted on our investor website at bellsouth.com.

Before we get started, let me point out that some of our remarks today may contain forward-looking statements. Actual results could differ materially from those projected statements. For discussion of the factors that could cause actual results to differ, I refer you to our various reports on file with the Securities and Exchange Commission.

I will begin our discussion by covering BellSouth’s consolidated financial results. Pat Shannon, chief financial officer for BellSouth, will cover the quarter’s highlights and our business unit results.

To supplement the reporting of BellSouth’s consolidated financial information under generally accepted accounting principles, the company presents certain non-GAAP financial measures, including normalized operating results and operating free cash flow. Normalized results from continuing operations include BellSouth’s 40% proportionate share of Cingular’s revenues and expenses, that are recognized as equity earnings for perfectly good GAAP reporting.

Normalized results exclude the impact of significant non-operational or non-recurring items. I will review the normalizing results for the second quarter of 2006. A complete list of normalizing items, as well as the full reconciliation of normalized results to GAAP reporting, is included in the quarterly financial statements which are also available on our website.

Slide 4 shows BellSouth’s consolidated GAAP results from continuing operations for the second quarter. Revenue was $5.2 billion, up 1.2% compared to the same quarter of 2005. Operating margin was 25.1% for the quarter. The year-over-year reduction in reported margin is primarily driven by costs associated with workforce reductions taken during the quarter. Sequential improvement in reported margin is due to the reduction of ongoing repair and restoration for the hurricanes that hit our region in 2005.

Reported earnings per share from continuing operations was $0.49, up 14% compared to the same quarter in 2005.

BellSouth’s normalized results for the second quarter of 2006 are on slide 5. Normalized earnings per share for the quarter was $0.60, up nearly 18% compared to the second quarter of 2005, reflecting improved profitability at both Cingular and the communications group.

Second quarter 2006 revenue was $8.8 billion, up 3.4% compared to the same quarter of 2005 and up 1.5% sequentially, driven by solid revenue performance across all operating segments. On a year-to-date basis, normalized revenues were $17.5 billion, a 4% increase over the first six months of 2005.

For the quarter, operating margins were 23.1%, improving 180 basis points year over year, driven by margin improvement at Cingular and the communications group. For the year, margins had expanded 200 basis points, reaching 22.5%.

Normalized net income for the quarter exceeded $1 billion and a year-to-date normalized net income expanded more than $300 million, totaling $2.1 billion.

Details of the normalizing items for the quarter are on slide 6. Adjustments to reported earnings per share from continuing operations include costs associated with wireless merger integration and wireless intangible amortization, costs associated with Hurricane Katrina, costs from workforce reduction, and costs associated with the pending merger with AT&T.

For the second quarter of 2006, pre-tax wireline network restoration costs associated with Hurricane Katrina were $25 million, which is net of $20 million for insurance recoveries during the quarter. BellSouth also incurred approximately $130 million of incremental capital expenditures for Katrina restorations. Since the third quarter of 2005, BellSouth has incurred approximately $910 million for Katrina-related network restoration expense in capital spending.

As previously disclosed, we expect a portion of the costs associated with Hurricane Katrina recovery efforts to be covered by insurance. While the exact amount has not been determined, our current estimate of the total amount of covered losses that will be covered by insurance, net of our deductible, remains at approximately $250 million, of which $40 million has been recognized to date. The actual recovery will vary depending on the outcome of the insurance loss adjustment network.

We are essentially complete with the restoration of Hurricane Katrina, as efforts are shifting towards the slow process of repopulation in the area. As we stated previously, we will no longer normalize costs associated with Katrina restoration.

At this point, I will turn the call over to Pat Shannon. Pat will begin his comments on slide 7.

Pat Shannon

Thank you, Nancy, and good morning. This quarter, BellSouth delivered our third consecutive quarter of double-digit earnings growth. EPS for the quarter grew nearly 18% year over year, driven by positive revenue results across all segments, cost management in the wireline business, and increased profitability at Cingular.

The communications group segment contributed to the strong results, with continued improvements in the mass market and further signs of stabilization in the large-business segment. During the quarter, margins for the wireline segment expanded due to improved contribution from broadband services and ongoing cost management efforts.

Cingular continues to contribute strong results to the top- and bottom-line, with strong customer growth, lower churn, and improved margins.

Advertising and publishing maintained its industry-leading performance, with continued revenue growth and sound margins.

For the quarter, this collective set of assets has generated $3.4 billion of operating income before depreciation and amortization, levels that we have not seen since 2001.

Slide 8 shows the revenue results for the communications group segments. Total communications group revenue increased 1% versus the previous year, and is up 1.2% year-to-date. Consumer revenue growth accelerated in the second quarter to 2.5%, as growth in DSL and long distance revenues once again outpaced access line declines.

Consumers continue to add additional BellSouth products to their bundles, and average revenue per customer was above $63 at quarter end, nearly an 8% increase year over year.

Small business had another great quarter, growing revenue 9.8% year over year. This segment continues to attract and retain loyal and profitable customers, with diverse and competitively-priced products.

The large business segment was stable during the quarter. Trends from previous quarters continued as growth in emerging data products and long distance offset slowing declines in the legacy voice and data products.

Wholesale revenues declined 5% year over year in the second quarter. Local wholesale, which includes revenues from UNE lines, was down over 20% in both the first quarter and the second quarter, as that customer base continues to dwindle.

Excluding local wholesale services, our wholesale revenue grew 1.1% in the second quarter as wireless transport growth continued at a strong pace.

Slide 9 reflects the improvements seen in BellSouth’s wireline operating margin over the past year and sequentially. Operating margin was 24.9% for the quarter. Year over year, margins expanded 130 basis points on improved scale in both long distance and DSL, coupled with significant management headcount reductions.

On a sequential basis, margin also grew by 130 basis points. The most significant driver of this improvement was the first quarter completion of restoration efforts for Hurricane Wilma, which hit southern Florida in late 2005. We discussed this point, and at some length, in the first quarter call.

Slide 10 illustrates the growth drivers of Network data revenue. In the second quarter, total Network data revenue growth accelerated to 10% year over year. This compares to 9% year over year growth last quarter, and 4.5% year over year growth in the second quarter of 2005. In fact, the last time we generated double-digit data revenue growth was the first quarter of 2002.

Total retail data revenue was up 18.7%, driven by ongoing growth in DSL services. Core retail data was up 3%, driven by long distance and emerging data products such as Metro Ethernet and Network VPN.

Wholesale data transport revenue was basically flat year over year and sequentially, as growth in wireless transport continues to offset declines in general transport services.

Slide 11 demonstrates that BellSouth continues to add more loyal and more profitable DSL customers. BellSouth served nearly 3.3 million DSL customers at the end of the second quarter of 2006. Total penetration reached 17.4% after adding 128,000 customers during the quarter. The net subscriber increase for the quarter follows typical seasonality patterns.

The good news is that our economic mix of customers continues to improve, contributing to top line growth and improving profitability.

Our simplified pricing plan continues to attract customers to higher-speed, higher-priced services, either the initial sale or as upgrades from lower speeds.

Customers for our lowest speed service actually decreased nearly 42,000 during the quarter, driven by strong upgrade activity, as the rest of the portfolio grew by 170,000. Three- and 6-megabit DSL customers now represent 28% of our entire DSL customer base, double what it was only a year ago. This mixed shift towards our premium DSL products again positively impacted DSL revenue per unit. While total DSL revenue per unit was up 4.4% versus last year, recurring service revenue per unit was up 8% year over year and was stable sequentially at $40.

For the second quarter, DSL revenues totaled $400 million. An increase in subscriber base, combined with increasing revenue per unit, has led to a 39% increase in DSL revenues, along with an increase in DSL profitability that contributes to BellSouth’s total bottom-line performance.

Access line trends are shown on slide 12. In the second quarter, BellSouth lost 392,000 residential access lines and 65,000 business access lines. As expected, residential access line loss accelerated in the second quarter due mainly to seasonal household moves.

While the largest driver of residential line loss continues to be wireless substitution, the absolute level of wireless substitution has trended downward over the past two quarters.

Line losses to VoIP and cable providers are up slightly in the quarter and now fall just above the 50,000 to 75,000 range we have discussed for the past few quarters.

Our data suggests that the increasing losses to cable correlate closely with increased cable telephony launches, suggesting that while the loss rates by market vary widely, actual market share loss rates across the region have remained relatively constant in total.

Another relatively new trend that affects residential [on net] access line is the UNE-P to UNE-L conversions. As you are aware, UNE-L services are not included in our reported access line results and accounted for a reduction of approximately 33,000 access lines in the second quarter, and about 100,000 access lines over the past year.

Our small business segment continued to grow access lines, adding 25,000 lines in the second quarter. Large business access lines were impacted by the loss of a single government customer accounting for 20,000 lines. Excluding that, large business lost about 28,000 lines, a third of which was migration to BellSouth data services, consistent with the trends that we saw in the first quarter.

Residential wholesale lines declined 141,000 and business wholesale lines decreased by 39,000.

Now, turning to Cingular, Cingular reported its quarterly results in detail last week, so I will only cover a couple of key highlights on slide 13.

Cingular reached 57.3 million subscribers at the end of June, adding 1.5 million net new customers during the second quarter of 2006. Postpaid net customer additions exceeded $1 million, which was about 70% of the total net adds during the quarter. Overall, monthly subscriber churn for the quarter was a record low 1.7%, and postpaid churn was also the lowest ever at 1.5%.

Net and gross customer additions were strong, due to improved service quality as Cingular rationalizes and integrates its networks and continues to offer a steady stream of innovative products and services.

Slide 14 illustrates Cingular’s performance for the quarter, and how that translates into significant contribution to BellSouth’s earnings per share.

Cingular continues to grow revenue and profits by growing subscribers, exercising pricing discipline, and increasing data penetration. Total operating revenue for the second quarter was $9.2 billion, up 7.1% year over year. Normalized margins were up 370 basis points year over year. Normalized net income grew $267 million in the second quarter compared to the same period a year earlier.

The bottom line impact and success of Cingular’s massive integration efforts over the past year are obvious. Cingular’s contribution to the BellSouth’s EPS has increased from $0.09 per share and the second quarter of last year to $0.15 per share this quarter. Over the past four quarters, Cingular has contributed a total of $0.53 to BellSouth’s earnings per share.

Their strong performance continues to benefit our shareholders in significant ways.

Slide 15 shows solid year over year growth continues for the advertising and publishing group. As of the second quarter, this business has had seven consecutive quarters of year-over-year revenue growth.

Second quarter revenue grew 3%, primarily due to strong electronic media revenue, which grew 39% year over year, and solid print advertising revenue, which grew nearly 1%.

A&P’s operating margin rebounded in the second quarter, as expected, and we expect the margins for the full year to be in the range of what we have seen year-to-date.

Capital expenditures for the quarter were $950 million, including approximately $130 million of incremental expenditures to complete Hurricane Katrina restoration efforts. As we mentioned on the first quarter call, we expect spending to be more weighted toward the first half of the year, with a decline in spending for the remainder of the year. Note that capital expenditures, excluding Katrina-related spending, was in line with our average 2005 capital spending.

As you can see from the chart, the second quarter capital spending declined $131 million. We expect capital to continue to trend downward while we remain focused on our broadband investments.

Furthermore, our operating free cash flow improved sequentially in the second quarter to $980 million and was $1.5 billion year-to-date, including $385 million of cash related to Hurricane Katrina restoration activities.

I will cover an update of the merger approval process on slide 17. This past Friday, July 21st, shareholders of both BellSouth and AT&T voted overwhelmingly to approve the merger agreement. Both companies have made significant progress towards attaining regulatory approvals from the Department of Justice, the FCC and the various state commissions. We filed with the DoJ and the FCC on March 31st, and over the last few months we have fulfilled all requests made of us. We believe that both the DoJ and the FCC have the information necessary to approve the merger. There are only a handful of states that have steps remaining to complete their merger reviews.

Overall, the regulatory approvals are on track and we currently expect the merger to close in the fall.

I will conclude on slide 18. Execution in the marketplace, revenue growth, cost management and Cingular merger synergies drove robust financial results that translated into BellSouth’s third consecutive quarter of double-digit earnings growth.

In the communications group, continued improvements in DSL profitability, strong growth in small business segment and continued stabilization in both the large business and wholesale segments, coupled with solid cost management, allowed us to further expand our industry-leading margins.

At Cingular, results for the quarter sent a clear signal that they are well on their way to achieving their goals.

Our advertising and publishing group continues to lead the industry in growth and provides a solid economic foundation in our portfolio.

As for our merger with AT&T, the approvals are on track and we look forward to the closing, because we believe the combination of AT&T and BellSouth will create the future for our industry that benefits shareholders, customers and employees.

Now, I will be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Simon Flannery with Morgan Stanley.

Simon Flannery - Morgan Stanley Dean Witter

Good morning, thanks very much. Pat, on the third quarter, what should we expect in terms of headcount numbers and cost trends? Is it similar to Q2? Do you think you can take the margins up again?

Then, as we enter hurricane season, you have obviously had relatively low insurance recovery here, relative to some other companies. Have you changed your attitude towards how much insurance you want to buy, or are you still primarily self-insured going into this season? Thank you.

Pat Shannon

As far as the headcount goes, we did take a pretty significant headcount reductions during the second quarter. The annual impact is around $150 million for those headcount reductions. We had a half-a-quarter or so benefit in the second quarter, so we should see a little bit of a pick-up.

I think if you take that half-a-quarter benefit out of the second quarter, you will see that even that benefit was somewhat offset by some continued pressures in the business. I am not going to call for future expansions in the margins, but I do think we will have some more benefits from this headcount reduction. We do not have any other large headcount reductions in the works, but certainly productivity continues to be managed.

As far as the insurance recovery, that is more of a timing issue with us. We are in the process with our insurance companies, working through the claims. The claims are, as you can imagine, very complex, working through which pieces of the recovery efforts are covered and which is outside plant and what is inside plant. Business interruption is always a tricky thing to document and get through the insurance company, so we are very comfortable with our $250 million of net recoveries. We have done 40 net, so we have about 100 cleared so far. I think it is just a matter of timing. We are still very comfortable with those numbers.

Simon Flannery - Morgan Stanley Dean Witter

But if it a hurricane strikes again this year, most of that loss will still be incurred by yourself? You will not have necessarily a significant increase in your insurance coverage?

Pat Shannon

No, it would be a new event so you would be going back through a whole new event if it was another hurricane this year, so no [change in] our coverage.

Simon Flannery - Morgan Stanley Dean Witter

Thank you.

Operator

Your next question comes from the line of David Barden with Banc of America Securities.

David Barden - Banc of America Securities

Good morning. Congratulations on the margins. A couple of questions, and I will hit the insurance question again, but going forward, I want to be clear -- as the recoveries are coming through, this roughly $250 million that is going to be flowing through the income statement, but you will not be normalizing that item?

Pat Shannon

No, we will be normalizing -- the insurance recoveries for Hurricane Katrina will be normalized because we normalized the expenses going out, so we are not going to do one and not the other, but from this day forward, we are not normalizing anymore hurricanes out of our business.

David Barden - Banc of America Securities

The second question I have is just business-wise, it looks like ISDN lines saw a decline, an accelerated rate of decline. I was wondering if that was related to some of the more aggressive take-up of the higher speed DSL lines that you have been seeing, and if maybe what we are seeing in the ISDN is a trend now back towards a decline related to the push on the DSL side.

Pat Shannon

You just looked at a trend that I have not looked at in a long time. We will have to study it and get back to you. I have not really paid attention to ISDN lines in quite a while, but the DSL uptake is pretty strong. I know that there cannot be much demand for ISDN in the marketplace anymore. It is just not a product that we really push, but it would not surprise me at all to see that drop off, because I doubt we are adding very many.

David Barden - Banc of America Securities

Then the last thing was I think you did touch on this a little bit, but you were mentioning that a lot of those line losses are related to launch mode for the cable companies coming into the territory, presumably that was Comcast. Have you been seeing any maturity in some of the markets where you have had the VoIP competition for longer? Are you starting to see a leveling out, or even down-ticks which are compensating for the Comcast up-tick which you presumably saw in the quarter? Thank you.

Pat Shannon

Yes, basically what we have seen pretty consistently across these launches is the first quarter out of the gate is their best quarter, so now you have some history. You look back and clearly the first quarter of each of the launches was the best, and then you would see a pretty significant drop-off in the second quarter, and then we have seen those trends stay relatively consistent.

Again, they are vastly different market by market. I will give you a couple of data points. We talked about the Raleigh market being a very good market for Time Warner, but if you look even at some of the other Time Warner markets, you will see a vastly different profile of their success. In Charlotte, which is also a decent market for them, they were about 30% less effective than they were Raleigh. Then in two other markets, like in Memphis and in Jackson, Mississippi market when they launched, they were 50% as effective in those two markets as in Raleigh.

So yes, we have seen some new launches mainly coming out from Comcast. No real surprises in the numbers. Again, first quarter launches were -- their success in the first quarter was higher than it was in their second and third quarter, but again nowhere near the Raleigh level. Again, overall the line loss that we have seen to cable has correlated pretty steadily with increased launches, so we have not seen an increase across the region and their effectiveness with this line loss. We have just see more availability as they roll out across the region.

I hope that makes sense.

David Barden - Banc of America Securities

Thank you.

Operator

Your next question comes from the line of Michael Rollins with Citigroup.

Michael Rollins - Citigroup

Good morning. A couple of questions, first on the DSL side. You talked about some of the different trends in terms of the speed. I was wondering what was going on with overall churn on the DSL side, to just try to get a better feel for the competitive environment.

The second question I have is related to the margins. I remember last quarter, I think you talked about Wilma having costs -- and correct me if I am wrong -- around $85 million that was actually not normalized out of performance. So if you look at those costs that went away in the second quarter, plus the changes in the numbers, is it fair to say that margins were slightly down sequentially on a fully, ex-hurricane basis? Is that just reflecting some of the competitive and secular pressures that you highlighted before hand? Thank you.

Pat Shannon

On DSL, the churn has improved year over year. Second quarter is a tough quarter seasonality wise, because you have a lot of household moves, and that affects not only the access lines but the DSL lines. Certainly we have not seen any sequential improvement in Churn, but it is more about seasonality than it is about competition. We have seen steadily improving churn trends, just like we said in the first quarter, on a year-over-year basis in the second quarter.

On profitability on DSL, I think it is important to step back and go through a little bit of the data, because we through out a data point that the largest driver of our margin improvement was DSL. Let me add a little flavor to that.

In the second quarter of 2006, we generated $400 million worth of DSL revenue. That, on a run-rate quarterly basis, is up about $113 million year over year. So we have $113 million more in revenue and very little change in the costs associated with DSL, so almost all of that fell to the bottom line of the wireline business.

The acquisition costs are only up a slight bit because the sales are only up a slight bit, and then the cost to serve is actually flat, as we have been able to -- first of all, which makes sense, it is a very leverage-able network-based product, just like our other ones, so we should have some natural leverage. We have also been able to work on our cost structure around our help desk and other areas of the business.

The profitability of it is just great. This is exactly what was supposed to happen and it is good to see that profitability begin to take place.

I forgot what your second question was.

Michael Rollins - Citigroup

On the hurricane costs with the $85 million I think you experienced.

Pat Shannon

That would probably be a fair observation. There continues to be pressures in the business, and if you went back to the first quarter and you took out this Hurricane Wilma expense, there was a little bit of Hurricane Wilma flop-over into the second quarter. It was like $10 million, so if you are going to get that precise in the reconciliation, there was a little bit more in the second quarter.

The pressures that we see in the business were then offset by the headcount reduction, so the net net of it, the headcount reduction kind of kept the normalized margin, if you take the Hurricane Wilma expenses out, relatively flat. That is why when I was talking to Simon’s point about the third quarter, again, think about that half-a-quarter’s worth of benefit that we saw in the second quarter was virtually offset by pressures in the business. You are going to get, in the third quarter, another half, presumably an incremental half-a-quarter benefit, so I would not call for any kind of margin expansion at that point but certainly, we have that benefit coming forward in the third quarter as well.

Michael Rollins - Citigroup

Thank you, really appreciate the help.

Operator

Your next question comes from the line of David Janazzo from Merrill Lynch.

David Janazzo - Merrill Lynch

Good morning. I noticed in your technology update section that it looked like some of the stats for the fiber-fed remote terminal and central offices, as well as the fiber-to-the-curb slowed down in the second quarter. Is that going to pick back up in the third or will that trend with the overall cap-ex budget?

Nancy Davis

I do not think it trended down significantly.

David Janazzo - Merrill Lynch

Well, it seemed to slow a little bit in terms of the remote terminal in central office site adds, and then the fiber-to-the-curb facilities remained the same sequentially, so yes, I agree it was not a big number, but it certainly did not accelerate in the second quarter.

Pat Shannon

There is nothing really going on in the business that would suggest that. I know that we have had some equipment delays in some of our upgrade activity, and as a result, we have shifted some of our upgrade efforts towards fiber deployment, but I am not sure if that affects those trends or not, to be honest with you.

Maybe we could take it offline and get back into your question a little bit deeper.

David Janazzo - Merrill Lynch

Okay, but your point is there should be no substantial changes there?

Pat Shannon

There is nothing, no. Nothing there.

David Janazzo - Merrill Lynch

Thank you.

Operator

Your next question comes from the line of Jonathan Chaplin with JP Morgan.

Jonathan Chaplin - JPMorgan Chase & Co.

Thank you very much. Two quick questions -- firstly, I am just wondering if Katrina and severance costs are normalized out of your segment reporting for the wireline segment.

Pat Shannon

Yes, it is.

Jonathan Chaplin - JPMorgan Chase & Co.

They are?

Pat Shannon

Yes.

Jonathan Chaplin - JPMorgan Chase & Co.

Okay. My second question is on pre-tax. It looks like you are trending well above your initial guidance for the year of $3 billion, excluding Cingular and Katrina. Particularly with cap-ex coming down in the second half of the year, are there any pressures on free cash flow, aside from normal operations that occur in the back-half of the year that I might not be thinking about? Thank you.

Pat Shannon

The free cash flow is kind of lumpy. One thing we have not had back-end loaded is tax payments. We have made no tax payments for the year, and they typically come in the later part of the year, so that will be a negative impact later that you do not have in the numbers.

Jonathan Chaplin - JPMorgan Chase & Co.

Excellent. Thank you very much.

Operator

Your next question comes from the line of Chris Larson with Credit Suisse.

Christopher Larsen - Credit Suisse First Boston

Thank you. Pat, two questions. One, I think you said that you attribute about $20,000 of the access line losses to a single government contract. I wonder if you could give us an idea of where you thought those lines went then, on enterprise. Is it more a shift towards voice-over IP or are these businesses moving out of the area?

Then, the DSL adds, I hate to beat a dead horse here, but it seems to be a bit slower than a year ago. Do you think this is a function of share where the cable guys are coming in with their voice-over-IP and getting that triple play and being more effective with that, or are there some other forces at play there? Thank you.

Pat Shannon

The 20,000 lines for the government contract was a function of us having to transfer a switch over to the government because of some rules that I do not really understand -- something to do with national security around this customer. It was not a competitive loss. It was more something that we had to deal with for this customer. That is why we talked about that separately.

As far as the DSL net adds, I think it was a little slower seasonally than we believed, but we do always see this significant drop-off in the second quarter. We do not believe that it is indicative of any share losses, but I guess we will have to wait and see over the next two weeks as we see other announcements. We think it is just a slow-down in the penetration curve and a seasonally weak second quarter.

Christopher Larsen - Credit Suisse First Boston

Thank you. Quick add-on, the resale line losses, have you gotten a sense for any shift in what is coming back to you guys and what you are gaining back and what might be going over to some competitors from the resale lines?

Pat Shannon

We have seen a steady decrease really over the last three years of UNE-P disconnects, and basically resell as well. So yes, with that decrease in disconnects on their side, you are going to see a decrease in what we are winning back, but it is really difficult. I think I have said this before on some calls, to accurately track every one of those disconnects, [inaudible] exactly what is coming back.

Our “win-back” rate, which is around 50%, is really -- we know that is how many numbers got ported back to us. I have to believe that just because of the trends that the numbers that we end up winning back on our network have to be higher than that, whether it could be bad debt, disconnects on their side, and coming back through a different channel. But the ones that we can actually track is still at around the 50% level.

Christopher Larsen - Credit Suisse First Boston

Thank you.

Operator

Your next question comes from the line of Jason Armstrong with Goldman Sachs.

Jason Armstrong - Goldman Sachs

Thank you, good morning. A couple of questions, first on DSL again, just on the ARPU side. You mentioned recurring service ARPU up 8% year over year but then flat sequentially, so I am wondering where we are in the tiering cycle. Do you see it slowing down or do you have expectations that ARPU can continue to increase from here on the DSL side?

Then, on wholesale, you talked about wireless transport, which continues to be strong. I am just wondering if you could break this down into components and talk about trends and price versus volume for wireless transport. Thank you.

Pat Shannon

As far as DSL ARPU, I think there will continue to be competitive pressures in that. I think as we continue to penetrate that market, I think the recent activity that we pushed in our channel, pushing customers to migrate to higher speeds I think has certainly helped offset some of that competitive pressure. You have seen now sequentially the ARPU’s are relatively flat.

I am not going to call for further expansion in that ARPU, but I certainly think as the customers migrate to higher speeds, and we are just starting that. Our 6-megabit product will have availability to around 60% of our homes by the end of this year using current technology, some [mac-sync] technology, and I think we can continue to push these higher speeds and keep those ARPU’s pretty high, but I would not say I will call for further expansion.

As far as wireless transport, it is really more driven by volume than price. There continues to be pricing pressure really across that whole transport area, but the volumes have been so strong that we are continuing to see some good growth in that area.

Again, I think throughout that wholesale business, the volumes continue to be strong and there continues to be pressure downward on the price, although a little less pressure than we have seen over the last couple of years.

Jason Armstrong - Goldman Sachs

Thank you.

Operator

Your next question comes from the line of Frank Louthan with Raymond James.

Frank Louthan - Raymond James & Associates

Just a couple of questions on the margins, and then back again to the DSL. Of your margin improvement, could you characterize how much of that is coming from the headcount reductions and some from the marketing, possibly cutting your marketing expend?

Then, as it relates to the DSL, you have noticed incrementally less marketing of DSL, which I think primarily has been focused on the 256K product, so do you think that is having an impact? Can you, maybe you said this and I missed it, but how many of those 42,000 256K customers that turned off do you think be picked up at higher speeds? Are those shown there? What is the percentage of your base on the 256K product? Thank you.

Pat Shannon

If I miss one of these, I will have to get reminded.

The margins improvement in the second quarter for the headcount reduction, again, you can do the math. It is about $150 million is the annual benefit, and we have about a half of a quarter worth of benefit in the second quarter. If I remember the number right, that is somewhere around 15 to 20 basis points of change in the margin for the headcount.

The rest of the margin improvement again, like I stated earlier, was driven strongly by DSL improved profitability. That same phenomenon we continue to see on the LD side -- again, a very leverage-able product, even modest growth drives strong margin improvement at the bottom line for the whole wireline group.

As far as less marketing for DSL, we certainly are marketing the 256K product less. That is definitely true. I do not think it is fair characterization that we are spending less marketing DSL. We are just pushing higher speeds of service. We have changed a lot of the internal compensation to push the reps towards upgrade activity and to really push the higher speed services, and that has worked through our channel. It has been a very effective move for us.

I want to make sure that you understand one thing -- the 42,000 loss in the 256K product was not churn-related. It was upgrade activity because again, we have done a great job through our channels of sending our reps in every call to attempt to upgrade the customers to higher speed services. That effort has worked.

So while the net adds were 128,000, and I believe again that is indicative of the market, we were able to not only -- we were able to shift the portfolio at a higher speed, and it is not churn-related on 256K. It is a purposeful push to upgrade our customers to higher speeds.

Frank Louthan - Raymond James & Associates

Okay, that is encouraging. Thank you. One quick follow-up on the SME market, obviously doing well there. Can you characterize what size businesses you are targeting there? What do you see as the outlook on that going forward, particularly with some improvements in wholesale and enterprise outlook just in general?

Pat Shannon

I think that business, that segment of the business is pretty representative of the economy in the southeast. I think you take a look at the business and the directory business and I think they are pretty clear pictures of pretty strong economy in the southeast. It is accelerating growth. They have accelerated growth over the last several quarters, really several years, and it has not slowed yet.

This targets I think the typical customers in the -- 50K a month is a typical customer in that space. It has been a great demographic. It is also reflective of the [C-line] competition in that area sort of drying up and focusing on something else, so the retail side has been the recipient of that over the last several years.

Frank Louthan - Raymond James & Associates

Great, thank you.

Operator

Your next question comes from the line of Michael Bowen with FBR.

Michael Bowen - Friedman, Billings, Ramsey Group, Inc.

Good morning, thank you very much. I guess my question is back on DSL. Again, I apologize for beating a horse here, but it looked like obviously the ARPU of $41 was up, yet you are moving your mix to higher speed, so the mix is getting better -- I guess what I would like to dig into is since your mix is improving, do you think the mix is improving at a faster rate than the ARPU at this point? In other words, can we take away from this that price continues to come down in the DSL segment, even though -- I do not want to give you the wrong impression, obviously you did very well in the segment, but would that be a correct takeaway?

Pat Shannon

We have not changed any of our pricing. There is some promotional pricing, some promotional bundles that are put out. We have not really made any significant moves in the pricing that would cause that to happen.

I would have to examine the trends a little bit more, but I think this flat-to-up ARPU is driven by the change in mix in the portfolio, but it has not been that significant of a change to drive the number one way or another, because you are talking about a pretty large base.

I think these trends are more indicative of a stable ARPU than they are of any sort of changing up or down, because even these mix changes they found significant, on a quarterly basis. When you talk about 3.3 million subscribers, it does not move the meter far enough, do you know what I mean?

Michael Bowen - Friedman, Billings, Ramsey Group, Inc.

One thing you guys also used to do, it has been quite a while since you have given your what you call a flow-share stack between you can cable. Are you willing to give any update on that, on how you feel like you are doing in the region versus the cable companies? Are there any numbers we can put behind those?

Pat Shannon

I do not have an updated number. I think the last time we gave one, we were roughly equivalent to what is going on in the industry, which is slightly ahead on the flow-share versus cable. Those trends really have not changed and I do not think you will see a change in this quarter.

Michael Bowen - Friedman, Billings, Ramsey Group, Inc.

Thank you.

Operator

Your next question comes from the line of Michael McCormack with Bear Stearns.

Michael McCormack - Bear, Stearns & Co.

Good morning. Just a couple of questions, first on the voice-over-IP thread, you talked about the line loss accelerating slightly on that. Could you just give us a sense of the trends for the quarter? Is there some acceleration there that may have caused you to move on this $99 triple choice product? Maybe your thoughts around that product, more generally?

Secondly, in the small-medium sized enterprise market place, are you seeing any cable success in that market as well? Thank you.

Pat Shannon

There are no trends that we saw during the quarter that made us react to the $99 offer. We continue to try different targeted offers in competition with cable. This recent offer of this triple play, $99 offer is just another trial that we are going through to see what works. That offer is being trialed in five metros that have VoIP competitors that are currently marketing a $99 triple play bundle.

I want to be honest with you -- neither bundle, neither their bundle or our bundle, is a very attractive product. On our side, we offer 1.5 megabit DSL and a 200 minute LD plan, and a pretty good video package, the standard digital package from DirecTV for one TV. If you look at Comcast in Atlanta, they have a little bit better data and voice package, with a 6-megabit cable modem and unlimited LD, but the video product is their expanded basic channel. You have to take a digital box, but you do not get any digital channels, and it is only a 12-month promotion and then it goes back up.

So both of those products again are designed to drive call volumes into the call centers and then we upgrade from their. We have some pretty interesting packages that bolt on top of that that will get the ARPU back up where it should be, and the product set would then be a little bit more robust.

It was not indicative of anything that we necessarily saw in the market. It is just again another iteration of seeing what the market wants and driving the DSL penetration.

Michael McCormack - Bear, Stearns & Co.

So the month-by-month change is more flowing sort of with the new market launches, particularly from Comcast, I assume?

Pat Shannon

Overall, that is true. The overall portfolio, the changes in the line loss is more indicative of just further market [wants]. It is not really any indication of one player is accelerating competitiveness. It is just further market [wants] in the areas.

Michael McCormack - Bear, Stearns & Co.

Are you seeing competition on the small-, medium-sized enterprise space?

Pat Shannon

Not any -- I am sure that our guys see some of them. Some of the better players, like Cox and Time Warner, but it has not risen to a level that I have seen any trends that I could share with you, because I just do not know the answer. I know that Cox is focused on small business in some of their key markets, and we do not have a big overlap with them. I am sure Time Warner has done the same thing in the Raleigh area, but I do not know the numbers enough to say that it has been a major impact on any of these markets.

Michael McCormack - Bear, Stearns & Co.

Just a quick follow-up, in your large enterprise business, you talked about the complex revenue being up. Is there any impact on the AT&T transaction from those customers perhaps pushing back decision making until the deal is done? Or is it just status quo there?

Pat Shannon

I do not know that I am feet on the street, but I am sure that there are some customers that would fall into that category. Again, we have not seen any major trends in that case, to the extent that our customers are comfortable dealing with us. Most of them are, most of them welcome this deal. Again, they like the service aspects that BellSouth has always brought to the table, and now, they see this deal as a very positive way to have more capabilities across the mix.

We have not seen any major changes in those relationships.

Michael McCormack - Bear, Stearns & Co.

Thank you.

Operator

Your next question comes from the line of Qaisar Hasan with Buckingham Research.

Qaisar Hasan - Buckingham Research Group

I was wondering if you could give an update on your cable footprint in terms of how many homes within your footprint are going against cable VoIP offers where that figure was perhaps [inaudible] , and where you expect that trend over the next few months, just so we can get a sense of how your access line trend lines shape up. Thank you.

Pat Shannon

As far as cable telephony, I think you are approaching about 50% of the markets with cable availability. Again, one thing that I want to make sure that you understand, based on what I was talking about before, is the markets vary widely, even the ones that have already launched, about their success. I mean, the best markets and the worst markets are vastly different, and you can only imagine that this first-half of the launch is the best.

What I would not do is take the line losses to cable and double them because the footprint might double, so I just caution you on that. But it is around 50%, but much more have the availability of VoIP, obviously. Everywhere there is a cable modem, for the most part, you can get Vonage or some of these other VoIP providers. The offering of VoIP over a cable modem is more ubiquitous, obviously, than just from the cable offering.

Qaisar Hasan - Buckingham Research Group

If I could just follow up on the merger approval process, there has been some talk of a federal judge who is looking into the SBC AT&T enterprise and MCI transactions and the [consent] decrease that were agreed upon. Is there any concern that review could either delay the AT&T BellSouth merger, or lead to the imposition of tighter conditions than you [worked in]?

Pat Shannon

I think as you pointed out, they are not looking at the AT&T BellSouth merger. They are looking at the AT&T, former AT&T and SBC merger. No, we believe it is very unlikely that his review will affect the merger approval process between AT&T and BellSouth.

Qaisar Hasan - Buckingham Research Group

Thank you.

Operator

Your next question comes from the line of Richard Klugman with Provincial.

Richard Klugman - Provincial

Thank you. Good morning, Pat. Could you just expand a little bit more on the cable competition? You said it depends on the launch. I find it very interesting that it is vastly different from one market to another. Are you doing anything different, or does Time Warner just have smarter people in Raleigh than they do in Jackson?

Pat Shannon

Well, you have followed cable for as long as I have. Their strength, market by market, is vastly different. You talked about Time Warner, but Comcast is the same way. Comcast Atlanta market is a weak cable market, and I am sure Philadelphia is a very strong one for them, so you could only imagine when they launch a product -- any product, whether that be a digital tier or cable modems or, in this case, we are talking about telephone service, that the penetration curves are going to be vastly different from market to market because their customer service levels are different, everything about their relationship with the customer is market focused.

That is why, again, it is important to understand whatever they do in one market, they are going to have a different outcome in another market. That should not surprise you, because again, the service ratings and everything about the operations are locally focused. The marketing is the same. The product mix is the same, but again, the service levels and their relationship with the local customers are vastly different market by market.

Richard Klugman - Provincial

So when that 50% goes to approaching full saturation, when it hits 90, what happens to that 50 to 75 per quarter range that you talked about, just now going above? Once you hit to the point where you are at a steady state and there is no more new markets with that big first quarter surge, where do you think that trends to?

Pat Shannon

Again, what my hypothesis would be is if it doubled today overnight, it would be less than double because the second half would be less successful than the first half. That would be my first hypothesis. But it is not going to double overnight. It is going to be over a period of time, and over a period of time, some of the earlier markets are going to continue to slow down, because there is a saturation level because you need to have a cable modem in order to buy this product. So at some point, the penetration level in some of the early markets are going to reach a level of saturation of the cable modem market, and those will slow down.

I think it is more complicated than just to say double the footprint, double the run rate, and it keeps going. I think you have to really look at market by market, which is the way we look at it.

There is going to be a topping-off as they further penetrate the cable modem base.

Richard Klugman - Provincial

That is great. One more question, if I could, unrelated, your wholesale revenue decline accelerated a little bit this quarter, from 3% last quarter to 5% this quarter. You talked about UNE-P being a contributing factor, but that has been happening for a while, so is that the major reason for that acceleration?

Pat Shannon

Yes, it is the major reason for that. I mean, UNE-P continues to drop off significantly, and I think you are just seeing the catch-up, compounding effect of what has happened over the last four quarters as that thing drops off significantly.

The rest of the business outside of the UNE business is growing modestly. Again, most of that growth is driven by wireless transport as we still continue to see some pressure on the general transport side as the larger carriers continue to groom their networks.

The largest drop in that is the UNE banks, which is welcomed.

Richard Klugman - Provincial

Thank you.

Operator

Ladies and gentlemen, we have reached the end of the allotted time for questions and answers. I will now turn the call back over to management for any closing comments.

Pat Shannon

Thank you. We appreciate your time and your interest in BellSouth. Should you have any further questions, I encourage you to contact Nancy Davis and other members of our investor relations team. Thank you for joining us this morning.

Operator

Thank you for participating in today’s BellSouth conference call. You may now disconnect.

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Source: BellSouth Q2 2006 Earnings Conference Call Transcript (BLS)
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