AT&T Inc. (NYSE:T)
Q3 2006 Earnings Call
October 23, 2006 10:00 am ET
Rick Lindner - CFO
Rich Dietz – IR
Simon Flannery - Morgan Stanley
John Hodulik - UBS
Michael Rollins - Citigroup
David Barden - Banc of America
Jason Armstrong - Goldman Sachs
Jeff Halpern - Sanford Bernstein
Chris Larsen - Credit Suisse
Jonathan Chaplin - JP Morgan
Good morning ladies and gentlemen and welcome to the AT&T third quarter earnings release for 2006. (Operator Instructions) I will now turn the call over to Mr. Rich Dietz, Senior Vice President of Investor Relations for AT&T. Mr. Dietz, you may begin.
Great, thank you, Dawn, and good morning to everyone and welcome to AT&T's third quarter earnings call. It's great to have you with us this morning. I am Rich Dietz, Head of Investor Relations for AT&T. Rick Lindner, our Chief Financial Officer, is on the call with me to cover our results, and then as Dawn indicated, we will have a Q&A session at the end of our prepared comments.
Our release, investor briefing and supplementary information were issued earlier today. They are available on the investor relations page of the AT&T web site. The presentation slides we will speak to on this call are also available on that same web page; that's AT&T.com/investor.relations/.
Before we get started, I need to cover our Safe Harbor statement, which is on slide 3. Information 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 web site.
Okay, with that as background, let me now cover our third quarter EPS comparisons, which is on slide 4. In the third quarter of 2006, our adjusted EPS was $0.63. The math is in the first column of this slide. Starting at the top and working down, reported EPS was $0.56. We add back $0.05 of Cingular merger integration and intangible amortization costs. We also add back $0.02 of merger-related costs at AT&T, and the result is an adjusted EPS of $0.63.
A couple of things to point out and note regarding EPS adjustments this quarter. First, as we've pointed out in past quarters, a very high percentage of the adjustments are non-cash. Second, you will note that AT&T merger-related costs were lower this quarter than in the past two quarters. This is due to a $246 million expense reduction which came from a change in policy regarding the timing for earning vacation days. This reduction affects reported results, but since it is a merger-related item, it does not affect our adjusted results. This vacation policy change has a remaining expense benefit of approximately $80 million that will be recognized in the fourth quarter of this year.
The EPS walk down for the year-ago quarter is in the right-hand column. In the third quarter of 2005, reported EPS was $0.38. We had $0.08 of Cingular merger-related costs, we also had $0.01 for Cingular hurricane-related costs, and that resulted in an adjusted EPS of $0.47.
So, our reported EPS in the third quarter this year was $0.56, up 47% versus the year-earlier quarter. Our adjusted EPS was $0.63, and that's up 34% versus comparable results in the third quarter a year ago. Included in these results, but not adjusted for, is a reduction in operating expense of approximately $100 million associated with opening balance valuations from the AT&T Corp. merger. Approximately $70 million of the reduction was for prior periods to the third quarter.
With that, I will now turn it over to Rick Lindner, AT&T's Chief Financial Officer.
Thanks, Rich, and good morning, everyone. Before we get into the slides, I'd like to make a couple of comments this morning about the quarter and about the overall trajectory of the business. You know, looking back at the beginning of the year and the analyst meeting we held in January, I think we started 2006 with a set of very sound plans and we started with a resolve this year to do a few key things.
The first was to get a great start on integrating the former AT&T operations, and the second was to ramp up performance at Cingular. Third, we set the target of delivering double-digit adjusted EPS in each of the next three years, starting this year in 2006.
Now that we have three quarters of results behind us, I think it's clear we have delivered what we said we would do, and more, in all of these areas. We're hitting and exceeding our targets, we have ramped up our performance every quarter and we had a very strong third quarter. In the third quarter, margins expanded in both Wireless and Wireline, EPS growth was strong, and I think we have solid momentum as we look ahead to 2007.
One of the things ahead of us, obviously, is the BellSouth merger, and as you know, the FCC has scheduled a November 3rd meeting to vote on the merger. I believe the operational progress we have made this year is a great foundation, and frankly, I think the timing is right for the BellSouth and Cingular integration process, which we look forward to getting started in the weeks ahead.
Also looking ahead, I think we continue to have substantial opportunities across our business, and BellSouth will add to that potential. And as we execute against those opportunities, we're also returning value to shareowners through a strong dividend and our stock buyback program, which we got underway in earnest at the end of July. So from my perspective, I think we have great assets, we're executing well against those assets and it's an exciting time and I think a very promising time for AT&T.
So with that as a perspective, let's get into the quarter in more detail. Slide 6 shows you our third quarter highlights and they start with Wireless. Cingular grew ARPU, kept churn low, completed their nationwide GSM network integration -- which is a key operational milestone -- and drove margins up sequentially by 300 basis points. I think there's no other way to say it, just terrific progress at Cingular.
We also did very well in business markets. We grew regional business revenues in the strong mid single-digit range, as we have over the past several quarters now, but I think you even see in this quarter some acceleration of that growth. Enterprise revenues declined sequentially by less than 1% for the second straight quarter, and the trends there continue to be encouraging.
In terms of the AT&T merger integration, we're clearly ahead of our original schedule. Through the third quarter, we've realized approximately $650 million in operating expense savings. With progress in all of these areas, we're delivering strong margin expansion and cash flow.
Consolidated margins, which as you know don't include Wireless, were 19.5% on an adjusted basis, up 50 basis points from last quarter, and cash from operating activities is up 26% year to date.
What I'd like to do now is drill down and look at some of these areas in more detail, starting with a look at our EPS trends, which are on slide 7. As Rich mentioned, before merger-related costs, third quarter EPS was $0.63. This is our sixth straight quarter of double-digit, year-over-year growth in adjusted EPS, and also our sixth consecutive quarter of sequential growth.
The EPS growth drivers are very straightforward. First, it's Wireless, where contributions have ramped up substantially and there's more upside ahead. The second driver is Wireline, where the AT&T merger integration, plus some good operational progress, have driven margin expansion. In addition, we're starting to see progress in Wireline revenue trends, particularly on the business side.
Cingular had their own call last Thursday, so I'm not going to spend a lot of time on their results, but there are a few key points I would like to emphasize, starting on slide 8. The first is simply that Wireless customer growth continues to be very strong. Cingular has led the industry for several quarters now in gross add flow share, and gross adds in the third quarter were 4.6 million. That's up from 4.4 million in both the preceding and year-ago third quarter.
The key for us, given the size of our customer base, obviously, is churn and the great news is churn has come down and stayed low, despite the fact that churn's typically higher in the third quarter. In addition, as you know, we made some pricing changes that impacted the remaining customers on our TDMA network and we're sunsetting some of the former AT&T Wireless prepaid plans. Despite all of this, postpaid churn was 1.5% and total churn, including prepaid and resale, was 1.8%, both down 50 basis points year-over-year.
The subscriber mix has also improved. Retail subscribers represented 87% of Cingular's net adds in the third quarter, up from 75% in the preceding quarter and 74% a year ago. We also had postpaid retail net subscriber adds of 928,000 in the quarter, the third straight quarter of at least 900,000 net adds.
So as I said, strong volumes, 1.4 million total net adds in the quarter, 6.4 million over the last year, and more than 11.5 million since the Cingular-AT&T Wireless merger. That subscriber growth, plus robust demand for Data services, have strengthened our Wireless revenue growth, and the highlights are on slide 9.
At the beginning of the year, we said we expected Cingular to deliver upper single-digit revenue growth, and that's what they have done. In the third quarter, total revenues were up 9.2% to $9.6 billion and service revenues were up a strong 12.2% to $8.7 million.
Cingular's retail ARPU and service ARPU both posted growth this quarter, up sequentially and year-over-year. Voice revenues are beginning to stabilize, and then Data growth on top of that continues to be very strong. In fact, Data ARPU was up 46% to $6.32; that is a $0.55 increase from last quarter, and Data ARPU for postpaid is now about $7.25.
This was Cingular's third consecutive quarterly increase in Data ARPU of more than $0.50, and on top of that, I think there's substantial upside potential for Data as our 3G network deployment expands further and usage grows. So Cingular is well positioned to be a long-term leader in Wireless Data.
I think the most encouraging and most promising part of the Wireless results this quarter was margin expansion, and that's on slide 10. Third-quarter margins before merger costs were 35.6%, up 400 basis points year-over-year, but even more impressively, sequentially up 300 basis points.
On its call last week, Cingular referred to this as a watershed quarter in the sense that a number of initiatives have started to come to fruition and their hard work and operational progress are starting to show up clearly in the financial results. I would echo those comments and add that not only did Cingular deliver good margin expansion in the third quarter, there's more to come.
In the first week of October, Cingular's GSM network conversion was completed and Cingular has rationalized distribution and taken costs out of IT and customer care. The GSM billing conversion is complete and that will allow better processes with lower cost and TDMA billing system conversions and sunset are still ahead. The TDMA network will be turned down and sunset in early 2008, and as we continue to make progress on the T-Mobile joint venture unwind, costs are coming down as Cingular migrates traffic onto its own network. So the third quarter was a big step forward in terms of margin expansion, and there's more progress to come.
In summary, in Wireless, merger synergies are flowing to the bottom line, revenue growth is accelerated, subscriber growth remains strong and ARPU has stabilized. And with all of these, we see considerable upside potential in the quarters ahead in Wireless.
Now while we have improved profitability in Wireless, we've also been on a path of margin expansion in our Wireline and Consolidated operations as shown on slide 11. As most of you know, because of joint venture accounting requirements, Cingular's results are not reflected in these consolidated margins, so this essentially shows Wireline plus Directory and Other.
Adjusted operating income margin in the third quarter was 19.5%, up 50 basis points versus the year-ago third quarter and 50 basis points sequentially. As you see on this chart, considerably above where we were early this year. In fact, we have now had six consecutive quarters of year-over-year improvement in adjusted consolidated margins.
The drivers of this margin improvement are merger synergies and the separate operational initiatives we have underway to streamline and remove costs. Consolidated operating expenses before merger costs were down $188 million sequentially, and that follows a $264 million sequential decline the quarter before that. Based on these year-to-date results, we now expect a full year adjusted margin in the mid-18% range. And of course, that's AT&T standalone without effects from the BellSouth merger being factored in.
The key to margin expansion for us has been the execution of our AT&T merger initiatives, and slide 12 provides an update. Last quarter we increased our outlook for merger expense synergies that we expected to realize in 2006 to a range of $700 million to $900 million. We now expect to be at or slightly above the high end of that range. Through September, we have realized $650 million in expense savings.
In early October, we completed the migration of former SBC mass-market long distance traffic to AT&T networks ahead of schedule, and our operational progress has allowed us to keep ahead of schedule on merger force targets as well. Total company force was down 3,600 in the quarter, roughly the same as in the preceding quarter, and year-to-date, force is down about 10,500.
We're still early in terms of realizing cost synergies. Much of the upside potential we identified in this merger is still in front of us, but so far, execution has been solid and most functions are on or ahead of schedule.
Let me turn now away from costs and look at revenue trends in the Wireline business, starting on slide 13. This is the same slide we have provided the past two quarters and it tracks Wireline revenues by customer category. And of course, it includes the combined operations of the former SBC and AT&T business units, so the growth rates shown here are on a pro forma basis.
Starting at the top, regional business revenues grew 6.6%. That's up from 5.1% growth last quarter and consistent with mid single-digit growth rates in this space that we've seen for several quarters. Our regional consumer revenues grew 0.7% with bundling and broadband offsetting competitive impacts. Combined, regional business and regional consumer revenues totaled $5.8 billion and had a combined third quarter growth of 2.7%, in line with last quarter.
Enterprise revenues totaled $4.4 billion with a year-over-year decline of 5.1%. This compares with a 7.3% decline in the second quarter and we're seeing clear improvement in Enterprise growth rates, and later in this discussion, we'll cover that improvement in greater detail. Sequentially, Enterprise revenues declined just 0.5%, and that's two consecutive quarters of sequential declines of less than 1%; an encouraging sign.
Next is Wholesale, and Wholesale results largely reflected this quarter some impacts from industry consolidation. As we expected, carriers are moving traffic onto their own networks, parallel to the moves we have made in our own business, and that affects year-over-year comparisons.
Also shown on the bottom of this slide are the former AT&T national mass-market customers. This category represents about 9% of our Wireline revenues, but about 60% of our year-over-year decline in revenue. We continue to be confident in the outlook for a return to overall revenue growth following the BellSouth transaction in 2007, and that's versus pro forma results for 2006.
Now let's take a quick look at some of these customer categories and we'll start with regional business on slide 14. As you know, this has been an area of strength for us for several quarters and the trends we're seeing continue to be solid. In fact, when you look at just the small and medium business space in our regional business category, year-over-year revenue growth this quarter was in the low double-digit range.
In addition to good overall growth, what stands out is the fact that we're seeing good growth in both Voice and Data. Data revenues grow 12% with growth in transport and more than 20% growth in IP data, led by strength in managed Internet services, virtual private networking and DSL. Data makes up about 30% of the total revenues in the regional business category.
On the Voice side, access lines increased modestly in the quarter, as they have over the past several quarters. Churn continues to be low and ARPU is stable. One of the keys for this group of customers is that we're selling products now from the former AT&T Enterprise portfolio, and customers like the network reliability, security and other services we're now able to provide. So bottom line, another quarter of solid performance in regional business.
Slide 15 shows our regional consumer trends, and as we drive growth and compete through bundling, the key drivers for the Consumer business are Consumer revenue connections. Total connections, that's retail access lines, plus high-speed data, plus video were up 376,000 over the past year. Primary access lines trends abated somewhat from the seasonally higher disconnects in the second quarter.
Total high-speed Internet net adds, which includes DSL, U-verse high-speed Internet access and satellite broadband were 380,000, of which about 90% are consumer. These net adds are up from the second quarter, but less than our normal third quarter pace. Gross sales in the quarter were strong; in fact, the best that we have had in four quarters, but we had some year-ago promotions plus a number of six-month contracts all expiring in the same quarter, and those contract expirations caused an increase in our churn for the quarter.
We now have 8.2 million total high-speed Internet connections, up 1.7 million, or 26% year-over-year. Our broadband penetration of primary lines is now above 31%, and in our West region, it's over 35%. More of our customers are opting for higher speeds. To date, 42% of our consumer DSL base subscribe to higher-speed service, and that's up from 22% just a year ago.
In early October, we simplified our pricing for DSL and added a new speed tier to our lineup and we expect that the convenience of simple, flat-rate pricing with no contract term, plus the added speed tier choice, will stimulate demand as well as enhance customer retention. In addition, we're expanding the size of our target market by increasing the DSL footprint at a rate of about 200,000 units per month.
We'll also take the concept of simplified pricing to our voice packages. In the next couple of months, we plan to roll out a simplified pricing structure that will be even easier to understand, more convenient for customers, and frankly, easier to sell in our consumer sales channels. We see a lot of opportunity in the regional consumer space and as we innovate with more bundles, including wireless, as we increase broadband penetration and speeds, and as we launch new video products.
Let me give you now a quick update on our next-generation video and integrated services deployment, which we market under the AT&T U-verse name on slide 16. As you know, we've begun our initial expansion in San Antonio, and by design, we're ramping the project in a measured way. We have made good progress this quarter on a number of fronts. The service is working well, customer response has been positive, and our marketing approach is producing good results with deployment on track.
At the end of the third quarter, living units passed was at 1.3 million. We expect to reach 2.4 million by year end with aggressive scaling in 2007. As I said, customers like the service. In fact, I have the service in my own home, and I can tell you that picture quality is excellent, features and the user interface I think beat cable in side-by-side tests. Word-of-mouth in the San Antonio community is good and 85% of customers receiving AT&T U-verse services are taking higher-end video packages. In late June, AT&T started the commercial launch of U-verse services in San Antonio, and the initial response has been strong with customer totals at approximately 3,000 or about 10% of the penetration of homes that we have marketed to.
We're doing some innovative things in terms of marketing, including live demos available at a Cingular store, and that's proving to be effective. Our next U-verse market will be Houston, which we plan to launch in late November. We currently have a trial going on in Houston homes, which includes HDTV. The picture quality is great and we're pleased with the overall results, and we'll launch that service, as I said, in late November, and at the same time, we look forward to launching HDTV in the San Antonio marketplace.
After that, we will launch about 15 markets by year end. All of these markets will include HDTV at launch. As we scale, we'll concentrate on delivering a quality customer experience, so you can expect we'll follow the approach we've taken in San Antonio, which is to be deliberate and focused as we build to a more aggressive ramp.
Last quarter, we gave you some guidance on 2006 Lightspeed dilution and said that it would be in the $0.05 to $0.07 range. That's still a good number for 2006, but that dilution, as you know, is during a ramp-up phase, and as we move into 2007, we will have a full year of deployment, so we would expect overall dilution to increase somewhat; although I would tell you that that expectation has been built into our guidance as we look forward into next year.
Let me turn now to Enterprise on slide 17 where our results continue to demonstrate progress towards stabilization in revenue trends. For the second consecutive quarter, sequential decline in Enterprise revenues was less than 1%. In addition, we're seeing improvements in the year-over-year growth rates.
In the second quarter of 2005, the former AT&T sold a payphone business that had been included in this category. Excluding those revenues from the year-ago results and adjusting for some nonrecurring CPE revenue, the year-over-year growth rates have improved from a decline of 6.3% in the first quarter to 5.9% in the second quarter, and now to a decline of just 4.4% in third quarter. So however you look at the trends in the Enterprise space, the results are improving.
Enterprise Data revenues, which make up about half of the category, grew 1.5% year-over-year. We had sequential and year-over-year growth in both Enterprise Data transport and IP-based Data revenues. Volumes continue to be strong in Transport, and Enterprise IP services, which include virtual private networks, managed internet services and hosting, had mid-teen percentage growth. Growth in these services is more than offsetting the decline in our traditional frame and ATN products.
Overall in Enterprise, we're seeing a continuation of the trends that you saw in the second quarter. Demand continues to be solid. Voice trends have improved with long distance minutes about flat for the last three quarters. Data Transport volumes are strong. Technology migration in this space is a continuing process with customers moving from packet-based service to IP data, but we're capturing this migration with a strong portfolio of services.
The pricing environment has not changed substantially with slowing declines in competitive point-of-sale pricing. The return to Enterprise revenue growth is a gradual process, but with our network and product sets, we're confident we'll do well in this segment and we continue to expect to achieve revenue growth as we exit 2008.
As you may have seen last Friday, we completed the acquisition of US Internetworking. USI is leader in managed enterprise software solutions and this is a key step for us in that it expands what we can deliver for enterprise customers as it pairs up USI's software and e-business management services with our portfolio of Enterprise Hosting and Managed Services.
The Wireline category where you did see a change in trend this quarter was Wholesale, which is on slide 18. Looking at the Wholesale market, underlying trends are consistent with recent quarters, volumes are strong, which are offsetting point-of-sale pricing pressures. But, the new factor this quarter, which was expected but which nevertheless does impact growth rates, is simply industry consolidation as consolidated carriers move their traffic onto their own networks. We have done that, moving traffic from the WilTel network to the AT&T network. Other carriers are also moving wholesale traffic from our network to their own, as you would expect.
Year-over-year revenue is down approximately $200 million and nearly half of that decline is due to the industry consolidation we just covered. We expect the majority of this movement to be completed in the first half of 2007, and at that point, we expect revenue trends will level off and be fairly flat through 2008.
Before concluding Wireline, let me comment just briefly on revenues from a product perspective, specifically Data revenues, and the highlights are on slide 19. In the third quarter, total Data revenues grew 2.8%, the same as in the quarter before. 84% of our Data revenues come from Transport and IP, both of which are growing. Data transport revenues were up 1.2%, packet data declined 10.1%, reflecting migration from frame relay to EVPN and managed Internet services, which are part of the IP data category. Partly due to this migration and also due to strong demand, IP data continued its double-digit growth, up 12.5%. About three-quarters of Data revenues are retail, business and consumer, and in the third quarter, retail data revenues grew 4.7%.
I also want to comment briefly this morning on a business that I think distinguishes AT&T from its peers, and that's our directory business. Our recent trends are on slide 20. As you know, we have substantial scale in traditional print directories, producing more than 750 Yellow Page titles and more than 110 million copies annually, and those numbers will grow following the BellSouth transaction. Currently through a joint venture with BellSouth, we're also a leader in Internet Yellow Pages, with the leading brand in that space, yellowpages.com. Following the BellSouth merger, AT&T will have 100% ownership of this business.
We like the directory business for a number of reasons. First, as you can see on the chart on this page, it has stable revenues, strong margins and it's a big cash generator with virtually no capital required.
We like this business strategically. It's a great fit with our traditional communications space, especially when you consider our strength in small and medium business. As we move to an integrated IP platform, yellowpages.com will provide local search capabilities across all of our communications and entertainment platforms, from the PC to the TV through U-verse and through Wireless. Yellowpages.com this year will have more than 1 billion local searches, and that's a 64% year-over-year growth versus 2005.
In addition, the local directory sales force will have opportunities going forward to generate additional advertising revenues by leveraging the integrated platform and selling advertising through yellowpages.com, which will then reach through to our U-verse and wireless customer bases.
Let me walk you through our cash generation for the quarter and year-to-date. Cash from operations has grown this year, despite integration costs from the AT&T merger, and we are solidly on track deliver on our full-year target of mid-$2 billion in free cash flow after dividends, and those details are on slide 21.
Cash from operations tends to be a bit lumpy quarter-to-quarter, typically reflecting the timing of cash tax payments throughout the year, and that was the case this quarter. But that said, cash from operations is up 26% year-over-year and through the third quarter, cash from operations was $10.6 billion, capital expenses were $6.2 billion and free cash flow after dividends was nearly $1 billion.
As you see on this chart, we also made good progress on our share repurchase program in the third quarter. Because of the timing of share owner votes for the BellSouth transaction, we weren't able to fully activate the buyback until the last week of July, so the $1.2 billion in repurchases for the quarter represent roughly two months of activity and we're firmly on track with the share repurchase target range of $2 billion to $3 billion that we outlined for you last quarter with a total of $10 billion in repurchases by the end of next year.
We will revisit all of our guidance after the BellSouth transaction closes and we have had some time to work through business plans for 2007, but we continue to be confident in the view we outlined for you earlier this year, which expects strong and growing free cash flow after dividends in the years ahead. Speaking of that guidance, our margins and our operational progress in both Wireless and Wireline add to the confidence and the guidance that we've provided to you.
By way of closing, let me recap that outlook on slide 22. We continue to expect to deliver double-digit adjusted EPS growth in each of the next three years, starting in 2006, and we now expect full year 2006 adjusted operating margin to be in the mid 18% range. Following the BellSouth merger, we continue to expect a return to overall revenue growth in 2007 on a pro forma basis, and our opportunity to reduce costs continues to be unmatched in the industry.
When you add together the costs energies from each of the mergers, AT&T Wireless, AT&T and BellSouth, plus add in our operational initiatives, we expect to realize $9 billion of annual savings by 2008.
As we have said before, we expect to generate strong and growing free cash flow after dividends in the mid-$2 billion range this year, $4 billion or more next year and more than $6 billion starting in 2008, and we will return substantial amounts of that cash to shareowners through our strong dividend and through our expanded share repurchase program with $10 billion of repurchases by the end of next year.
So let me close with one comment. In our call last quarter, I emphasized to you that the management team was confident about achieving the guidance we provided, and the best way to validate our belief with you was to deliver consistent results each and every quarter. I think our third quarter results provide another solid set of data points and add to our confidence, and hopefully to yours as well, and we look forward to building on these results going forward.
So with that, I will turn back to Rich for our Q&A session.
Thank you very much, Rick. Dawn, if you would begin the Q&A session, we're now ready to take our first question.
(Operator Instructions) Your first question comes from Simon Flannery - Morgan Stanley.
Simon Flannery - Morgan Stanley
Thank you very much, good morning. Rick, you talked about deployment of free cash flow, and the strong earnings growth brings us to the dividend payout ratio. It has obviously dropped significantly. You have only had a low-single-digit dividend increase in the last couple of years. As we approach the December Board decision, can you think about how we should be considering dividend policy in the light of the free cash flow and the earnings momentum that you're showing? Thanks,
Thanks, Simon, good morning. Well, I think you've said it appropriately. The combination of the earnings growth that we're seeing, combined with the projections and prospects for growing free cash flow after dividends, gives us a lot of flexibility going forward. In terms of how we'll use that cash, first of all, we remain committed to the share repurchase program that we outlined for you at the time we announced the BellSouth transaction. So we will complete that in 2007.
I think then going forward, the combination of the earnings growth and the cash available gives us more flexibility to continue to return cash to share owners. As we look at the market with where our stock price is, where our dividend yield is, I think it certainly points us toward being able to support continued dividend growth and moving in a direction more towards dividend growth as we go forward.
So, obviously, we have not met with the Board or made any decisions relative to our next dividend increase, but we'll be doing that in the months coming up.
Simon Flannery - Morgan Stanley
Thank you very much.
Your next question comes from John Hodulik - UBS.
John Hodulik - UBS
Good morning. Just trying to square some of the comments you made regarding margin guidance, you kept the mid-18% range for '06, but you moved up the synergies to over the $900 million mark. So it looks like you're going to do $250 million-plus in terms of annualized synergies in the fourth quarter. You're at 18.5% year-to-date, margin is already leaving the quarter at 19.6%. Is it that you expect margins to come down substantially in the fourth quarter, or are you guys just being conservative at this point?
Secondly, a related question, the $0.05 to $0.07 in terms of Lightspeed dilution, how much have you realized thus far year-to-date? Do you have a big pop in the fourth quarter as you roll out these 15 markets?
Thirdly, you raised the guidance for this year. You have $1.6 million to $1.9 million guidance for '07 in terms of the AT&T deal. Does that go up proportionately as well? Thanks.
Okay, John, let me try to take those in order. First of all, in terms of the margin guidance, I think you're right, we're currently year-to-date on an adjusted basis in the mid-18s. Seasonally, the fourth quarter tends to be lower for us in terms of margins for a variety of factors, including the fact that there tend to be, with the holidays, less business days so you see usage-sensitive services like long distance come down in the fourth quarter.
In addition, in this fourth quarter, we will see, I think, some growth in expenses related to Lightspeed. Of the $0.05 to $0.07 we have incurred through the first nine months right at about $0.04 of that. So we'll see somewhat of a jump in the fourth quarter.
I think the other thing related to margins as we've talked about on the call and as we've talked about in our press release, the margins in the third quarter did have some impact that was out-of-period, related to some balance sheet revaluations for the AT&T beginning balance sheet that we did during the quarter, and that impacted margins about 40 basis points out of period. So if you kind of normalize for that, the quarter would have been about 19.1%, and then you would look at some element of fourth quarter seasonality, plus Lightspeed, and that's how you get into a mid-18 range for the year, which I would tell you, we feel very comfortable with.
John Hodulik - UBS
Got it. That makes sense. And then the synergies for next year?
I think as we look at the synergies, clearly, we're ahead of schedule in terms of migration of network traffic, which will now have a full year of impact, and we are also ahead in terms of force reductions, probably in the neighborhood of about a quarter or so ahead of plan. So we'll have the positive benefit of both of those as we go into next year.
We haven't changed guidance overall in terms of the synergy levels, but we are very confident in meeting those targets for the AT&T merger. I think, overall, we will get there quicker than the three-year spread we outlined originally.
John Hodulik - UBS
Okay, thanks, Rick.
Your next question comes from Michael Rollins - Citigroup.
Michael Rollins - Citigroup
Hi, good morning. Just a couple of questions. So the true-ups that you were just talking about, was that related to $100 million on the bottom of page 2 of the investor briefing?
Michael Rollins - Citigroup
And then the second question I had just more broadly, can you give us an update in terms of where the Large Enterprise Group is at migrating the base from the older data technologies to the newer data technologies? Is that something that can continue to significantly weigh on the Enterprise revenue number, or can you start seeing progress on that over the next 12 months? Just a little bit of the detail as to why would be great, thanks.
Mike, on Enterprise migration, first of all, I think we're still relatively early in that transition. If you look ahead, I've seen some marketing surveys that indicate as much as 40% of Enterprise customers are looking to increase their IP services over the next year, and that's largely migrating legacy voice and data services. So I think we'll continue to see that.
The incentive for customers to migrate is that it's a more efficient solution for them. They're able to combine voice and data traffic and voice and data networks, and that results in lower costs for them and therefore, lower revenues for us.
But the good news, I think, is as customers go through that migration, and once they have gone through some of that migration, we have then the ability to sell additional bandwidth and to sell additional managed services to them. So a typical pattern for a customer going through that migration would be to reduce revenues as they migrate traffic to IP and then over time, through increases in network requirements, bandwidth and managed services, we have the opportunity to grow that revenue stream again as we have those customers under longer-term contracts.
So that's the typical progression you see. I think looking ahead over the next couple of years, we have that benefit to look forward to.
Michael Rollins - Citigroup
Your next question comes from David Barden - Banc of America.
David Barden - Banc of America
Hi guys, good morning. Thanks. First question, just real quick on merger expenses, Rick, if you could touch on kind of how from a reported basis these expenses are accumulating versus the about $1.25 billion guidance for 2006? By extension, with some of the accounting changes, how it's all affecting the cash-flow statement for the year?
The second question would be on your outlook for the Wholesale business leveling out after some of the integration we're seeing in '06 through '07/'08. Obviously there has been incremental consolidation in the wholesale market, with the prospect of more consolidation coming. I guess there is a universe of companies out there that hope that the Wholesale business outlook is something more than flat. I was wondering if you could talk through some of your assumptions that go into a flattish Wholesale market outlook through '08? Thanks a lot.
Sure, David. Let me go back and talk a little bit first about the merger expenses. As you saw this quarter, the merger expenses, in terms of merger integration costs being normalized, were significantly less than some prior quarters. That was due to a couple of reasons: one is, the incremental costs we incurred relative to re-branding to AT&T have been reducing. Those were obviously much heavier in the first half of the year. Secondly, we had this change that we made to our vacation policy which produced a one-time reduction in expense. The policy change was related to developing consistent policies across both legacy SBC and AT&T employee bases. So we normalized that as well this quarter.
But, overall, we are running about at our expectation on integration costs, a little bit under. I think we have been conservative in the past in estimating those costs. But we're going to be in the ballpark across those cost estimates. Certainly, the re-branding costs are coming in about as we expected. That was a big piece this year. Some of the costs associated with reducing force and consolidating organizations is coming in less than we originally expected, and that's a function purely of trying to manage changes in our employee base and to try to achieve as much of the reductions as possible through attrition. I think our organizations have done a good job of that.
Looking at the Wholesale business, there's a number of things that we put into our Wholesale revenue stream that in some ways are a little bit unrelated. But for example, in our Wholesale business, we have our local Wholesale operations which are sales of our UNE-P platform and sales of resale customers. So as those bases, particularly the UNE-P base, are declining, Wholesale has to overcome those revenue declines to generate positive revenue growth.
In addition, we have our access revenues that we collect from other carriers, are included in that Wholesale base. So as access lines have declined somewhat and as rates, particularly on intrastate access have declined, that reduces that revenue stream.
I think what you're thinking of and many others would think of in terms of Wholesale revenue streams, in terms of carrying Wholesale Voice and Data traffic, we are seeing growth in those areas, absent some reduction due to carriers consolidating their own traffic. But in general, we are seeing growth in minutes; a lot of it is Wireless-related.
We are seeing growth in Data traffic, although we're still seeing some pricing pressures in that area. So that's why, once you get through some of this consolidation of traffic, then we expect revenues to flatten out as we go into 2008. But embedded in there, the revenues associated with carrying Wholesale traffic will be increasing, and they will be offsetting any declines in local Wholesale revenues.
The other thing I would mention relative to consolidation is that while some carriers consolidating their traffic are moving traffic off AT&T's network, at the same time, that frees up capacity and gives us the ability, as we have done, to move all of our voice traffic, prior SBC national voice traffic, onto that network. It also gives us then capacity that we can use to put all of BellSouth's traffic and the remainder of Cingular's traffic on our own networks as we move throughout 2007.
So while you will see some revenue reduction, you're also going to see some reduction in expenses, and the net impact on the bottom-line is going to be positive from those movements.
David Barden - Banc of America
Thanks for the color, Rick.
Your next question comes from Jason Armstrong - Goldman Sachs.
Jason Armstrong - Goldman Sachs
Hi Rick, good morning. A couple of questions; first on line loss. You've previously made comments about '06 being a peak year of erosion. I'm just wondering, given three quarters of relatively stable erosion, what's the interpretation here? Is it that it levels off here and stays around these levels, or that rates of line loss actually step down next year/ Just what the assumptions underlying your expectation are.
A second question, as we look out into '07, a couple of moving parts that I'd like to dig into on the EPS side; maybe first, some comments on pension impacts. I think, directionally, you should start phasing in a stronger '06 fund performance and ultimately the results there. Maybe offsetting that, you talked about incremental Lightspeed dilution. Just sort of any incremental color on quantifying the magnitude of the incremental dilution from Lightspeed? Thanks.
Sure. On line loss expectations, I think a couple of things. One is, there's a lot of moving parts there, as you know, Jason. We are seeing some growth right now in our regional business base in terms of lines, but we're actually seeing line loss reductions in the larger enterprise customers. But when you look at it on the business side, a lot of that is really related to the transition of customers to IP-based services. So they line loss there is not necessarily indicative of our expectations with respect to revenues.
On the consumer side, we're still seeing some impacts from customers going wireless, or from wireless cannibalization, although it looks to be that some of those impacts are starting to flatten out somewhat, and the losses there are starting to reduce.
In terms of competitive impacts in consumer, we're seeing increased line loss related to cable competition, and I think that's as you would expect. In 2005, we had the launch of just about all of the Time Warner markets in our territory and in 2006, we're seeing the launch of all of the Comcast markets. By the end of this year, I think cable competition from a voice perspective will be pretty much fully launched.
As a result of that, you'll start to see, I think, the line loss there begin to top out, stabilize. At the same time, while Wholesale lines have been declining, the rate of decline there is reducing, we would expect that to continue into 2007.
So I think when you put all of those together, our expectations as we go into 2007 is that we would start to see line losses overall begin to reduce somewhat. Still, we'll have impacts from all of those factors, and I think in particular, cable competition in next year. But on balance, it seems that we're starting to top out in terms of line loss.
On earnings per share, there will be some additional moving parts as we go into next year, certainly as we bring BellSouth into the Company. I think the good news there is that BellSouth's pension and post-retirement medical plans are very well funded, in the 90%-plus range. So as we get to the end of this year, this is somewhat dependent on where discount rates and interest rates end up at the end of the year. But post-merger I would expect that we will be, in total, both pension and post-retirement and medical, funded in about the mid-80% range, which is a very good position to be in. Looking ahead to next year, I think at this point our expectation is that our pension and benefit costs on a pro forma basis, certainly, would be relatively flat for this next year.
We will see, as we talked about, some additional Lightspeed dilution as we start to ramp the markets. That will be primarily related to customer acquisition costs. I can't give you any definitive guidance at this point. We're still finalizing '07 plans, and obviously, the BellSouth merger and how we roll out video products within the BellSouth territory will have some impact on that.
But where we are this point and looking ahead to 2007, again, we remain confident in the ability to grow adjusted EPS at double-digit rates next year.
Jason Armstrong - Goldman Sachs
Your next question comes from Jeff Halpern - Sanford Bernstein.
Jeff Halpern - Sanford Bernstein
Good morning, guys. Most of my questions have been answered, but Rick, just a follow-up on that last one. FAS 158 is going to cause you to have to recognize a reduction in shareholder's equity as a result of pension funding and OPEB funding. Can you just talk about when you think that's going to end up on the balance sheet and what the effect is going to be in dollar terms? And then also on a pro forma basis, given what you've just said about BellSouth's balance sheet?
Sure, Jeff. First of all, let me address it just AT&T standalone. If you looked at our pension and post-retirement and medical funding and liabilities today, we would expect at the end of this year, assuming if discount rates stay the same as last year, we would have an additional liability on the balance sheet of about $16 billion. That additional liability would be tax affected, and so it would impact shareholder's equity by about $10 billion.
Now I would tell you, and my expectation is that the impact in the number will be less than that, and it will be less because I think at current rates, we're going to see probably at least a 25 basis point increase and maybe a 50 basis point increase, depending upon where we end the year in discount rates. That increase in discount rates obviously reduces the liability that will have to be booked. But I think that should give you kind of a magnitude of the number, certainly on a worst-case basis.
When you then fold in BellSouth, as I said, BellSouth is funded in total in their liability at about 90%, or a little over 90% and the amount that would be unfunded is around $2 billion, I believe. When you purchase a company, we will state all of the assets and liabilities, including the pension and post-retirement and medical assets and liabilities at market in the beginning balance sheet. So that's the funding level that you'll see hit the balance sheet.
Jeff Halpern - Sanford Bernstein
Thank you very much.
Your next question comes from Chris Larsen - Credit Suisse.
Chris Larsen - Credit Suisse
Hi, thanks. A couple of questions. Enterprise has been flat, as you mentioned, the last couple of quarters, yet the guidance is that at end of '08 is when you start seeing that return to growth. Is it possible we could see that return to growth a little bit earlier?
Secondly, on the concessions you have offered to date for the BellSouth transaction, can you give us a sense for what the impact to the income statement might be of those?
What is the long pole in the tent, so to speak, on the HDTV rollout with U-verse? Are there constraints on set-top boxes or anything else for the mid-November or late-November rollout there? Thanks.
Chris, on Enterprise, we are encouraged by the results that we're seeing this last quarter or two. Frankly, I would like to see another quarter or two of results and see if that changes our outlook. We still have a situation where, if you look at the Enterprise base in terms of areas that are declining, it's in voice traffic, and it's primarily LD traffic, and we still have a difference between average point of sale pricing and pricing embedded in the base that's in the low 20% range.
Now that has come down. If you looked at it a year ago, it was closer to 30%. But that difference between point-of-sale pricing and pricing in the base is still there, and so that will put pressure on revenues for the next year or so. So that's the primary driver of our expectation that it's in the second half of '08 before we start to see year-over-year growth.
But, clearly, if we continue to see good results there, continue to see good results in Data and IP revenues -- there are some categories, like Managed Services and Hosting that are growing at strong double-digit rates. We continue to see that; that will impact those results, but I would like to see another quarter or two before we change our outlook there.
Relative to the BellSouth transaction and approval at the FCC, as you know, we have a meeting scheduled at the FCC on November 3rd. We believe that the merger is a positive. We believe it's a positive for the industry, it's a positive for consumers, and we believe it should be approved.
As all of you know, there aren't really any competitive issues associated with this merger. We're seeing strong and increasing competition across just about every segment of the market that we participate in, and that's why 18 states and the Department of Justice approved this merger without conditions. But, we would like to get the deal done, and in trying to expedite the approval, we have made some proposals that I think are very pro-competitive and pro-consumer. Hopefully, we look forward to getting this deal done on November 3rd.
We're still awaiting to hear a response from the FCC, and so there aren't any proposals related to the merger that have been agreed to or finalized, and so it's premature for me to comment on financial impacts. What I would say is that I don't see anything at this point that would change guidance that we have provided relative to the company in total, or guidance that we've provided to you at the time we announced the BellSouth merger.
On HDTV, you know, I don't think there are any long poles in the tent at this point. We're going through the trial process in Houston, it's going very well. We are on the same schedule that we outlined when we talked to you at the end of last quarter. The field trial with HDTV is going well in Houston. We have done some upgrades to our network here in San Antonio, so we'll roll HDTV here at the same time. I believe the set-top boxes are on target, so I would expect by the end of November to be rolling on a commercial basis with HD in both San Antonio and Houston, and then we're lined up to begin rolling markets on a weekly basis after that.
Chris Larsen - Credit Suisse
Dawn, this will have to be to be our last question. The next question will have to be our last question.
Your final question comes from Jonathan Chaplin - JP Morgan.
Jonathan Chaplin - JP Morgan
Great, thanks for taking the question. If I could just follow up on the last question quickly. In looking at the Enterprise revenue trends, we've had two quarters in a row now of flattish trends in mid-'06. As we look out to '07, you're seeing improving trends in Voice, and that's where the drag is. There's obviously strong growth in the growing pieces of Enterprise.
I'm just wondering what you're most concerned about? Are you concerned that Voice declines might accelerate again, or that the growing pieces of Enterprise might start to slow meaningfully? I'm just wondering why 2007 isn't the turnaround year in Enterprise revenue growth.
Secondly, if I could just ask quickly on the Video, I think you launched at the end of June. The footprint that you're serving, now that you have 10% penetration of, did you go out to all of that footprint at about the same time at the end of June, or have you expanded that footprint since you've been in the market?
I'm just wondering if you have any sense of how not having HD has held back penetration in that market? Thanks.
Jonathan, on Enterprise revenues, our expectation is we will continue to see improvement as we go into 2007 and throughout 2007. Again, I think the expectation in terms of 2008 being the year where in total the revenue stream there turns positive again has more to do with just the remaining impact and pressure on Voice revenues that we see in the base versus what's in the marketplace today.
I think, obviously, a concern as we look ahead in Enterprise is always a combination of what happens in the economy and what happens with respect to overall spending with these large Enterprise customers combined with what we see in the marketplace going forward from a competitive pricing standpoint. This is still a very competitive marketplace with a number of players and some consolidation of smaller players that you've seen that are and will be more of a factor in the marketplace. So we'll have to see there how those dynamics play out in terms of pricing.
But again, we're encouraged by this quarter's results and I'd just like to see another quarter or two, and then we'll continue to refine our projections going forward based on that.
In terms of U-verse, let me tell you a little bit about what has happened here in San Antonio. As we've talked about, we've purposely gone slow in San Antonio. We wanted to trial the service and the platform. Frankly, we didn't want to put too many customers on the platform before we had the HD capability. That was not so much an issue in terms of marketing and adding customers at this time, as it was the fact that we'll need to go back in for our existing customers, we'll have to replace the -top boxes. It does have some customer impacts in areas like, for example, that customers will lose some programming that they may have recorded on their DVR and so forth. That, plus just the additional cost, we wanted to limit the homes that we were marketing to, and we limited it to a range of about 30,000 households, 30,000 living units.
What we have seen has been very encouraging. Within a three-month period, we have achieved about 10% penetration across that base. In some areas, for example, we've gone into some multiple-dwelling units where we have gotten penetration as high as 25% within a three-month period. So the results there are encouraging to us. We're doing it with some different marketing techniques, going very local into the neighborhoods as we turn the service up; that's working very well for us.
We look forward to getting HD in the platform. I do think that, today, that's certainly important and will open up the market further for us. But mainly, we look forward to just beginning to ramp and scale this product.
Jonathan Chaplin - JP Morgan
Thanks very much.
Okay, that concludes our question-and-answer session. Rick has some closing comments before we adjourn the call.
Thanks, Rich. First of all, let me just say thanks to everybody for taking part in the call today. We always appreciate your time and certainly appreciate your interest. I think, overall, it was a strong quarter for us. As we talked about today, merger integration and achievement of synergies in the AT&T merger are not only on track, they are ahead of schedule. As a result, margins have expanded, EPS growth was strong, cash flow, solid.
The bottom line, as we said, is we're delivering on our targets and doing what we said we'd do. But I think just as important, when I look at the trends in the business and I look ahead to what AT&T will become once we have completed the BellSouth merger, I think the most encouraging thing that I saw this quarter is that, in addition to merger integration and cost-savings opportunities, which are substantial, we also have a business that over the next few years is going to be able to generate value through top-line growth.
At the time of the BellSouth merger announcement back in March, I said we expected to return to overall revenue growth in 2007 versus pro forma results for '06, and the revenue trends we saw this quarter, particularly in Wireless with over 12% Wireless service revenue growth and in Business with accelerating growth in regional business revenues and improved trends in Enterprise, those things add to the confidence we have in that overall revenue outlook and give us a much better line of sight towards that goal.
That's encouraging, and frankly, it's exciting for us. So, again, we look forward to building on this quarter's results going forward, we want to thank you for joining us, and again, thank you for your interest in AT&T.
Thank you, Rick. Dawn, that will conclude the call from our part.
Thank you, ladies and gentlemen. This concludes today's conference.
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