AT&T Inc. is a North American telecommunications company. In addition to telephone, data and video telecommunications, AT&T also provides mobile communications and internet services for companies, private customers and government organizations. AT&T has long had a monopoly in the United States and Canada.
United States
Washington, D.C. 20549
For the quarterly period ended March 31, 2005
or
For the transition period from to
Commission File Number 1-8610
Incorporated under the laws of the State of DelawareI.R.S. Employer Identification Number 43-1301883
175 E. Houston, San Antonio, Texas 78205Telephone Number: (210) 821-4105
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).Yes X No
At April 29, 2005, common shares outstanding were 3,303,115,625.
See Notes to Consolidated Financial Statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)Dollars in millions except per share amounts
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of OperationsDollars in Millions except per share amounts
Throughout this document, SBC Communications Inc. is referred to as “we” or “SBC.” A reference to a “Note” in this section refers to the accompanying Notes to Consolidated Financial Statements. You should read this discussion in conjunction with the consolidated financial statements, accompanying notes and management’s discussion and analysis of financial condition and results of operations included in our Annual Report on Form 10-K for the year ended December 31, 2004. In our tables throughout this section, percentage increases and decreases that equal or exceed 100% are not considered meaningful and are denoted with a dash.
Consolidated Results Our financial results in the first quarter of 2005 and 2004 are summarized as follows:
Overview Our operating income increased $40, or 2.6%, in the first quarter of 2005 and our operating income margin increased from 15.1% to 15.2%. The increase was driven by continued growth in long-distance voice and data revenue. These increases were largely offset by a continued decrease in voice revenue resulting from a decline in retail access lines, and a 2.3% increase in operating expenses. The decline in retail access lines historically has been primarily attributable to customers moving from our retail lines to competitors using our wholesale lines provided under the Unbundled Network Element-Platform (UNE-P) rules. However, starting with the third quarter of 2004, the number of UNE-P lines has been declining and we reported a decrease in the number of UNE-P lines at the end of the first quarter 2005 as compared with the same period in 2004. This decline reflects developments in the federal regulatory environment over the past year, the continued success in our bundling strategy described below and the previously announced pullbacks from competitors in the consumer market. However, the decline in UNE-P lines also could increase pressure on our operating revenues should a customer that was receiving service from a UNE-P provider switch to an alternative technology (see below). See our “Competitive and Regulatory Environment” section for further discussion of UNE-P developments.
Retail access lines declined in the first quarter of 2005 due to increased competition, as customers disconnected both primary and additional lines and began using wireless and Voice over Internet Protocol (VoIP) technology and cable instead of phone lines for voice and data; this was also a contributing factor in the year-ago period. Retail access lines also declined for both periods due to customers disconnecting their additional lines when purchasing our broadband internet-access (DSL) services. While we lose some revenue when a wireline customer shifts from one of our retail lines to a competitor that relies on the UNE-P rules to offer service (i.e., one of our wholesale customers), we lose all revenue when a wireline customer shifts to an alternative technology such as cable, wireless or VoIP. However, when a customer signs up for Cingular Wireless (Cingular) service, our net income impact of the lost revenue is lessened because we own a 60% economic interest in Cingular (see Note 5). Increasing use of alternative technologies will continue to pressure our operating margins. Although retail access line losses have continued, the trend has slowed, reflecting in part our ability to now offer retail nationwide long-distance service in all of our regions as well as the introduction of offerings combining multiple services for one fixed price (bundles).
Operating revenues Our operating revenues increased $236, or 2.4%, in the first quarter of 2005. Our significant revenue impacts are listed below and discussed in greater detail in our “Wireline Segment Results” section.
These increases in data and long-distance voice revenues were partially offset by the $127 decline in voice revenues primarily resulting from the loss of retail access lines and increased competition.
Operating expenses Our operating expenses increased $196, or 2.3%, in the first quarter of 2005. Our significant first-quarter 2005 increases are listed below and discussed in greater detail in our “Wireline Segment Results” section. These increases were partially offset by lower depreciation and amortization expenses.
Combined Net Pension and Postretirement Benefit Our combined net pension and postretirement cost increased approximately $88 in the first quarter of 2005. This cost increase primarily resulted from our recognition of unrecognized net losses on plan assets that occurred during the years 2000 through 2004. In accordance with U.S. generally accepted accounting principles (GAAP), we recognize actual gains and losses on pension and postretirement plan assets equally over a period of not more than five years. The unrecognized losses in 2000 through 2002, partially offset by our unrecognized gains in 2003 and 2004 increased our combined pension and postretirement cost approximately $82.
In January 2004, the majority of nonmanagement retirees were informed of medical coverage changes. Concurrent with our second-quarter 2004 bargaining agreement with the Communications Workers of America, we also modified our nonmanagement retiree benefits. This modification of nonmanagement retiree medical coverage changes occurred in the second quarter of 2004; as a result, our quarterly combined pension and postretirement cost increased approximately $50 for the first quarter of 2005 when compared to the first quarter of 2004.
Our combined net pension and postretirement cost also increased approximately $25 due to our decision to reduce the discount rate used to calculate service and interest cost from 6.25% to 6.00%, in response to lower corporate bond interest rates.
Partially offsetting these increases was the amortization of actuarial gains from prior year lower-than-expected medical and prescription drug claims, which decreased cost approximately $31, and our change in the calculation of pension benefits provided to management employees, which became effective January 2005 and decreased cost $30 in the first quarter of 2005.
As a result of these economic impacts and assumption changes previously discussed, we expect a combined net pension and postretirement cost of between $1,400 and $1,550 in 2005. Approximately 10% of these costs are capitalized as part of construction labor, providing a small reduction in the net expense recorded. While we will continue our cost-cutting efforts, certain factors, such as investment returns, depend largely on trends in the U.S. securities market and the general U.S. economy. In particular, uncertainty in the securities markets and U.S. economy could result in investment losses and a decline in the value of plan assets used in pension and postretirement calculations, which under GAAP we will recognize over the next several years. Should the securities markets decline and medical and prescription drug costs continue to increase significantly, we would expect increasing annual combined net pension and postretirement cost for the next several years. Additionally, should actual experience differ from actuarial assumptions, combined net pension and postretirement cost would be affected in future years.
Interest expense increased $121, or 52.2%, in the first quarter of 2005. The increase was the result of our issuing additional debt of $8,750 in the fourth quarter of 2004 to finance our portion of the purchase price for AT&T Wireless Services Inc. (AT&T Wireless).
Interest income decreased $7, or 6%, in the first quarter of 2005. The decrease was primarily a result of a lower average investment balance in the first quarter of 2005 compared with the year-ago quarter. In the fourth quarter of 2004 we used a significant amount of these investments to fund our portion of the purchase price for AT&T Wireless.
Equity in net income (loss) of affiliates decreased $650 in the first quarter of 2005. The decrease was partially due to a decline in results from our international holdings of approximately $378, largely attributable to gains that occurred in 2004 and foregone equity income from our 2004 disposition of investments. The decrease was also due to lower results from Cingular. Our proportionate share of Cingular’s results decreased approximately $280 in the first quarter of 2005.
We account for our 60% economic interest in Cingular under the equity method of accounting and therefore include our proportionate share of Cingular’s results in our “Equity in net income (loss) of affiliates” line item in our Consolidated Statements of Income. Cingular’s operating results are discussed in detail in the “Cingular Segment Results” section and results from our international holdings are discussed in detail in “International Segment Results.” Our accounting for Cingular is described in more detail in Note 4.
Other income (expense) – net We had other income of $47 in the first quarter of 2005 and $861 in the first quarter of 2004. Results for the first quarter of 2005 primarily consisted of gains of $68 on the sale of shares of Amdocs Limited (Amdocs) and SpectraSite, Inc. (SpectraSite), partially offset by a charge of $21 related to the other-than-temporary decline in the value of various cost investments. Results for the first quarter of 2004 primarily consisted of a gain on the sale of our investment in Belgacom S.A. (Belgacom) of approximately $832 and a gain of $57 on the sale of shares of Teléfonos de Mexico, S.A. de C.V. (Telmex) and América Móvil S.A. de C.V. (América Móvil), partially offset by a loss on a sale of an investment of approximately $21.
Income taxes decreased $526, or 55.8%, in the first quarter of 2005. The decrease was due to lower income before income taxes in 2005, which was primarily the result of a decrease in “Equity in net income (loss) of affiliates” (see previous discussion) and the gain in 2004 on the sale of our interest in Belgacom. Our effective tax rate for the first quarter of 2005 was 32.0% and 2004 was 33.0%.
Income from Discontinued Operations decreased $26 in the first quarter of 2005. The decrease was due to the sale of our directory advertising business in Illinois and northwest Indiana in 2004. (See Note 7)
1 See our “Liquidity and Capital Resources” section for discussion. 2 Numbers represent 100% of the cellular/PCS customers of Cingular (the 2004 number does not include AT&T Wireless customers).
Segment Results
Our segments represent strategic business units that offer different products and services and are managed accordingly. As required by GAAP, our operating segment results presented in Note 4 and discussed below for each segment follow our internal management reporting. Under GAAP segment reporting rules, we analyze our various operating segments based on segment income. Interest expense, interest income, other income (expense) – net, and tax expense are managed only on a total company basis and are, accordingly, reflected only in consolidated results. Therefore, these items are not included in the calculation of each segment’s percentage of our total segment income. We have five reportable segments that reflect the current management of our business: (1) wireline; (2) Cingular; (3) directory; (4) international; and (5) other.
The wireline segment provides both retail and wholesale landline telecommunications services, including local and long-distance voice, switched access, data and messaging services and satellite television services through our agreement with EchoStar Communications Corp (“SBC | DISH Network” offering). In discussing regional trends in this segment, the “Midwest” refers to Illinois, Indiana, Michigan, Ohio and Wisconsin; the “Southwest” refers to Arkansas, Kansas, Missouri, Oklahoma and Texas; the “West” refers to California and Nevada; and the “East” refers to Connecticut (all combined, “13-state area”).
The Cingular segment reflects 100% of the results reported by Cingular, our wireless joint venture. In our consolidated financial statements, we report our 60% proportionate share of Cingular’s results as equity in net income of affiliates. Cingular’s first quarter 2004 results have been restated to reflect the correction of an error relating to the lease accounting practices of Cingular, which was announced in February 2005.
The directory segment includes all directory operations, including Yellow and White Pages advertising and electronic publishing. Results for this segment are shown under the amortization method which means that revenues and direct expenses are recognized ratably over the life of the directory, typically 12 months. Results for all periods presented in this segment have been restated to reflect the sale of our interest in the directory advertising business in Illinois and northwest Indiana to R.H. Donnelley (see Note 7). In November 2004, a subsidiary in our directory segment entered into a joint venture agreement with BellSouth Corporation and purchased the online directory provider YellowPages.com (YPC). Our portion of the results from YPC is recorded as equity in net income of affiliates.
Our international segment includes all investments with primarily international operations. The other segment includes results from paging services, all corporate and other operations as well as the equity income from our investment in Cingular. Although we analyze Cingular’s revenues and expenses under the Cingular segment, we record equity in net income of affiliates (from non-international investments) in the other segment.
The following tables show components of results of operations by segment. A discussion of significant segment results is also presented following each table. Capital expenditures for each segment are discussed in “Liquidity and Capital Resources.”
Our wireline segment operating income margin was 11.0% in the first quarter of 2005, compared to 10.4% in the first quarter of 2004. The modest improvement in our wireline segment operating income margin in 2005 was due primarily to the continued growth in our data and long-distance voice revenue, which more than offset the loss of voice revenue from the decline in total access lines (as shown in the following table) from 2004 to 2005 of approximately 2.4 million lines, or 4.4%. This voice revenue decline was caused by customers continuing to disconnect primary and additional lines and using alternative technologies, such as wireless, VoIP and cable instead of phone lines for voice and data; our bundling strategy and other pricing responses to competitors’ offerings; and lower demand for services. Revenue also has declined over the past several years as our retail customers have disconnected their lines in order to obtain service from competitors who lease our UNE-P lines. However, that trend started to change in the third quarter of 2004 and for this quarter UNE-P lines declined by almost 0.7 million, or 10.1%, from March 31, 2004 levels (see table below). The impact of the UNE-P rules on our operating revenue is discussed below. (The UNE-P rules are discussed in “Competitive and Regulatory Environment.”) Our operating income margin was also pressured on the cost side due to higher costs caused by severe weather and our growth initiatives in long-distance, DSL and the large-business market.
Following is a summary of our switched access lines at March 31, 2005 and 2004:
Total switched access lines in service at March 31, 2005 declined 4.4%, from March 31, 2004 levels. Retail access lines, while declining 3.5% from March 31, 2004 levels, represent 86.7% of total switched access lines at March 31, 2005 compared to 85.8% a year earlier. During this same period, wholesale lines (which include UNE-P and resale) decreased 10.2% and at March 31, 2005 represented 12.5% of total access lines, down from 13.3% a year earlier.
The decline in total access lines reflects many factors including the disconnection of additional lines as our existing customers purchase our DSL broadband services and for other reasons, the continued growth in alternative communication technologies such as wireless, cable and other internet-based systems and continuing slow demand from U.S. businesses. While we lose some revenue when a wireline customer shifts from one of our retail lines to a competitor that relies on the UNE-P rules to offer service (i.e., one of our wholesale customers), we lose all customer revenue when a retail wireline customer shifts to an alternative technology such as cable, wireless or the internet using VoIP. However, due to new UNE-P rules that became effective March 11, 2005, we expect that UNE-P will have less of an impact on our access line losses in the future. Increasing use of alternative technologies and our negotiated commercial agreements with competitors could continue to pressure our wireline segment’s operating margins. For a more detailed discussion on the UNE-P rules see “Competitive and Regulatory Environment.”
While retail access lines continued to decline, the trend slowed in our West, Midwest and Southwest regions, reflecting continued success with our bundling strategy. In late 2003, we began offering retail nationwide long-distance service in our Midwest region (see our “Competitive and Regulatory Environment” section). Retail access lines for the Midwest region have decreased 3.3% since March 31, 2004, compared with declines of 4.1% in the Southwest region and 2.9% in the West region, for the same period.
Our retail consumer primary lines increased by 16,000 compared to December 31, 2004 levels, which is our first quarter over quarter increase since the first quarter of 2000. See further discussion of the details of our wireline segment revenue and expense fluctuations below.
Accounting for CingularWe account for our 60% economic interest in Cingular under the equity method of accounting in our consolidated financial statements since we share control equally (i.e., 50/50) with our 40% economic partner BellSouth Corporation (BellSouth) in the joint venture. We have equal voting rights and representation on the board of directors that controls Cingular. This means that our consolidated results include Cingular’s results in the “Equity in net income (loss) of affiliates” line. However, when analyzing our segment results, we evaluate Cingular’s results on a stand-alone basis using information provided by Cingular during the year. Accordingly, in the segment table above, we present 100% of Cingular’s revenues and expenses under “Segment operating revenues” and “Segment operating expenses.” Including 100% of Cingular’s results in our segment operations (rather than 60% in equity in net income (loss) of affiliates) affects the presentation of this segment’s revenues, expenses, operating income, nonoperating items and segment income but does not affect our consolidated net income.
In the first quarter of 2005, to be consistent with industry practices, Cingular changed its income statement presentation for the current and prior-year periods to record billings to customers for various state gross receipts taxes and other fees as “Service revenues” and the taxes assessed by the various state jurisdictions and other fees as “Cost of services and equipment sales.” This amount totaled $39 in the first quarter of 2005 and $25 in the first quarter of 2004. Operating income and net income for all restated periods were not affected.
In February 2005, Cingular announced restated first quarter 2004 results to correct an error relating to its lease accounting practices. This correction, which is reflected in the table above, reduced Cingular’s previously reported first quarter 2004 “Segment Operating Income” by approximately $9 and “Segment Income” by $12.
Acquisition of AT&T Wireless On October 26, 2004, Cingular acquired AT&T Wireless for approximately $41,000 in cash. In connection with the acquisition, we entered into an investment agreement with BellSouth and Cingular. Under the investment agreement, we and BellSouth funded, by means of an equity contribution to Cingular, a significant portion of the acquisition’s purchase price. Based on our 60% equity ownership of Cingular, and after taking into account cash on hand at AT&T Wireless, we provided additional equity of approximately $21,600 to fund the consideration. In exchange for this equity contribution, Cingular issued to us and BellSouth new membership interests in Cingular. Equity ownership and management control of Cingular remains unchanged after the acquisition.
Cingular’s Operating Results Our Cingular segment operating income margin was 1.4% in the first quarter of 2005 and 13.9% in the first quarter of 2004. The lower 2005 margin was caused by increased expenses that were only partially offset by increased revenues. The primary driver for the first quarter 2005 increases in almost every component of Cingular’s total operating revenues and operating expenses was the acquisition of AT&T Wireless in late October 2004 and the resulting inclusion of AT&T Wireless operating results and wireless customers in Cingular’s results.
As of March 31, 2005, Cingular served over 50 million cellular/PCS (wireless) customers, compared to approximately 25 million at March 31, 2004. Cingular is the largest provider of mobile wireless voice and data communications services in the United States, based on the number of wireless customers. Cingular’s wireless customer net additions from operations were 1,419,000 in the first three months of 2005 and 554,000 in the first three months of 2004. Customers gained or lost through property divestitures related to the AT&T Wireless acquisition and other adjustments totaled a customer loss of 159,000 in the first three months of 2005 and a customer gain of 37,000 in the first three months of 2004. Including these net customer gains and losses, during the first three months of 2005 the number of Cingular’s wireless customers increased 1,260,000 as compared to 591,000 in the first three months of 2004. Cingular’s first quarter 2005 wireless customer gross additions totaled 4.8 million, an increase of 90.7% over the first quarter of 2004. Cingular’s increase in customer gross additions during the first quarter of 2005 were due to its larger distribution network, broad range of service offerings and increased advertising. Cingular has license coverage serving an aggregate population of potential customers, referred to as “POPs,” of nearly 292 million, including all of the 100 largest metropolitan areas.
Cingular’s operating expenses increased $4,698 in the first quarter of 2005 primarily due to incremental expenses from AT&T Wireless; merger and integration costs of $105 related to the acquisition of AT&T Wireless; acquisition costs associated with significantly higher gross customer additions; extensive customer retention and customer service initiatives; and higher depreciation and amortization expenses (including $486 of amortization expense related to Cingular’s purchase price valuation of AT&T Wireless customer contracts and other intangible assets acquired). Network operating costs also increased due to growth in customer usage, increased costs Cingular is now paying T-Mobile USA (T-Mobile) for the utilization of their network in California and Nevada and redundant expenses related to concurrently operating its Time Division Multiple Access (TDMA) and Global System for Mobile Communication (GSM) networks. Handset equipment costs increased $758 in the first quarter of 2005. Equipment costs increased at a higher rate than equipment revenues due to Cingular’s sales of handsets below cost, through direct sales sources, to customers who committed to one-year or two-year contracts or in connection with other promotions.
Only partially offsetting these expense increases was revenue growth $4,262, including incremental revenues from the acquisition of AT&T Wireless. Average revenue per user/customer (ARPU) increased 2.7% in the first quarter of 2005 compared to the first quarter of 2004 due to increases in average data, long distance and regulatory fees revenue per customer partially offset by a decline in the local service revenue component of ARPU. Local service ARPU declined primarily due to customer shifts to all-inclusive rate plans that offer lower monthly charges and “rollover” minutes (which allow customers to carry over unused minutes from month to month for up to one year) as well as due to Cingular’s free mobile to mobile plans, which allow Cingular customers to call other Cingular customers at no charge. An increase in customers on rollover plans tends to lower average monthly revenue since unused minutes (and associated revenue) are deferred until subsequent months, up to one year. These revenue and expense fluctuations are discussed in more detail below.
Competition and the slowing rate of wireless service penetration will continue to adversely impact Cingular’s revenue growth, increase expenses and put pressure on margins. We expect Cingular’s cost of services increases to continue due to higher network system usage, including the costs Cingular is now paying T-Mobile USA (T-Mobile) for the utilization of their network in California and Nevada, higher costs as Cingular integrates AT&T Wireless’ network and operations, and, to a lesser extent, redundant expenses related to operating multiple networks as Cingular’s customer base transitions from its TDMA network to its GSM network.
The effective management of customer churn is critical to Cingular’s ability to maximize revenue growth and maintain and improve margins. Cingular’s wireless customer churn is calculated by dividing the aggregate number of wireless customers who cancel service during each month in a period by the total number of wireless customers at the beginning of each month in that period. For the three months ended March 31, 2005, Cingular’s wireless churn rate was 2.2%, down from a 2.7% churn rate in the first three months of 2004.
The decline in Cingular’s churn rate resulted from a change in methodology of calculating churn related to its reseller customers, a lower churn rate in its postpaid customer base, and changes resulting from conforming Cingular’s and AT&T Wireless’ churn methodologies. Beginning in the first quarter of 2005, Cingular adopted a new reseller churn calculation methodology that will result in an aggregate churn calculation that is more comparable with its major competitors. Prior to 2005, Cingular included gross reseller disconnects in its churn calculation. Effective with the first quarter of 2005, Cingular’s churn calculation is based on total net reseller disconnects. This change resulted in an improvement to first quarter 2005 reported churn of approximately 30 basis points. Changes to conform the traditional Cingular presentation to certain of the AT&T Wireless churn methodologies resulted in an improvement to first quarter 2005 reported churn of less than 10 basis points.
The decline in postpaid churn reflects Cingular’s ability to provide more attractive offerings to customers due to the acquisition of AT&T Wireless, including more affordable rate plans, broader network coverage, higher network quality, exclusive devices and mobile to mobile calling among Cingular’s 50 million customers. During the first quarter of 2005, Cingular successfully retained and transitioned approximately two million former AT&T Wireless customers to Cingular service offerings. Approximately three million former AT&T Wireless customers have transitioned to Cingular service offerings since its acquisition of AT&T Wireless.
Other Cingular Transactions In November 2004, Cingular entered into a number of disposition agreements to divest certain assets and spectrum in certain markets in response to the agreement made with the U.S. Department of Justice (DOJ) and the Federal Communications Commission (FCC) as a condition to receiving regulatory approval to acquire AT&T Wireless. In April 2005, Cingular sold certain former AT&T Wireless assets and properties, including licenses, network assets, and subscribers that Cingular operated in several markets, the largest of which is Oklahoma City, Oklahoma to Alltel Corporation (Alltel). As part of this agreement, Cingular also sold 20 MHz of spectrum and the network assets formerly held by AT&T Wireless in Wichita, Kansas, which it was not required to divest. Additionally, in February 2005, Cingular sold 10 MHz of former AT&T Wireless spectrum in each of Dallas, Texas and Detroit, Michigan to MetroPCS and 10 MHz of former AT&T Wireless spectrum in Knoxville, Tennessee to Cellco Partnership (d/b/a Verizon Wireless). In March 2005, Cingular sold AT&T Wireless properties and assets in specific rural regions of Arkansas, Mississippi, Missouri and Texas. Finally, in April 2005, Cingular completed the disposition of AT&T Wireless assets in Missouri. No gains or losses were recognized on the sale of these former AT&T Wireless properties or spectrum. Cingular has completed all required divestitures required by the FCC and DOJ.
In January 2005, Cingular and T-Mobile dissolved their network infrastructure joint venture. In connection with the dissolution, Cingular sold its ownership of the California/Nevada network assets to T-Mobile for approximately $2,500 in cash. In connection with the dissolution, Cingular was required to contribute an additional $200 to the venture to equalize the capital accounts. Cingular expects to use a significant portion of the proceeds from the sale to fund capital expenditures through July 2005 (see “Liquidity and Capital Resources”). At March 31, 2005, $2,145 of these funds remained and were invested in a qualified trust specifically designated for future capital expenditures.
Our directory operating income margin was 52% in the first quarter of 2005, compared to 56% in the first quarter of 2004. The decrease in the segment operating income margin was the result of lower local yellow pages revenues and increases in production, bad debt and employee-related expense in the first quarter of 2005 compared to the first quarter of 2004. See further discussion of the details of our directory segment revenue and expense fluctuations below.
In November 2004, our directory segment entered into a joint venture agreement with BellSouth and acquired the internet directory provider, YPC. We account for our interest in YPC under the equity method of accounting in our consolidated financial statements since we share control equally in the joint venture. Operating results for this joint venture are reported in the “Equity in Net Income (Loss) of Affiliates” line.
Our international segment consists primarily of equity investments in international companies, the income from which we report as equity in net income of affiliates. Revenues from direct international operations are less than 1% of our consolidated revenues.
Our earnings from foreign affiliates are sensitive to exchange-rate changes in the value of the respective local currencies. Our foreign investments are recorded under GAAP, which include adjustments for the purchase method of accounting and exclude certain adjustments required for local reporting in specific countries. In discussing “Equity in Net Income of Affiliates,” all dollar amounts refer to the effect on our income. We first summarize in a table the individual results for our significant equity holdings then discuss our quarterly results.
Our equity in net income of affiliates by major investment at March 31, is listed below:
Our other segment results in the first quarter of 2005 and 2004 primarily consist of corporate and other operations. Revenues decreased in the first quarter of 2005 primarily as a result of lower revenue from a paging subsidiary. Expenses increased as a result of various adjustments that had a favorable impact in the first quarter of 2004 that did not recur in the first quarter of 2005. Substantially all of the equity in net income (loss) of affiliates represents the equity income (loss) from our investment in Cingular.
COMPETITIVE AND REGULATORY ENVIRONMENT
Overview In the Telecommunications Act of 1996 (Telecom Act), Congress established a pro-competitive, deregulatory national policy framework to bring the benefits of competition and investment in advanced telecommunications facilities and services to all Americans by opening all telecommunications markets to competition and reducing or eliminating burdensome regulation. Since the Telecom Act was passed, the FCC and state regulatory commissions have maintained many of the extensive regulatory requirements applicable to incumbent local exchange companies (ILECs), including our wireline subsidiaries, and imposed significant new regulatory requirements, including rules requiring us to unbundle our traditional network, in a purported effort to jump-start a specific definition of competition. However, over the past year, the FCC has begun to curtail and, in some cases, eliminate certain of these requirements in order to promote investment and deployment of next generation, broadband services and facilities, and in response to a series of federal court decisions that the FCC’s rules (in particular, those requiring ILECs to unbundle their networks) exceeded the FCC’s authority. For example, in February 2005, in response to a March 2004 decision by the United States Court of Appeals for the District of Columbia Circuit (D.C. Circuit), which overturned significant portions of the FCC’s third set of unbundling rules, including those mandating the availability of the UNE-P, the FCC released new rules that establish a path toward elimination of the UNE-P. Those new rules became effective March 11, 2005, see “Triennial Review Remand Order” discussed later.
Set forth in the following paragraphs is a summary of the most significant developments in our regulatory environment during the first quarter of 2005. While these issues, for the most part, apply only to our wireline subsidiaries, the words “we” or “our” are used to simplify the discussion. In addition, the following discussions are intended as a condensed summary of the issues rather than a precise legal description of all of those specific issues.
Triennial Review Remand OrderIn December 2004, the FCC adopted its fourth set of rules concerning an ILEC’s obligation to make elements of its network available to other local service providers. Each of its previous three sets of rules had been overturned by the federal courts. On February 4, 2005, the FCC released its written order containing the new rules, the Triennial Review Remand Order (TRRO) which became effective on March 11, 2005. The TRRO provides significant relief from unbundling by eliminating our obligation to provide local switching, and hence the UNE-P, for mass market customers, subject to a 12-month transition period. During the transition, we are allowed to raise the monthly rate for the UNE-P by one dollar. At March 31, 2005, we had approximately 6.1 million UNE-P lines, one-third of which are covered by commercial agreements we have negotiated with competitors and which also include this monthly rate increase. We expect that these commercial agreements will result in a slight incremental increase in revenue compared with the UNE-P rates. Because we cannot predict how competitors who do not sign commercial agreements with us will choose to provide lines to their customers beyond the transition period, we are not able to determine the impact of eliminating our obligation to provide UNE-P on our financial results.
The FCC’s revised rules, however, fail to fully comply with the D.C. Circuit’s decision; for example, the FCC largely retained unbundling requirements for many of our high-capacity loop and transport facilities. Therefore, we (together with several other parties) filed an appeal with the D.C. Circuit on February 14, 2005, challenging this portion of the TRRO and asking the court to order the FCC to adopt rules that are consistent with the court’s March 2004 order. Several other parties, including competitive local exchange carriers (CLECs), filed appeals of the TRRO in other circuits. Those appeals have been consolidated in the D.C. Circuit, which will hear the case later this year.
In addition other parties, including CLECs, have asked the FCC to reconsider various other aspects of the FCC’s order, such as extending the 12-month transition period for unbundled mass market switching to 18 months, and modifying the unbundling analysis for high-capacity loops and dedicated transport. Specifically, the CLECs asked the FCC to change the criteria used to determine if an ILEC is required to unbundle high-capacity DS1 loops used to serve small buildings. These parties have also asked the FCC to modify or rescind that portion of the order relating to the eligibility criteria for obtaining access to combinations of unbundled high-capacity loops and transport elements (often referred to “enhanced extended links” or EELs), which can be used as a substitute for special access services.
It is unclear how state regulatory commissions will ultimately respond to the TRRO. Under the overturned rules, state commissions have set the rates that we were allowed to charge competitors for the UNE-P and for leasing other unbundled elements of our network. Many of the states in our 13-state area have opened proceedings to consider the FCC’s detailed findings and transition plans outlined in the Triennial Review Order (TRO) and TRRO. Some states have taken the position that their relevant state laws have been pre-empted by the FCC’s order and federal court decisions, while other states appear to be taking the position that their state laws have not been pre-empted. We expect that as the various state commissions issue rulings in these proceedings, various parties, including SBC, will litigate some or all of these rulings.
Broadband In the FCC’s preceding TRO of August 2003, the FCC eliminated unbundling of certain telecommunications technology that is primarily used for transmitting data and high-speed internet access (DSL) across telephone lines. Prior to that, we were required to share with our competitors on an unbundled basis, the high-frequency portion of local telephone lines, which is used to provide DSL service, among other things. Under the TRO, this high-frequency portion of the telephone line was no longer considered a UNE. However, the FCC required us to maintain then-existing line-sharing arrangements until 2004. In March 2005, in a separate ruling, the FCC held that states cannot require ILECs to sell DSL service, as a stand-alone product, over the high-frequency portion of a local line provided to a competitor. The FCC did however indicate that it will examine the competitive consequences when providers bundle legacy (traditional) services with new services.
The FCC has reviewed the rules governing broadband services offered by cable, satellite and wireless operators in addition to traditional wireline offerings and tentatively concluded that wireline broadband internet access services are “information” services rather than “telecommunications” services, which would result in less regulation. Companies that provide information services do not have to comply with regulations requiring them to lease lines to competitors or meet certain service standards and state public utility requirements. In October 2003, the United States Court of Appeals for the Ninth Circuit ruled that broadband internet access services provided by cable operators involve both an information service and a telecommunications service. In March 2005, the Supreme Court of the United States (Supreme Court) heard arguments on whether internet service provided by cable companies should be defined as an information service or a telecommunications service.
Settlement with AT&T In March 2005, we reached agreement to settle outstanding claims between SBC and AT&T Corp. (AT&T) prior to April 1, 2005. The largest portion of the payment related to AT&T agreeing to reimburse us for the adjustment of the UNE-P rates in California, Michigan, Ohio and Wisconsin. The agreement also settled claims relating to, among other items, traffic compensation, cellular roaming access, collocation (AT&T equipment located on our premises), long-distance presubscription and other transport issues. As part of the agreement, we also settled our pending lawsuit against AT&T for unpaid access charges due on terminating interexchange traffic transported partially over the Internet, with no effect on our financial statements. As a result of the settlement, in the first quarter of 2005 we recorded an increase in operating revenue of approximately $32 and a decrease in operating expense of approximately $29.
Proceeding on Other Post-Retirement Benefit Costs In March 2003, the FCC reinstated a proceeding which it claimed to have incorrectly terminated in 2002 relating to the costs of providing post-retirement employee benefits other than pensions. The FCC asked local exchange companies, including our wireline subsidiaries, to provide additional information concerning the treatment of these post-retirement costs in their 1996 access tariff filings and any other related matters. On March 30, 2005, the FCC issued an order terminating its investigation without requiring any adjustments to our 1996 tariff filings.
OTHER BUSINESS MATTERS
Pending Acquisition of AT&TOn January 30, 2005, we agreed to acquire AT&T using shares of SBC common stock. The transaction has been approved by the Board of Directors of each company and also must be approved by the shareholders of AT&T. The transaction is subject to review by the DOJ and approval by the FCC and various other regulatory authorities. We expect that the acquisition of AT&T will create overall net synergies, primarily from reduced costs, with a present value of more than $15,000. We expect that approximately 85 to 90 percent of the synergies will come from reduced costs in areas such as network operations and information technology areas, and from combining business services organizations and eliminating duplicative corporate functions. We expect that the acquisition will slow our revenue growth rate in the near term following the closing, but that the transaction will increase our earnings per share beginning in 2008.
We are analyzing options under our agreement with WilTel Communications (WilTel) if, and when, the acquisition of AT&T closes and we thereby acquire AT&T’s network facilities. WilTel currently provides nationwide network access to our wireline subsidiaries where we do not currently own lines. If we decide to voluntarily terminate the agreement prior to its expiration, the agreement states that WilTel is entitled to be paid up to $200 for transition costs, as that term is defined in the agreement.
Project Lightspeed In June 2004, we announced key advances in developing a network capable of delivering a new generation of integrated IP video, super-high-speed broadband and VoIP services to our residential and small-business customers, referred to as Project Lightspeed. During the first quarter of 2005, Project Lightspeed has achieved substantial progress in terms of trials, deployment and technology development. We began deployment of the fiber-to-the-premises portion of the network and began conditioning the fiber-to-the-node portion of the network in preparation for deployment. We plan to offer the first set of products, including IP video, in late 2005 or early 2006. With respect to our IP video service, we continue to negotiate with programming owners (e.g., movie studios and cable networks) for permission to offer existing television programs and movies and, if applicable, other new interactive services that would rely on advances in the IP technology we are testing. Our ability to provide an attractive and profitable video offering will depend in large part on the results of these negotiations.
We believe that our planned deployment is subject to federal oversight as an “information service” under the Federal Communications Act, but not subject to state or local regulation. However, some cable providers and municipalities have claimed that certain IP service should be treated as a cable service and therefore subject to the applicable state and local regulation, which could include the requirement to pay fees to obtain local franchises for our IP video service. If the courts were to decide that state and local regulation were applicable to our Project Lightspeed services, it could have a material adverse effect on the cost, timing and extent of our deployment plans.
LIQUIDITY AND CAPITAL RESOURCES
We had $427 in cash and cash equivalents available at March 31, 2005. Cash and cash equivalents included cash of approximately $291, money market funds of $107 and other cash equivalents of $29. In addition, we held $35 in other short-term held-to-maturity securities at March 31, 2005. The decline in cash and cash equivalents of $333 since December 31, 2004 was due to cash used to meet the financing needs of the business including, but not limited to, payment of operating expenses, dividends to stockholders, increased tax deposits and payments, funding capital expenditures, repayment of maturing debt, and the decrease to cash related to our discontinued operations. This decline was partially offset by cash receipts from operations, increased short-term borrowings and cash received from Cingular. We discuss many of these factors in detail below.
Cash from Operating Activities During the first three months of 2005 our primary source of funds was cash from operating activities of $1,256 as compared to $1,998 in the first three months of 2004. Cash provided by operating activities decreased approximately $742 when compared to the same period of the prior year. This was primarily due to increased tax payments of approximately $1,066 in the first quarter of 2005 reduced by benefit plan funding of $232 in the first quarter of 2004. The first quarter 2005 tax payments included amounts related to prior year accrued liabilities. The timing of cash payments for income taxes, which is governed by the Internal Revenue Service and other taxing jurisdictions, will differ from the timing of recording tax expense and deferred income taxes, which are reported in accordance with GAAP. We also made advance tax payments, which we consider to be a refundable deposit, to a certain state jurisdiction. These payments were made in order to avoid potentially onerous interest and penalties. The issues involved are in dispute and we intend to pursue all procedural options available to us in order to obtain refunds of the amounts deposited. For calendar year 2005, we do not expect our cash payments for taxes to exceed our reported income tax expense.
During the first three months of 2004 our primary sources of funds were cash from operating activities of $1,998 and proceeds from the sale of our entire investment in Belgacom of approximately $2,000.
During 2005 we expect to continue using our available excess cash primarily to reduce our debt levels, which will provide us greater financial flexibility. We expect to repay approximately $765 of long-term debt scheduled to mature in 2005 with cash from operations. Available excess cash will be used to repay our commercial paper borrowings of approximately $5,158 or to further reduce long-term debt. As opportunities permit, we may also repurchase shares of SBC common stock under our repurchase program.
Cash from Investing ActivitiesFor the first three months of 2005, cash used for investing activities consisted of:
Capital expenditures in the wireline segment, which represented substantially all of our total capital expenditures, increased by approximately 12.4% for the first three months of 2005 as compared to the same period in 2004. Our 2005 capital spending plans reflected the improving federal regulatory environment and our resulting revenue expectations. In response to an improving federal regulatory environment and competition, we announced our Project Lightspeed initiative (see “Other Business Matters”) and expect to spend approximately $4,000 over the next three years in deployment costs and $1,000 in customer-activation capital expenditures spread over 2006 and 2007. We expect total capital spending for 2005 to be between our targeted range of $5,400 and $5,700, excluding Cingular, substantially all of which we expect to relate to our wireline segment primarily for our wireline subsidiaries’ networks, Project Lightspeed and support systems for our long-distance service. We expect to continue to fund these expenditures using cash from operations and incremental borrowings, depending on interest rate levels and overall market conditions. The international segment should be self-funding as it consists of substantially equity investments and not direct SBC operations. We expect to fund any directory segment capital expenditures using cash from operations. We discuss our Cingular segment below.
For the first three months of 2005, cash provided by our investing activities consisted of:
Cash from Financing Activities In the first three months of 2005 we paid cash dividends of $1,066 compared to $1,034 for the first three months of 2004. The $32 increase was due to an increase in the regular quarterly dividend from $0.3125 to $0.3225 per share approved by our Board of Directors in December 2004. On March 11, 2005, our Board of Directors declared a first quarter dividend of $0.3225 per share, which was paid on May 2, 2005. Our dividend policy considers both the expectations and requirements of stockholders, internal requirements of SBC and long-term growth opportunities. All dividends remain subject to approval by our Board of Directors.
In the first quarter of 2005, approximately $572 of our long-term debt matured, of which approximately $327 related to debt maturities with interest rates ranging from 6.25% to 6.96%, $238 related to the exercise of a put on our 5.95% notes originally maturing in 2038 and $7 related to scheduled principal payments on other debt. Funds from operations and dispositions were used to repay these notes. As of March 31, 2005 we expect to repay approximately $765 of long-term debt scheduled to mature for the remainder of 2005 with funds from operations.
Our consolidated commercial paper borrowings totaled approximately $5,158 at March 31, 2005. All of these commercial paper borrowings are due within 90 days.
We have a 3-year credit agreement totaling $6,000 with a syndicate of banks which expires on October 18, 2007. Advances under this agreement may be used for general corporate purposes, including support of commercial paper borrowings and other short-term borrowings. There is no material adverse change provision governing the drawdown of advances under this credit agreement. We are in compliance with all covenants under the agreement. We had no borrowings outstanding under committed lines of credit as of March 31, 2005.
At March 31, 2005, our debt ratio was 40.2% compared to our debt ratio of 31.3% at March 31, 2004. The increase was primarily due to additional debt of $8,750 we issued to fund our portion of Cingular’s acquisition of AT&T Wireless.
As mentioned previously, during the remainder of 2005 we continue to expect to use our available cash primarily to reduce our debt levels and, as opportunities permit, we may also repurchase shares of SBC common stock under our repurchase program.
Pending Acquisition of AT&TOn January 30, 2005, we agreed to acquire AT&T in a transaction in which each share of AT&T common stock will be exchanged for 0.77942 of a share of SBC common stock (equivalent to approximately 19% of SBC’s outstanding shares as of March 31, 2005). In addition, immediately prior to the closing of the transaction, AT&T will pay each AT&T shareholder a special dividend of $1.30 per share. Based on the closing price of SBC common stock on January 28, 2005, the exchange ratio equals $18.41 per share and the total transaction is valued, for purchase accounting purposes, at approximately $16,000, including the special dividend. After the acquisition, AT&T will be a wholly owned subsidiary of SBC. The transaction has been approved by the Board of Directors of each company and also must be approved by the shareholders of AT&T. AT&T shareholders are expected to vote on the proposed merger as early as June 2005. The transaction is subject to review by the DOJ and approval by the FCC and various other regulatory authorities. We expect the transaction to close in late 2005 or early 2006. See “Other Business Matters” for more details.
Cingular Effective August 1, 2004, we and BellSouth agreed to finance Cingular’s capital and operating cash requirements to the extent Cingular requires funding above the level provided by operations. We and BellSouth also entered into a one-year revolving credit agreement with Cingular to provide short-term financing for operations on a pro rata basis at an interest rate of LIBOR (London Interbank Offer Rate) plus 0.05% and may be renewed annually upon agreement of the parties. We expect this agreement will be renewed. This agreement includes a provision for the repayment of our and BellSouth’s advances made to Cingular in the event there are no outstanding amounts due under the revolving credit agreement and to the extent Cingular has excess cash, as defined by the agreement. In the first quarter of 2005, we received net repayments totaling $596 from Cingular in accordance with the terms of this revolving credit agreement. Our share of advances to Cingular related to this revolving credit agreement was approximately $406 at March 31, 2005 and $1,002 at December 31, 2004 and was reflected in “Investments in and Advances to Cingular Wireless” on our Consolidated Balance Sheet.
The upgrade, integration and expansion of the Cingular and AT&T Wireless networks and the networks acquired in a transaction with Triton PCS Holdings, Inc. will require substantial amounts of capital over the next several years. Including the incremental capital requirements during 2005 as a result of the AT&T Wireless acquisition, Cingular expects 2005 capital investments for completing network upgrades, integrating its network with that of AT&T Wireless and funding other ongoing capital expenditures to be approximately $6,800 to $7,200, including Cingular’s announced plans to deploy third-generation Universal Mobile Telecommunications System network technology with High-Speed Downlink Packet Access over the next two years.
At March 31, 2005, Cingular had designated $2,145 of proceeds from the termination of a joint venture with T-Mobile for future capital expenditures, mentioned previously. The designated proceeds were invested in a qualified trust. Cingular expects to fund its capital requirements for at least the next 12 months from existing cash balances, including $2,145 of designated funds mentioned above; cash generated from operations; proceeds from the sale of assets Cingular was required to divest by the FCC and the DOJ in connection with its acquisition of AT&T Wireless and from the sale and distribution of non-strategic equity investments; and, if necessary, drawing under the revolving credit agreement with us and BellSouth, mentioned previously.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
At March 31, 2005, we had interest rate swaps with a notional value of $4,250 and a fair value of approximately $7.
Item 4. Controls and Procedures
The registrant maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed by the registrant is recorded, processed, summarized, accumulated and communicated to its management, including its principal executive and principal financial officers, to allow timely decisions regarding required disclosure, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. The chief executive officer and chief financial officer have performed an evaluation of the effectiveness of the design and operation of the registrant’s disclosure controls and procedures as of March 31, 2005. Based on that evaluation, the chief executive officer and chief financial officer concluded that the registrant’s disclosure controls and procedures were effective as of March 31, 2005.
CAUTIONARY LANGUAGE CONCERNING FORWARD-LOOKING STATEMENTS
Information set forth in this report contains forward-looking statements that are subject to risks and uncertainties, and actual results could differ materially. We claim the protection of the safe harbor for forward-looking statements provided by the Private Securities Litigation Reform Act of 1995.
The following factors could cause our future results to differ materially from those expressed in the forward-looking statements:
Readers are cautioned that other factors discussed in this report, although not enumerated here, also could materially impact our future earnings.
PART II — OTHER INFORMATION
Item 2. Unregistered Sales of Securities and Use of Proceeds
During the first quarter of 2005, non-employee directors acquired from SBC shares of common stock pursuant to SBC’s Non-Employee Director Stock and Deferral Plan. Under the plan, a director may make an annual election to receive all or part of his or her: (1) annual retainer in the form of SBC shares or deferred stock units (DSUs) and (2) fees in the form of DSUs. DSUs are convertible into SBC shares. Also under the plan, each Director will receive an annual grant of DSUs during the second quarter. During this period, an aggregate of 14,191 SBC shares and DSUs were acquired by non-employee directors at prices ranging from $23.69 to $24.60, in each case the fair market value of the shares on the date of acquisition. The issuances of shares and DSUs were exempt from registration pursuant to Section 4(2) of the Securities Act.
Item 6. Exhibits
Exhibits identified in parenthesis below, on file with the Securities and Exchange Commission (SEC), are incorporated by reference as exhibits hereto. Unless otherwise indicated, all exhibits so incorporated are from File No. 1-8610.
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.