Rich Dietz – Head of Investor Relations
Rick Lindner – Chief Financial Officer
David Barden - Banc of America Securities
Mike McCormack - Bear Stearns
Simon Flannery - Morgan Stanley
John Hodulik - UBS
Chris Larsen - Credit Suisse
Jason Armstrong - Goldman Sachs
Tim Horan - CIBC
Jonathan Chaplin – JP Morgan
AT&T, Inc. (T) Q2 2006 Earnings Conference Call July 25, 2006 10:00 AM ET
Good day and welcome to the AT & T Inc. Second Quarter 2006 Conference Call. (Operator Instructions) I would now like to turn the call over to Mr. Rich Dietz, Senior Vice President of Investor Relations. Mr. Dietz, you may begin.
Thank you operator and good morning, everyone. Welcome to our second quarter call. It's great to have all of you with us today. I'm Rich Dietz head of Investor Relations for AT&T and with me today on the call is Rick Lindner, our Chief Financial Officer.
Our earnings release, investor briefing and supplementary information were issued earlier today and they are all available at our Investor Relations' Page on the AT & T Website. The presentation slides that we will speak to on this call are also on that same Webpage and that's www.ATT.com/investor.relations.
Before we get started I need to cover our Safe Harbor Statement, which is on slide three. Information that's set forth in this presentation contains financial estimates and other forward-looking statements that are subject to risks and uncertainties and actual results may differ materially. A discussion of factors that may affect future results is contained in AT & T's filings with the Securities and Exchange Commission. AT &T disclaims any obligation to update or revise statements contained in these presentations based on new information or otherwise. This presentation may contain certain non-GAAP financial measures. Reconciliations between the non-GAAP financial measures and the GAAP financial measures are also available on our Website.
Let me begin with a quick update on approvals for our planned acquisition with Bell South. The update is summarized on slide 4. As you know, we announced the acquisition agreement on March the 5th of this year and we moved ahead promptly to get the various approvals processes underway and we've made very good progress. As you no doubt saw, stockholders of both companies voted to approve the acquisition last week. We filed with Department of Justice and the FCC back on March 31st and those reviews are well underway. Plus we filed for some form of approval in 18 states. Most are complete. Review processes in some form are still underway in four states, three of them in the Bell South region. We expect the remaining approvals to be completed shortly. So there's reason to be optimistic regarding a closing date. We expect the approvals can be concluded to allow closing this fall.
With the shareowner votes behind us we are now able to ramp up our planned share repurchase. As you know at the time of the Bell South agreement we announced that we planned to repurchase $10 billion of our shares by the end of 2007. We expect now to approximately repurchase $2 to $3 billion to be bought back this year. Because of the pending shareholder votes to date our repurchases have been minimal, just $148 million in the second quarter. However, we will ramp up the program during the second half of the year as we execute against the repurchase plans we outlined.
Before we hear from Rick let me review our EPS comparisons, which are on Slide Five. In the second quarter of 2006 our adjusted EPS was $0.58. The math is in the first column of this slide. Starting at the top and working down reported EPS was $0.46. We add back $0.05 of Cingular merger integration and intangible amortization costs. We also add back $0.07 of costs related to the AT &T merger and the result is an adjusted EPS of $0.58. You'll note that 70% of the adjustments we made this quarter were non-cash items.
The year ago EPS walk down is in the right hand column. Our adjusted EPS in the second quarter of 2005 was $0.43. Reported EPS was $0.30. We had $0.08 of Cingular merger related costs and $0.05 of AT & T merger related costs and that was for the termination of Will Tell Contracts. This resulted then in adjusted EPS of $0.43. So our reported EPS in the second quarter of 2006 was $0.46 up 53% versus the year earlier quarter and our adjusted EPS was $0.58. That's up 35% versus comparable results in the second quarter a year ago. With that as our background it is now time to turn the presentation over to Rick Lindner, AT &T's Chief Financial Officer. Rick.
Thanks Rich and good morning everyone; we're pleased you could join us for the call. As you've seen, AT &T delivered another strong quarter. Before we cover the slides, if I were to sum up the quarter in a few words I'd simply say we're delivering on targets. We're doing what we said we would do and then some. The AT&T merger is working. We're delivering synergies as planned. Margins have expanded. Wire line execution is very solid. Cingular is on a good track. We have excellent momentum looking ahead to the second half of the year and the expected close of our acquisition of Bell South; and I believe the quality of Bell South's results yesterday add to a positive outlook. Plus, as Rich mentioned, in addition to the opportunities we have to generate value from our business, which are substantial, we also have concrete plans to return value to shareowners through our dividend and through our $10 billion share repurchase program, which, as Rich said, will ramp up in the second half of this year. So with that perspective let me cover the quarter.
Slide 7 summarizes the highlights. First I'm very pleased with the EPS growth and margin expansion we delivered this quarter and based on these results we've raised our target range for full year adjusted margins. Second we delivered some strong execution in wire line. In addition to impressive margin improvement, regional revenues continue to grow, enterprise trends are stabilizing and we were able to offset anticipated declines in national mass markets to achieve sequential growth in total wire line revenues. Our wire line revenues were up sequentially .1% and excluding national mass markets they were up .7%. In addition, Cingular Wireless continues to make solid progress. Network performance is up and Churn is down to our best levels ever; and margins continue to expand with opportunities for margin improvements are still ahead of us.
Cash flow is growing. In the second quarter cash from operating activities was up 24% and free cash flow after dividends was more than a billion dollars. We've increased guidance to the mid $2 billion range in free cash flow after dividends for the full year.
So what I'd like to do next is drill down in each of these areas starting with EPS and margins. Slide eight shows our earnings per share trajectory. As Rich mentioned, before merger related costs our second quarter EPS was $0.58. This is our fifth straight quarter of double-digit year-over-year growth and adjusted EPS. It was also our fifth consecutive quarter of sequential growth in adjusted EPS. The drivers are first wireless, where contributions have ramped up substantially over the past five quarters and there's more upside ahead. And the second driver is wire line. Despite second quarter seasonality and competitive trends our wire line revenue showed considerable stability. In fact, sequentially they were up slightly plus the SPC and AT &T merger integration is on plan and generating expense savings and the result is substantial margin improvement.
As we show on slide 9, our adjusted operating income margin in the second quarter was 19%. That's up 200 basis points versus the year ago second quarter and it's up 180 basis points sequentially well above our previous full year guidance of 15-16%.
Consolidated operating expenses before merger costs were down $263 million sequentially and based on first half results we're raising our outlook for full year adjusted margins to the 17-18% range. The drivers of this margin improvement are merger synergies and plus the separate operational initiatives that we've had underway for some time to streamline and remove costs. In addition, increases in pension and retiree costs, which we had forecast in the $0.06 to $0.08 range for the full year we now expect will be in the $0.04 to $0.06 range for the full year. There will be expense pressure this year from Project Light Speed deployment of $0.05 to $0.07 for the year but that's down from our previous guidance of $0.08 to $0.10.
The key to margin expansion is the integration of our SBC AT &T merger and Slide ten provides an update. In January we said we expected the operating expense portion of merger synergies this year to be in the $6 to $700 million range. We're ahead of plan and I'm comfortable in saying we expect to achieve savings of $7 to $900 million this year. Through June we had realized about $300 million in expense savings. Traffic migration has begun and we expect to have all Legacy SBC mass market LD traffic on the AT & T network by the end of this year. And we're ahead of schedule on our merger force targets. In the quarter total force was down 3600 and for the first half the total decline was 7000. I would emphasize that we're very early in terms of realizing synergies but we've not seen any significant risk to our merger plan and so far most functions are on, or ahead of, schedule.
Now let me cover our wireless line results, which include the combined operations of the former SBC and AT &T business units. By looking at wire line revenues by customer category. Slide 11 updates the revenue break out that we provided last quarter. And as a reminder, the growth rates shown here are pro forma meaning the operations whose results are included in the categories are consistent for all periods. Also these wire line revenue comparison reflect the movement of certain customer accounts between categories that were made in the second quarter and that reflects changes on how the Company serves customers as we've integrated operations. Total quarterly wire line and product revenues were not affected by those changes.
Starting at the top, our Regional Business Revenues, this includes small and medium business customers in our former SBC 13-state region and they grew 4.9%. Our regional consumer revenues grew 1.5%. Through the end of 2005, as you know, SBC had posted seven consecutive quarters of wire line consumer and business revenue growth and our regional results for the first two quarters for 2006 continue that trend. Combined regional, small and medium business and regional consumer revenues totaled $5.6 billion and had a combined second quarter growth of 2.7%.
The next customer category is Enterprise, which combines former AT &T and SBC large business operations. Revenues in this category totaled $4.4 billion in the quarter with a 7.5% decline as reported. The former AT &T had sold a pay phone business that had been included in this category. So excluding those revenues from the year ago second quarter Enterprise revenues declined 6.9% year-over-year but were nearly flat sequentially.
Next is Wholesale with revenues of $2.9 billion. Wholesale results are down just slightly about .4% year-over-year. In the second quarter these revenue categories added up to over $13 billion in revenues with a decline of 1.8% or 1.6% when excluding the results of the sold pay phone business and sequentially these revenues grew .7%. Also shown here are the former AT &T national mass-market customers and this category represents a little under 10% of our wire line revenues but two-thirds of our year-over-year decline in revenue. The first four categories on this slide that we talked about are customer groups that we are managing for long-term growth. In the national mass-market areas our strategy has been to focus on managing this space for cash flow and for that portion of the base located in our local service regions, especially where we have a change to offer our full line of broadband and bundled services, we'll work to convert them to regional bundles over time.
Now let's take a more detailed look at some of the customer categories starting with Regional Small and Medium Business on Slide 12. Revenues in this category were up 4.9% with growth in both data and voice. Small medium business data revenues grew 14% with double-digit growth in both transport and IP data led by strength in managed Internet services, virtual private networking, and DSL. It may be somewhat of a surprise to you but data represents nearly 30% of our total revenues in the Small/Medium business category.
On the voice side, access lines increased modestly in the quarter as they have over the past several quarters and Churn has been low. So bottom line continues solid performance in regional Small and Medium Business.
Slide 13 shows our Regional Consumer Trends. Our consumer business has evolved to center on broadband and bundles and as that has occurred regional consumer revenues correlate closely with the measure we call Consumer Revenue Connections. Total connections, that's retail access lines plus DSL plus video, were up $637,000 over the past year, about 2% growth; and total revenues in this category were up 1.5%. We achieved this growth even with typical second quarter seasonality for both primary lines and DSL as college student disconnects go up at the end of the school year. We had total DSL net adds in the quarter of $342,000. That's consistent with our second quarter DSL net adds for the past two years. Both were in the mid $300,000 range. We now have 7.8 million DLS lines, up 30% or 1.8 million over the past year. Our DLS penetration of primary lines is closing in on 30% and in our West region it's over 35% and more of our customers are opting for higher speeds. 37% of our consumer DSL base now subscribe to higher speed service and that's up from 16% a year ago. We continue to see opportunity in the regional consumer space as we innovate with more bundles, including wireless, and we increase broadband penetration and speeds; and as we launch our new video products.
In recent weeks we've taken significant steps on the video front. Some of the highlights are on Slide 14. In June we made our initial expansion of AT &T U-verse services in San Antonio powered by Project Light Speed. San Antonio is the first metro area where the services are commercially available and by design we're ramping the project in a measured wave to insure a good customer experience. In our first wave we're marketing to about 6200 homes. We're doing some innovative things in terms of marketing using neighborhood events, going door-to-door, hosting customer parties and so forth. We also have live demos available at a Cingular store and the initial response is very promising. Customers love the service. Picture service and features beat cable in side-by-side tests. We expect to have 10% of the targeted customers in service by the end of July and three-fourths of our U-verse customers are also taking a higher speed broadband service.
Our next launch will be in Houston. We expect to launch there in the fourth quarter with HDTV in the service offering. At the same time, we're moving ahead with our Home Zone product, which we launched last week in Ohio and San Antonio. Home Zone integrates AT &T Yahoo high-speed Internet, AT &T Dish Network satellite television and AT &T home networking services all via a single device. It features digital video recording, movies on demand, photos and music sharing, storage for both and Web-based access to the system. Home Zone is also an innovative product and it brings some of the same advantages of integrated video and data services to customers who are outside of our Light Speed footprint.
Let's turn now to Enterprise customers on Slide 15. We posted a sequential decline in Enterprise revenues of just .3% and Enterprise data revenues increased sequentially 1.5%. Data makes up 47% of our Enterprise revenues and that's up over the past year, as you would expect. We had sequential growth in both Enterprise data transport and IP based data revenues. Volumes continue to be strong in transport. We had double-digit year-over-year growth in IP services. That includes virtual private networks, managed Internet services, and hosting. Overall in Enterprise we are seeing a continuation of the trends that we shared with you in first quarter results. Demand is solid. Volumes are strong. Customer response to the new AT &T continues to be very positive.
Technology migration is a constant with customers moving from packet based service to IP data and we're capturing this migration with an outstanding portfolio of services including virtual private networks hosting and managed Internet services; and the pricing environment has not changed substantially with slowing declines in point of sale pricing supporting stabilizing trends. The return to Enterprise revenue growth is a gradual process as we described to you but with our networks and product sets we're confident we'll do well in this segment of the market.
As you see on Slide 16, we're taking the initiative in areas that will strengthen our capabilities in Enterprise. For example, we announced our plans to deploy OC-768 optical network technology across our MPLS network serving some 31 cities in the United States starting this year and in 2007. That will provide the capacity to support the migration of our LD traffic and the continuing strong growth in IP data traffic. We've also expanded on the product front. For instance, making our network integration services available to more international markets. And we continue to have good sales momentum. The Enterprise Sales Team has won some 48,000 deals this year comprised of both new business, as well as renewals.
Some of the same broad trends we see in Enterprise are also evident in Wholesale on Slide 17. Total Wholesale revenues were essentially flat with the proceeding quarter in year-over-year with growth in Wholesale data and long distance largely offsetting expected voice declines from a shrinking Uni-P base. 40% of our Wholesale business comes from data services and data and long distance combined represent approximately two-thirds of the total. In the second quarter Wholesale data and Wholesale long distance both grew 4.1% year-over-year.
Before moving on to wireless let me comment just briefly on revenues from a product perspective and specifically data revenues. The highlights are on Slide 18. We have data revenues in several customer categories but primarily they reflect Business, Wholesale and Consumer DSL. Data now makes up more than 30% of our total wire line revenues up from about 28% a year ago. In the second quarter our total data revenues grew 2.8% and data revenue growth has improved now for five straight quarters. Data transport revenues were up 3.4%. That follows 1.6% growth in the first quarter. Packet data declined 13.2% reflecting migration from frame relay to EBPN in managed Internet services, which are part of our IP Data category. Partly due to this migration and also due to the strong demand, IP Data continued its double-digit growth up 11.4%. As you see on the pie chart on this slide, 84% of our data revenues come from Transport and IP, both of which have good growth; so overall, another quarter of solid trends in data.
In addition to wire line, the other key driver of our EPS growth has been wireless. Cingular had their own call last Thursday so I'm not going to spend a great deal of time covering their results but there are a few things that I'd like to emphasize starting on Slide 19. One of the key questions when you look at our business and looking ahead at our opportunities over the next three years is how well we will manage integrations and how well we'll deliver on merger targets. Our wire line margin expansion and EPS growth this quarter are providing one positive set of answers to that question. Cingular Wireless is providing another and looking at results over recent quarters I think it's clear the Cingular AT &T Wireless merger integration is working. As you see on this chart, Churn has come down dramatically driven by network service improvements and customer service enhancements. Total Churn declined 20 basis points in each of the past three quarters down to 1.7% and post pay Churn is even lower at 1.5%. Meanwhile, gross adds continue to be strong, 4.4 million in the second quarter likely leading the industry in flow share as we have for several quarters and the result is strong subscriber growth, 1.5 total net adds in the quarter, 5.9 million over the past year to reach 53.7 million subscribers in service and post paid net adds were above a million, up strongly over the past several quarters as Churn has declined. So very good subscriber metrics continuing what by any standard would have to be called one of the great merger integration stories this industry has seen. Since the AT &T Wireless merger just six and a half quarters ago Cingular has added 10 million subscribers while at the same time rationalizing distribution and converging networks. Cingular now has 92% of its customers and 98% of its minutes on the GSN Network and nearly 26 million customers have been added to that GNS Network since the merger began.
Cingular subscriber adds and demand for data services have driven revenue growth with the highlights on Slide 20. At the beginning of the year Cingular said they expected to deliver upper single digit revenue growth for the year and through the first half they've done just that. In the second quarter total revenues were up 7.1% to $9.2 billion. Data revenues were up 51% year-over-year and 13% sequentially and that has helped stabilize ARPU, which was also up sequentially. Data ARPU is up dramatically, more than 38%, over the past year and up nearly 11% sequentially. Data ARPU for Cingular's post-paid subscriber base was nearly $6.60 in the second quarter. I think it's important to note that Cingular has just begun to realize the potential in data. With our 3-G deployment and with a rich array of applications and data services Cingular is well positioned to be the long-term leader in wireless data. Since the merger Cingular's increased its adjusted EBITDA margin by more than 900 bases points; 70 basis points to that expansion came in the second quarter and the margin details are on slide 21.
The great news is that there's considerable margin opportunity ahead at Cingular. Merger integration activities are on track and expense reductions will follow as systems and networks are converted. There are a number of obvious catalysts. We still have a full TD main network in operation. We are approaching the time when we will be able to sunset billing systems and Cingular continues to unwind it's T-Mobile arrangement in California and Nevada. Costs will continue to decline as more and more of our customers migrate onto our own GSN Network. As Cingular completes its network integration in the latter half of 2006 and beginning of 2007 we expect continued steady margin expansion and that margin expansion will drive both earnings and cash flow.
I'd like to close with a recap of our updated outlook. Slides 22 and 23 lay out the specifics with regard to how we're delivering on our targets and what we now expect for the full year. We said we expected to deliver double-digit adjusted EPS growth in each of the next three years. In the first half of this year adjusted EPS is up 44% and our three-year outlook is unchanged. We targeted adjusted operating income margins for the full year 2006 in the 15 -16% range and our margin for the first half of the year was 18.1% and we've raised our range for the full year. We said we expected to achieve merger expense savings of $600 to 700 million this year. We've realized $300 million in savings through the first half of the year and we now expect savings of $700 to $900 million in 2006. At the beginning of the year we expected increased pension and OPED expense for the full year of $0.06 to $0.08 in EPS. We're now expecting that pressure to be $0.04 to $0.06 for the full year. In terms of Light Speed deployment expense we expected a full year dilution the $0.08 to $0.10 range for the full year. We saw $0.02 of pressure through the first half of the year and we expect a full year impact now of $0.05 to $0.07.
Cingular targeted revenue growth in the upper single digit range and, as we said, that's exactly where they are. Capital expenditures are on track to come in at, or slightly above, the high-end of our guidance range to $8 to $8.5 billion driven by higher than planned demand for our data products. We said we expected to deliver $2 billion of free cash flow after dividends this year but with improved margins and merger synergies we're on track to be in the mid $2 billion range and we now expect to repurchase approximately $2 billion to $3 billion of our shares this year with a total buyback of $10 billion by the end of 2007.
So with that, let me close with this comment. In our last call last quarter I emphasized that the management team is confident about achieving the guidance we provided and that the best way to validate our belief with you is by delivering consistent results each and every quarter. We believe our second quarter results provide another solid set of data points and they add to our confidence and hopefully yours as well. We look forward to building on these results going forward and with that I'll turn it back over to Rich Dietz for Q&A.
Thank you, Rick. We are now ready for our question-and-answer session. So if you would begin with the first question for us?
(Operator Instructions) Our first question comes from David Barden - Banc of America Securities.
David Barden - Banc of America Securities
Hi guys, good morning. A couple of questions. Obviously, the merger integration exercise seems to be going at or above the plan that you guys laid out at the beginning of the year and even before then, looking back to the original AT&T merger assumption.
Could you speak to the idea that maybe, as we look ahead to the BellSouth merger integration, that obviously if we go back to the original expectation for the benefits of the BellSouth merger, that there's probably some meaningful upside to those expectations? Now that you have kind of seen how the AT&T business is integrating with the AT&T business, maybe revisit those guidance expectations.
The second question relates to Lightspeed. There's this continued debate about whether AT&T is prepared to be patient and deploy, as they are able, the Lightspeed program over time or whether you are going to become more impatient, give up on the technology and commit more aggressively to more of a fiber to the premise strategy, which I think is an issue for people looking ahead at the cash flow picture. Could you kind of revisit that debate, Lightspeed versus fiber to the premise? Thanks.
I'd be happy to address those, David. First of all, we're extremely pleased with the progress that we are making on the AT&T integration. We talk a lot about the numbers, but I think the most important part about that integration is the fact that I think it has been relatively seamless for our customers. Customer response to it has been good. That's one of the things we found in the Cingular/AT&T Wireless merger, that that is the first thing that you have to focus your efforts on.
At the same time, as we said, our work and our merger integration activities are on or ahead of target. We are, I would tell you, on target with respect to plans to migrate traffic onto the network. We are ahead of target in terms of force reductions. As you know, over 50% of the merger synergies in this transaction come from force.
I think, as we look ahead to the BellSouth merger, I think it's premature at this point for us to make any judgment relative to the merger synergy guidance that we had provided previously. We have groups across the Company that are actively involved in merger planning at this point, and certainly once we close the acquisition, we will have full access to data to enable us to complete that planning. Then I think we will see where we come out relative to the original estimates.
But I would tell you so far in the planning, we have certainly not seen anything that tells us that those original estimates cannot be achieved. So, so far in the BellSouth merger integration, I think planning is going very well.
With respect to Lightspeed, I think you characterized it well. We are being patient, and I would tell you I think we are making very good, steady progress in Lightspeed. Our launch in San Antonio has gone very well. We have opened it up just recently to marketing to about 6,200 homes. I think within the next week, we will be at about 10% of penetration of those homes. That has happened in just a couple of months; so good, strong customer demand.
I would tell you the service itself works very well. I have had it in my house for about the last six weeks and picture quality is excellent. The user interface and the menus are easy and very intuitive. Video-on-demand and DVR capabilities works very well. Content is competitive.
In the last three or four years, I personally have had digital cable at home, I've had satellite service at home and now U-verse. Even in the early stages of U-verse, I would stack the service competitively up against either of those.
We are being patient, and we are rolling it out in a measured way, because we want to ensure a good customer experience. I think that's extremely important in rolling out a product that has this kind of visibility. We want customers to have a good experience. We want word-of-mouth to be a positive impact on our marketing efforts.
The major milestone that is in front of us yet is completion of the testing and approval of the next software upgrade and the final set-top boxes, which will give us HD capability. Once that is approved, then you should expect to see us begin to ramp U-verse into a number of additional markets. We still expect this year to be in 15 to 20 markets by the end of the year. You also see us start to ramp up the number of homes that we're marketing to.
So I would tell you we feel very good about how the service is progressing. We feel very good technically about how it's operating. We are not looking at any options at this point that would involve fiber to the premise, other than in situations that are new builds. So there's been really, no change to our strategy since the very beginning on Lightspeed.
David Barden - Banc of America Securities
Thanks a lot.
Our next question comes from Mike McCormack - Bear Stearns.
Mike McCormack - Bear Stearns
Thanks, good morning. Hi Rick, how are you?
Pretty good, Mike. How are you?
Mike McCormack - Bear Stearns
Good, thanks. Just some digging in on the margin side maybe a bit further. Obviously, the first half of the year you're tracking a bit higher than the range you've given. On the back half of the year, obviously we have got some Lightspeed impact there. Fourth quarter is typically seasonally tough, particularly for the AT&T legacy business, potentially offset by the ramping of synergies and less pension expense. So just your thoughts on how that margin rolls out in the back half of the year?
Then, with respect to the AT&T transaction, the 2007 synergies, are we looking at the improvement this year as a pull-forward from 2007? Or do you think 2007 could come in higher than expected as well?
Then lastly, the SBC legacy margin impact that the guys have talked about getting you to a run rate in savings of about $500 million in 2006 on SBC legacy. Just a sense for how far along you are on that? Thanks.
Mike, I think on margin, you actually touched on really all of the factors. I think the way to think about margins for the year is that year-to-date, we are a little over 18% on adjusted margins. In the back half of the year, we will have some dilution driven by the Lightspeed launches. Offsetting that, we will have some additional gains in merger synergies.
But, as you mentioned, traditionally the fourth quarter is a weaker margin quarter for us. So I would expect third quarter to be a very solid margin quarter. I would expect fourth quarter to be a little lower. I think overall, we are very confident in the revised guidance we gave in the 17% to 18% range overall for the year.
In terms of the merger synergies, I think what were we are predominately seeing right now is that we're achieving -- and keep in mind, we just revised our merger synergy guidance upward last January, for this merger. We are seeing everything track toward those numbers. I think actually the increased performance this year is predominantly that we're taking costs out of the business quicker than we had expected in the original plan.
Looking ahead to 2007, I think we have got to get a little further in the year, a little further in the merger integration efforts. What we have seen so far gives us confidence in the guidance we provided for 2007. Whether some of that acceleration will carry over into next year I think still remains to be seen. But we will be looking at that as we do our update to our business plan and our detailed plan for 2007.
In terms of legacy SBC, I think the initiatives that we talked about at the beginning of the year, the issues than John Stankey laid out for you at the January analyst conference, are all tracking and in progress. Those have also supported reductions in costs, reductions in force, more efficiency in our sales and call center operations. We are tracking with the targeted savings that we had in areas like procurement that were part of those savings. Those were pretty aggressive targets, but I think we feel comfortable that we are on track for those at this point.
Mike McCormack - Bear Stearns
Is there any way to look at the margin improvement year to date and pick apart what is the actual SBC legacy impact versus the ongoing AT&T integration process?
We'd have to do some analysis on that Mike, to do that. I don't have the numbers here in front of me, but they would be estimates, clearly. One of the things that we have tried to do in our planning process and actually I think this is important, it's a strength of how we put these plans into place and how we operationalize them. We take all of these factors and we build them into each individual function and target. Once you do that, it becomes a little more difficult to pull them apart, in terms of what specifically is being driven by merger synergy versus what is being driven by other initiatives. But when we look at those individual initiatives, both on the merger as well as the operational factors, on balance, all of those are on track at this point.
Mike McCormack - Bear Stearns
Our next question comes from Simon Flannery - Morgan Stanley.
Simon Flannery - Morgan Stanley
Thanks a lot. Good morning, how are you?
Great, Simon. How are you?
Simon Flannery - Morgan Stanley
Good, thanks. First, on enterprise, it's down about 7.5% year-over-year but virtually flat sequentially. I know you've talked about your ability to get that back to stable and positive. Is that something that could start to happen quicker than you expected? Is this sort of stabilization something we can expect for the second half?
Secondly, you have talked about buybacks quite extensively, not much on dividend policy. But with these recent earnings surprises, your payout ratio is really starting to drop down quite materially. Do you think there's the possibility for more than a small dividend increase later in the year? Thanks.
Good question, Simon. On enterprise, I would tell you that the trends that we're seeing are very consistent with our expectations and consistent with what we saw in the first quarter. Enterprise revenues, though, from quarter to quarter can be a little bit lumpy, if you will. That is caused by in some cases things like CPE sales, for example.
So when you look at second quarter of last year in 2005 was a fairly high quarter for CPE sales. We have been changing our focus somewhat on how we want to emphasize CPE in this channel to one where we clearly want to sell CPE when it facilitates network and data services, but we're deemphasizing somewhat stand-alone CPE services. So, as we go forward on a quarter-to-quarter basis, you may see that rate of revenue change go up or down, just depending upon that factor.
But overall, we are seeing good volume trends. We are seeing actually stable volumes in even long distance voice minutes. We are seeing good growth in transport data. We are seeing good growth in IP data. Sales activity is strong.
The pricing is at a point in terms of point-of-sale pricing where we are still seeing some declines, but at a much reduced level from where we were seeing even a few quarters ago. So I think that's a positive sign.
However, you still have to work those pricing changes and the difference between the point-of-sale price and the embedded price in the base -- that has to work its way through the base. I would still say that that's going to take a couple of years to work through.
But bottom line, we are still confident in the trends we're seeing in enterprise and the guidance we provided earlier.
Dividend increases and how we balance the use of cash between dividend growth and share repurchase is something that will evolve and adapt over time based on where the stock is trading, what the dividend yield is and so forth. So, as we see some lift in the share price, we're going to continue to complete this current share repurchase commitment we have made and authorization. But as we see lift in earnings per share and see lift in the stock price and in cash flow, I think that certainly gives us the flexibility to do more on the dividend side.
Simon Flannery - Morgan Stanley
Great. Thank you.
Our next question comes from John Hodulik - UBS.
John Hodulik - UBS
Good morning. Two quick things. First, Rick could you give us an update on cable competition? You've had Comcast begin service with voice in a couple markets. Just give us an update there and what your seeing? Is that having an impact on your DSL net add growth? It seemed to be a little bit lighter than we expected. Is it a competitive issue or maybe a saturation issue?
Secondly, can you update your thoughts on the directories, potentially selling the directories in light of Verizon's move? Does the BellSouth deal limit your flexibility as it relates to potentially spinning that business?
That's a lot of questions. I'll do my best on those. In terms of cable, obviously the change this year versus last year is Comcast's entry. As cable companies enter specific markets, we do see some impact from that activity. The impact is more in the early periods following their entry, and then it starts to level off somewhat. So I think we're seeing impacts from Comcast entering this year.
Some of the other cable competitors that have been in the market for a while, penetration rates are leveling off a little bit in markets they have been in for some period of time.
One of the things that is kind of interesting is when you step back and you look at our overall access line decline, it seems to be topping out a little bit. We have seen two or three quarters where the rate of access line decline had increased, and now the last couple of quarters, we have been pretty steady in about the 6% to 6.1% range in terms of total switched lines.
If you back it down and you look at just consumer lines and include both consumer retail and wholesale, what you see is actually the number of lines lost in the second quarter of 2006, total consumer retail and wholesale, was a little less -- about 55,000 less than the number of consumer lines that were lost in second quarter of last year. So in total that too seems to be topping out a little bit.
In terms of DSL net adds, as we said in the presentation, we're in the mid-300,000 range. That is where we have been the last couple of years in the second quarter. So I think you're seeing more just typical second quarter seasonality.
We have had very good churn rates in DSL, but primarily what you saw in the second quarter is you saw a typical second quarter increase in that churn rate, still at pretty good levels. We were running in the low 2% churn on DSL, and in second quarter went up into the mid-2%. But I think that's primarily what you're seeing.
Some of the other factors we're seeing in DSL are also very good. 39% of gross adds this quarter were at higher speed tiers. More importantly than that, I think, through the first six months of the year, about 16% of our total base has upgraded their service to higher speed tiers so that, in total, the last couple of quarters, we have actually had a reduction in the number of customers at the low speed tier, and an increase in customers at the higher speed tier. That is actually greater than the total net adds. So that is helping to stabilize the ARPUs there.
In directories, as we have said before, we will always look at options to the extent that we think we can provide value to the shareowners in the business. But we like the directory business. Our directory revenues this quarter were stable. Looking ahead to the merger, BellSouth's directory revenues have been growing at about a 3% rate. The directory companies in both instances are very good operations, very high margin, great cash flow.
More importantly, we see some synergies with the directory sales force and the contacts we have with those customers and that database of information. We see synergies being able to leverage that now across our full wireless customer base, as well as across our customer base of video subscribers as we roll out U-verse.
Bottom line, we like that business. We see some opportunities on the electronic side of it.
John Hodulik - UBS
Great, thanks Rick.
Our next question comes from Chris Larsen - Credit Suisse.
Chris Larsen - Credit Suisse
Thanks. A couple questions on pensions. If you could go through in terms of why there is less EPS impact this year? Is there any cash flow impact? The increase in the free cash flow guidance; any less money going into funding the pensions?
Then on the HD holdup for U-verse, is that a chipset holdup? Is that the bottleneck in the pipeline for the set-top box? Or is there something else there that's holding up the HD?
Chris, on the pension side, the lower estimates in terms of dilution this year is primarily the result of just the normal process we go through each year of updating and truing up our census data, looking at actual activities and costs and truing that up for the year.
So I think the good news there is that some of the things that we have done over the last two or three years now, in terms of making changes to benefit plans and so fourth, are having some impact. I think that's helping us, in terms particularly of our OPEB costs.
In terms of cash flow, there's really not a cash flow impact there in this year from the standpoint that we were not anticipating funding the plans this year and we are still not anticipating any funding of the plans.
Looking ahead, when you look at the total company including Legacy SBC, AT&T and then add in Cingular and BellSouth, we are very, very well-funded on the pensions side and we are going to be very well-funded relative to just about any company you look at across the country in terms of our total pension and OPEB obligation.
On a stand-alone basis today, we are funded at about the low to mid-70's as a percent of those liabilities. That is based on the discount rates that were in effect at the end of last year. With increases in interest rates, with the merger with BellSouth, who is very well-funded on pension and OPEB, we will increase that number substantially, at least into the mid 80's. So we are in a very good position, from a pension and OPEB standpoint.
On high definition for Lightspeed, I would characterize it as we are in the normal process of bringing some new technology and new software and CPE to the market. So we have had the software and the chipsets and the set-top boxes in the labs. We have been going through testing. We have been going through various releases of those, fixing issues and problems. It's just part of that normal process.
But as I said before, our expectation is that we will be prepared to launch with HD in the fourth quarter. Once we bring out those final set-top boxes, you'll see us ramp up our launch pretty quickly.
Obviously, we are going to go a little slower now. Certainly, as I said before, from a customer perspective, we want it to be a good experience. But we also are not ramping up in terms of bringing lots of customers on, that we just have to come back three months later and change out set-top boxes on. So we want that final CPE in place.
Chris Larsen - Credit Suisse
Our next question comes from Jason Armstrong - Goldman Sachs.
Jason Armstrong - Goldman Sachs
Great, thanks. A couple of questions. First, on earnings, you have taken up the operating income margin guidance by about 200 basis points. Everything else being equal, this sort of translates into a $0.20 EPS hike for 2006. If you look at this in the context of double-digit earnings growth, you're going to have a higher base to work off of on 2006. You have pulled forward some of the Legacy AT&T synergies. You've pushed out some of the dilution from Lightspeed, which both of these in combination provide a bit of a headwind into 2007, yet you are still committed to double-digit earnings growth.
This implies to me you have better expectations for other areas of the business. So I'm wondering if you can help us put a framework around this, give us a sense as to where the opportunities might be, or where you had built in some sort of cushion.
Then, on the line loss trajectory, Rick as you mentioned, total consumer line loss I think was down 7.7% year over year. It's exactly what the rate was in the first quarter. It's really the first time the rate hasn't picked up in a couple years. So if you think about the line loss trajectory from here, there are other companies out there putting a stake in the ground and talking about 2006 as the peak year for line losses. I'm just wondering, is this your perspective as well?
Jason, on your questions regarding EPS, one of the facts of life is as you have good results in an organization, it sets the bar higher. There's some truth to that. I think your comment in terms of the margin guidance translating into something in the neighborhood of $0.20 of EPS, I think that's probably pretty good math. It depends on what your starting point is.
I think, when you look across the consensus estimates today, I think some of you certainly had built in higher margins than our original guidance to start with. So I think you just need to be cautious there.
But we are committed to maintaining double-digit EPS growth, and we are going through our planning process now for 2007/ 2008 including the BellSouth merger. We are setting our targets there, and I think we are going to be there.
There is good momentum in the business. There is good momentum on the cost side. There's good momentum at Cingular.
I think in some cases, not all owners or analysts had built in what we had previously talked about in terms of our expectations, for example, for Cingular margins. So I think there's some upside there to some models, as we get further into the integration process.
But bottom line is good momentum on costs, good momentum at Cingular, some improving revenue trends that we have talked about. When you put that all together, and even with some better results in 2006, we are going to target to be at double-digit EPS levels in 2007.
On consumer line loss, I think you are seeing it the same way we are. We will see how the rest of the year goes, but I think we are seeing a peak in terms of line loss in total switched as well as on the consumer side. So we will see how that plays out as the year goes on.
Certainly, as we are able to launch more high-speed data offerings, expand our footprint with 6 Mb service -- by the way, we are continuing to expand our footprint this year on the ability to offer basic DSL. Then, as we expand and offer U-verse services, that also would give us, I think, the ability to reduce line loss.
Jason Armstrong - Goldman Sachs
Our next question comes from Tim Horan, CIBC.
Tim Horan - CIBC
Thanks. I just wanted to focus on the wireline revenue growth a little bit more. It seems like the data trajectory is pretty clear. Volume has picked up. Maybe you can elaborate why you think the buying is picking up. But it seems like, if the pricing is improving there, we should continue to have a step-up in the revenue growth there.
On the voice side, this quarter was a little bit better than we had expected. I guess you have been declining voice revenues by $200 million per quarter the last bunch of quarters. It was only down about $100 million this quarter. Maybe you could talk about what you are seeing there and what you're expecting going forward.
Then lastly, on the access line side, I am calculating you lost 1.8% sequentially, which is probably the worst quarter you have had in access lines. What is giving you the optimism overall in total switch to access lines that you are seeing? Thanks.
Let me kind of take those in reverse order. Tim, on access lines, when you look at it year over year, our switch line loss this quarter was at about the same level, just slightly more than second quarter of last year. So the total switch line loss seems to have ramped up in the last year or so to a range that now seems to be, to us, flattening out.
When you look at the year-over-year percent loss in switch lines, we see the same thing. Last quarter, I think, was at 6%. This, we are at 6.1%.
There has been some shift in terms of those losses between wholesale and retail. A year ago, the losses were skewed more to the wholesale side, because we were coming out or coming through the UNE-P bundle. Now, when you look at it, the line loss has switched a little more to the retail side.
One of the factors there really has to do with the fact that as UNE-P losses have declined, our win-back opportunities from the base has declined. So that has skewed the mix a little bit, plus the fact that we are not being as active in marketing into the legacy AT&T UNE-P base as we were pre-merger.
But as I said before, when you step back from it, an interesting thing to me is that when you get away from those shifts that were occurring in consumer, for example, between retail and wholesale and you just look at the combined retail and wholesale consumer lines, actually our absolute number of lines lost in second quarter 2006 was less than 2005, which I think is also a positive sign.
On voice revenues, as you noted, we had a stronger quarter this quarter in voice revenues. To some degree, that reflects the fact that we have been successful in achieving some pricing flexibility, which has allowed us in the second quarter to put in some price actions. I think we're seeing some benefits from that.
On the data side, I think the data growth continues to be good. We're seeing, obviously, good volume growth in transport on both wholesale and retail, and that's helping to offset some price pressures that we still see that are rolling through the base on the transport side. Then IP growth continues to be very good.
So I think those are the drivers. As long as the economy stays solid there, I think we will continue to see some nice growth in data in particularly those two categories, transport and IP.
Tim Horan - CIBC
Randi, the next question will have to be our last for this morning.
Our final question comes from Jonathan Chaplin – JP Morgan.
Jonathan Chaplin - JP Morgan
Hi. Two quick questions, if I may. First on the increasing CapEx guidance, it seems that it's been driven by a greater demand for data services. I'm wondering if you can give us an idea of exactly what data services are driving that, whether it's long-haul, whether it's wireless back-haul or a combination of the two? And whether you are really seeing an acceleration in demand for those services? I'm wondering also if you can give us an idea of what the relationship is between incremental revenues and incremental CapEx for data services.
Secondly, on Lightspeed expenses coming in lower than expected, was this really driven by the delay in deployment of Lightspeed this year? Or are the underlying costs actually lower than expected on a per-sub basis? Thanks.
Thanks, Jonathan. Again, I'll take those in reverse. On the Lightspeed side, the reduction in the earnings dilution guidance is really a factor of both. We're going to launch the same number of markets, but we're launching a little bit later in the year so we won't have as much in terms of acquisition costs in those markets.
In addition to that, I think we're also seeing some areas, primarily in the deployment of Lightspeed, where some of our trailing expenses in network and IT had not been as great as we originally projected. So it's a combination of those two.
In terms of CapEx, as we talked about, we're seeing growth that's a little stronger than we had anticipated in the beginning of the year. Transport's certainly a big piece of that. We are seeing some costs in terms of DSL, in some areas where we are actually expanding our DSL footprint, and we continue to push expanding the DSL footprint. We continue to push taking, for example in wholesale, investing more in fiber to wireless cell sites, which helps us grow that business in terms of the transport from those cell sites.
So those are areas that we're seeing pressure in the numbers. It's not significant relative to our total cash flows, but we're talking a few hundred million dollars of pressure there. It will take us to the upper end of that range, and we could exceed that range by a couple of percent.
So that's the magnitude of it. It's good news from the standpoint that if you think about, for example, transport products as being one of the primary drivers, those are products that are good margin products for us, and products that we have a high degree of confidence, in terms of earning a good return on those investments.
That will conclude our Q&A session. Rick has a closing comment for our call this morning. Rick, would you do that?
Well, first of all, let me say thanks to everyone for taking part in the call. We very much appreciate your interest. As I've said before, in our last call I told you that our management team is focused and confident about achieving the guidance. I think the results we have covered with you this morning show that we are achieving those goals. Essentially, we're doing what we said we would do.
We are ahead of schedule at this point on merger synergies. We're seeing margins expand as a result. Even with heavy AT&T integration expense this year, cash flow is very solid. As a result, we have been able to increase our full-year targets in all three of these areas.
Most importantly, I think these financial trends are built on a solid foundation of execution throughout our operations. In wireline, our regional business continues to grow despite competition and seasonality. Enterprise trends are on track and stabilizing, and initial network and marketing results from Project Lightspeed are very promising.
Cingular continues to make great progress, and they have a great deal of opportunity ahead. I would add to that that BellSouth results, which were reported yesterday, add to our positive view.
So I believe we are delivering on a strong, consistent record of achieving our targets. We have excellent momentum as we move into the second half of the year, and we look forward on building on these results going forward and rewarding your confidence.
So again, thank you for your interest in AT&T and thanks for joining us today.
Randi, that will conclude our earnings call this morning.
Thank you. This does conclude today's conference. Thank you all for participating. You may now disconnect.
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