Edgar Filing: AT&T INC.

FORM 10-Q

United States

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

(Mark One)

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

Securities Exchange Act of 1934

For the quarterly period ended June 30, 2006

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

Securities Exchange Act of 1934

For the transition period from to

Commission File Number 1-8610

AT&T INC.

Incorporated under the laws of the State of Delaware

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

175 E. Houston, San Antonio, Texas 78205

Telephone Number: (210) 821-4105

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

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

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

At July 31, 2006, common shares outstanding were 3,884,164,837.

PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
AT&T INC.
CONSOLIDATED STATEMENTS OF INCOME
Dollars in millions except per share amounts
(Unaudited)
		Three months ended				Six months ended
		June 30,				June 30,
		2006		2005		2006		2005
Operating Revenues
Voice	$	8,618	$	5,760	$	17,340	$	11,612
Data		4,477		2,438		8,919		4,829
Directory		909		901		1,810		1,806
Other		1,806		1,218		3,536		2,304
Total operating revenues		15,810		10,317		31,605		20,551
Operating Expenses
Cost of sales (exclusive of depreciation and
amortization shown separately below)		6,928		4,401		14,056		8,789
Selling, general and administrative		3,792		2,589		7,776		5,054
Depreciation and amortization		2,486		1,809		4,978		3,634
Total operating expenses		13,206		8,799		26,810		17,477
Operating Income		2,604		1,518		4,795		3,074
Other Income (Expense)
Interest expense		(472)		(349)		(936)		(702)
Interest income		95		100		180		209
Equity in net income of affiliates		455		181		789		123
Other income (expense) – net		15		34		26		81
Total other income (expense)		93		(34)		59		(289)
Income Before Income Taxes		2,697		1,484		4,854		2,785
Income taxes		889		484		1,601		900
Net Income	$	1,808	$	1,000	$	3,253	$	1,885
Earnings Per Common Share:
Net Income	$	0.47	$	0.30	$	0.84	$	0.57
Earnings Per Common Share - Assuming Dilution:
Net Income	$	0.46	$	0.30	$	0.83	$	0.57
Weighted Average Number of Common
Shares Outstanding – Basic (in millions)		3,886		3,302		3,884		3,303
Dividends Declared Per Common Share	$	0.3325	$	0.3225	$	0.6650	$	0.6450

See Notes to Consolidated Financial Statements.

AT&T INC.
CONSOLIDATED BALANCE SHEETS
Dollars in millions except per share amounts
		June 30,		December 31,
		2006		2005
Assets		(Unaudited)
Current Assets
Cash and cash equivalents	$	1,097	$	1,224
Accounts receivable – net of allowances for
uncollectibles of $1,039 and $1,176		8,484		9,351
Prepaid expenses		1,144		1,029
Deferred income taxes		1,876		2,011
Other current assets		1,034		1,039
Total current assets		13,635		14,654
Property, plant and equipment		151,716		149,238
Less: accumulated depreciation and amortization		93,365		90,511
Property, Plant and Equipment – Net		58,351		58,727
Goodwill		13,433		14,055
Intangible Assets – Net		7,978		8,503
Investments in Equity Affiliates		2,147		2,031
Investments in and Advances to Cingular Wireless		32,656		31,404
Other Assets		16,150		16,258
Total Assets	$	144,350	$	145,632

Liabilities and Stockholders’ Equity
Current Liabilities
Debt maturing within one year	$	3,314	$	4,455
Accounts payable and accrued liabilities		15,472		17,088
Accrued taxes		2,955		2,586
Dividends payable		1,291		1,289
Total current liabilities		23,032		25,418
Long-Term Debt		27,159		26,115
Deferred Credits and Other Noncurrent Liabilities
Deferred income taxes		14,886		15,713
Postemployment benefit obligation		18,461		18,133
Unamortized investment tax credits		195		209
Other noncurrent liabilities		5,148		5,354
Total deferred credits and other noncurrent liabilities		38,690		39,409

Stockholders’ Equity
Common shares issued ($1 par value)		4,065		4,065
Capital in excess of par value		27,217		27,499
Retained earnings		29,771		29,106
Treasury shares (at cost)		(5,002)		(5,406)
Additional minimum pension liability adjustment		(218)		(218)
Accumulated other comprehensive income		(364)		(356)
Total stockholders’ equity		55,469		54,690
Total Liabilities and Stockholders’ Equity	$	144,350	$	145,632

See Notes to Consolidated Financial Statements.

AT&T INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Dollars in millions, increase (decrease) in cash and cash equivalents
(Unaudited)
	Six months ended
	June 30,
		2006		2005
Operating Activities
Net income	$	3,253	$	1,885
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization		4,978		3,634
Undistributed earnings from investments in equity affiliates		(752)		(87)
Provision for uncollectible accounts		320		413
Amortization of investment tax credits		(14)		(11)
Deferred income tax expense (benefit)		65		(264)
Net gain on sales of investments		(10)		(75)
Changes in operating assets and liabilities:
Accounts receivable		545		217
Other current assets		(84)		(14)
Accounts payable and accrued liabilities		(1,431)		(1,123)
Stock-based compensation tax benefit		(5)		(3)
Other - net		288		465
Total adjustments		3,900		3,152
Net Cash Provided by Operating Activities		7,153		5,037
Investing Activities
Construction and capital expenditures		(4,042)		(2,329)
Receipts from (investments in) affiliates – net		(717)		1,179
Maturities of held-to-maturity securities		3		98
Dispositions		55		86
Acquisitions		(115)		(169)
Proceeds from note repayment		-		37
Other		4		-
Net Cash Used in Investing Activities		(4,812)		(1,098)
Financing Activities
Net change in short-term borrowings with original
maturities of three months or less		1,020		(882)
Repayment of other short-term borrowings		(3)		-
Issuance of long-term debt		1,491		-
Repayment of long-term debt		(2,540)		(1,037)
Purchase of treasury shares		(148)		(235)
Issuance of treasury shares		236		298
Dividends paid		(2,581)		(2,130)
Stock-based compensation tax benefit		5		3
Other		52		-
Net Cash Used in Financing Activities		(2,468)		(3,983)
Net increase (decrease) in cash and cash equivalents from continuing operations		(127)		(44)
Net Cash Used in Operating Activities from Discontinued Operations		-		(310)
Net increase (decrease) in cash and cash equivalents		(127)		(354)
Cash and cash equivalents beginning of year		1,224		760
Cash and Cash Equivalents End of Period	$	1,097	$	406
Cash paid during the six months ended June 30 for:
Interest	$	1,015	$	752
Income taxes, net of refunds	$	979	$	1,493

See Notes to Consolidated Financial Statements.

AT&T INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
Dollars and shares in millions, except per share amounts
(Unaudited)
		Six months ended
		June 30, 2006
		Shares	Amount
Common Stock
Balance at beginning of year		4,065	$	4,065
Balance at end of period		4,065	$	4,065

Capital in Excess of Par Value
Balance at beginning of year			$	27,499
Issuance of shares				(223)
Stock based compensation				(59)
Balance at end of period			$	27,217

Retained Earnings
Balance at beginning of year			$	29,106
Net income ($0.83 per diluted share)				3,253
Dividends to stockholders ($0.665 per share)				(2,584)
Other				(4)
Balance at end of period			$	29,771

Treasury Shares
Balance at beginning of year		(188)	$	(5,406)
Purchase of shares		(6)		(148)
Issuance of shares		13		552
Balance at end of period		(181)	$	(5,002)

Additional Minimum Pension Liability Adjustment
Balance at beginning of year			$	(218)
Balance at end of period			$	(218)

Accumulated Other Comprehensive Income, net of tax
Balance at beginning of year			$	(356)
Other comprehensive income (loss) (see Note 3)				(8)
Balance at end of period			$	(364)
	See Notes to Consolidated Financial Statements.

AT&T INC.

JUNE 30, 2006

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Dollars in millions except per share amounts

NOTE 1. PREPARATION OF INTERIM FINANCIAL STATEMENTS

Basis of Presentation Throughout this document, AT&T Inc. is referred to as “AT&T,” “we” or the “Company.” The consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) that permit reduced disclosure for interim periods. We believe that these consolidated financial statements include all adjustments (consisting only of normal recurring accruals) necessary to present fairly the results for the interim periods shown. The results for the interim periods are not necessarily indicative of results for the full year. You should read this document in conjunction with the consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended December 31, 2005.

The consolidated financial statements include the accounts of the Company and our majority-owned subsidiaries and affiliates. Our subsidiaries and affiliates operate in the communications services industry both domestically and internationally providing wireline and wireless telecommunications services and equipment as well as directory advertising and publishing services.

All significant intercompany transactions are eliminated in the consolidation process. Investments in partnerships, joint ventures, including Cingular Wireless (Cingular), and less than majority-owned subsidiaries where we have significant influence are accounted for under the equity method. We account for our 60% economic interest in Cingular under the equity method since we share control equally (i.e., 50/50) with our 40% economic partner in the joint venture. We have equal voting rights and representation on the Board of Directors that controls Cingular. Earnings from certain foreign equity investments accounted for using the equity method are included for periods ended within up to three months of the date of our Consolidated Statements of Income.

The preparation of financial statements in conformity with U.S. generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes, including estimates of probable losses and expenses. Actual results could differ from those estimates.

We have reclassified certain amounts in prior-period financial statements to conform to the current period’s presentation. As a result of our November 2005 acquisition of AT&T Corp. (ATTC), in 2006, we revised our segment reporting (see Note 5). In addition, we revised the product categories reported in operating revenue as follows: long-distance voice is now reported in voice revenue; integration services and customer premises equipment revenue, previously reported as voice and data revenue are now reported in other revenue; and directory revenues now reflect our traditional directory segment revenues.

FIN 48 In June, 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48), an interpretation of Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (FAS 109). FIN 48 clarifies the accounting for uncertainty in income taxes by prescribing a recognition threshold for tax positions taken or expected to be taken in a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact FIN 48 will have on our financial position or results of operations.

EITF 06-3 In June 2006, the Emerging Issues Task Force (EITF), a task force established to assist the FASB on significant emerging account issues, has ratified the consensus on EITF 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement” (EITF 06-3). EITF 06-3 provides that taxes imposed by a governmental authority on a revenue producing transaction between a seller and a customer should be shown in the income statement on either a gross or a net basis, based on the entity’s accounting policy, which should be disclosed pursuant to Accounting Principles Board Opinion No. 22, “Disclosure of Accounting Policies.” If such taxes are significant, and are presented on a gross basis, the amounts of those taxes should be disclosed. EITF 06-3 will be effective for interim and annual reporting periods beginning after December 15, 2006. We are currently evaluating the impact EITF 06-3 will have on our financial position or results of operations.

AT&T INC.

JUNE 30, 2006

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued

Dollars in millions except per share amounts

Employee Separations In accordance with Statement of Financial Accounting Standards No. 112, “Employers’ Accounting for Postemployment Benefits,” we establish obligations for expected termination benefits provided to former or inactive employees after employment but before retirement. These benefits include severance payments, workers’ compensation, disability, medical continuation coverage and other benefits. At June 30, 2006, for employees not affected by the change-in-control provisions of the ATTC merger, we had severance accruals of $321, of which $251 was established as merger-related severance accruals. In accordance with Statement of Financial Accounting Standards No. 141, “Business Combinations” (FAS 141), severance accruals recorded for ATTC employees were included in the preliminary purchase price allocation (see Note 2).

NOTE 2. ACQUISITIONS AND DISPOSITIONS

AT&T Corp. In November 2005, we acquired ATTC in a transaction accounted for under FAS 141, issuing 632 million shares. ATTC was one of the nation’s largest business service communications providers, offering a variety of global communications services, including large domestic and multinational businesses, small and medium-sized businesses and government agencies, and operated one of the largest telecommunications networks in the U.S. ATTC also provided domestic and international long-distance and usage-based-communications services to consumer customers. ATTC is now a wholly owned subsidiary of AT&T and the results of ATTC’s operations have been included in our consolidated financial statements after the November 18, 2005 acquisition date.

Under the purchase method of accounting, the transaction was valued, for accounting purposes, at $15,517 and the assets and liabilities of ATTC were recorded at their respective fair values as of the date of the acquisition. We obtained preliminary third-party valuations of property, plant and equipment, intangible assets (including the AT&T trade name), debt and certain other assets and liabilities. Because of the proximity of this transaction to year-end, the values of certain assets and liabilities were based on preliminary valuations and are subject to adjustment as additional information is obtained. Such additional information includes, but is not limited to: valuations and physical counts of property, plant and equipment, valuation of investments and the involuntary termination of employees. We have 12 months from the closing of the acquisition to finalize our valuations. As these issues are identified, modified or resolved, resulting increases or decreases to the preliminary value of assets and liabilities are offset by a change to goodwill, which may be material. Adjustments to the preliminary valuation will be recorded in the period finalized. Changes to the valuation of property, plant and equipment may result in adjustments to the fair value of certain identifiable intangible assets acquired. Additionally, as part of the final valuation of the acquisition, we will determine to which entities and to what extent the benefit of the acquisition applies, and as required by GAAP, record the appropriate goodwill to each entity.

AT&T INC.

JUNE 30, 2006

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued

Dollars in millions except per share amounts

The following table summarizes the preliminary estimated fair values of the ATTC assets acquired and liabilities assumed and related deferred income taxes as of the acquisition date and adjustments made thereto during the first quarter of 2006. There were no adjustments recorded in the second quarter.

		Purchase Price Allocation
		As of				As of
		12/31/05		Adjustments		6/30/06
Assets acquired
Current assets	$	6,295	$	19	$	6,314
Property, plant and equipment		10,921		-		10,921
Intangible assets not subject to amortization:
Trade name		4,900		-		4,900
Licenses		40		-		40
Intangible assets subject to amortization:
Customer lists and relationships		3,050		-		3,050
Patents		150		-		150
Brand licensing agreements		70		-		70
Investments in unconsolidated subsidiaries		160		-		160
Other assets		4,247		-		4,247
Goodwill		12,343		(653)		11,690
Total assets acquired		42,176		(634)		41,542

Liabilities assumed
Current liabilities, excluding current portion of long-term debt		6,740		39		6,779
Long-term debt		8,293		-		8,293
Deferred income taxes		531		(673)		(142)
Postemployment benefit obligation		8,807		-		8,807
Other noncurrent liabilities		2,288		-		2,288
Total liabilities assumed		26,659		(634)		26,025
Net assets acquired	$	15,517	$	-	$	15,517

Purchase accounting rules require that as certain pre-merger issues are identified, modified or resolved, resulting increases or decreases to tax liabilities are offset by a change in goodwill. During the first quarter of 2006, modifications to various pre-merger tax estimates and the resolution of an ATTC Internal Revenue Service audit (an adjustment of $385 for the years 1997-2001) resulted in a reduction in goodwill of $653 and are reflected in the adjustments column above.

ATTC maintained change-in-control provisions with its employees that required enhanced severance and benefit payments be paid to employees of ATTC when a change-in-control occurred. Included in the liabilities assumed at acquisition, were employee-related accruals of $1,543. Following is a summary of the accrual to be paid by the Company, from ATTC’s pension plans and from ATTC’s postemployment benefit plans.

		Balance at		Cash Payments for the Quarter Ended				Balance at
		12/31/05		3/31/06		6/30/06		6/30/06
Paid out of:
Company funds	$	870	$	(46)	$	(59)	$	765
Pension and Postemployment benefit plans		673		(4)		(26)		643
Total	$	1,543	$	(50)	$	(85)	$	1,408

AT&T INC.

JUNE 30, 2006

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued

Dollars in millions except per share amounts

The following unaudited pro forma consolidated results of operations assume that the acquisition of ATTC was completed as of January 1, 2005.

		For the Quarter Ended								For the Year Ended
		3/31/05		6/30/05		9/30/05		12/31/05		2005
Revenues	$	16,656	$	16,591	$	16,452	$	16,240	$	65,939
Net Income		1,319		1,257		1,729		1,862		6,167

NOTE 3. COMPREHENSIVE INCOME

The components of our comprehensive income for the three and six months ended June 30, 2006 and 2005 include net income, adjustments to stockholders’ equity for the foreign currency translation adjustment, net unrealized gain (loss) on available-for-sale securities and net unrealized gain (loss) on cash flow hedges. The foreign currency translation adjustment was due to exchange rate fluctuations in our foreign affiliates’ local currencies. The reclassification adjustment on cash flow hedges was due to the amortization of losses from our interest rate forward contracts.

Following is our comprehensive income:

	Three months ended				Six months ended
		June 30,				June 30,
		2006		2005		2006		2005
Net income	$	1,808	$	1,000	$	3,253	$	1,885
Other comprehensive income, net of tax:
Foreign currency translation adjustment		(25)		32		(45)		30
Net unrealized gains (losses) on securities:
Unrealized gains (losses)		7		(7)		34		(23)
Less reclassification adjustment realized in net income		(2)		(6)		(8)		(33)
Net unrealized gains on cash flow hedges: Unrealized gains, net of taxes		2		-		2		-
Reclassification adjustment for losses
on cash flow hedges included in net income		4		-		8		1
Other		-		-		1		-
Other comprehensive income (loss)		(14)		19		(8)		(25)
Total Comprehensive Income	$	1,794	$	1,019	$	3,245	$	1,860

AT&T INC.

JUNE 30, 2006

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued

Dollars in millions except per share amounts

NOTE 4. EARNINGS PER SHARE

A reconciliation of the numerators and denominators of basic earnings per share and diluted earnings per share for net income for the three and six months ended June 30, 2006 and 2005 is shown in the table below:

	Three months ended				Six months ended
	June 30,				June 30,
	2006		2005			2006		2005
Numerators
Numerator for basic earnings per share:
Net income	$	1,808	$	1,000	$	3,253	$	1,885
Dilutive potential common shares:
Other stock-based compensation		1		1		3		3
Numerator for diluted earnings per share	$	1,809	$	1,001	$	3,256	$	1,888
Denominators (000,000)
Denominator for basic earnings per share:
Weighted-average number of common
shares outstanding		3,886		3,302		3,884		3,303
Dilutive potential common shares:
Stock options		2		1		2		1
Other stock-based compensation		17		9		17		10
Denominator for diluted earnings per share		3,905		3,312		3,903		3,314
Basic earnings per share
Net income	$	0.47	$	0.30	$	0.84	$	0.57
Diluted earnings per share
Net income	$	0.46	$	0.30	$	0.83	$	0.57

At June 30, 2006, we had issued and outstanding options to purchase 247 million shares of AT&T common stock. The exercise prices of options to purchase a weighted average of 217 million shares in the second quarter and 224 million for the first six months exceeded the average market price of AT&T stock for the six months ended June 30, 2006. Accordingly, we did not include these amounts in determining the dilutive potential common shares for the respective periods. At June 30, 2006, the exercise price of 31 million share options were below market price, commonly referred to as “in the money.” Of these options, 4 million will expire by the end of 2007.

At June 30, 2005, we had issued and outstanding options to purchase 206 million shares of AT&T common stock. The exercise prices of options to purchase a weighted average of 199 million shares in the second quarter and 198 million for the first six months exceeded the average market price of AT&T stock for the six months ended June 30, 2005. Accordingly, we did not include these amounts in determining the dilutive potential common shares for the respective periods.

AT&T INC.

JUNE 30, 2006

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued

Dollars in millions except per share amounts

NOTE 5. SEGMENT INFORMATION

Our segments are strategic business units that offer different products and services and are managed accordingly. We analyze our various operating segments based on segment income. Interest expense, interest income and other income (expense) – net are managed only on a total company basis and are, accordingly, reflected only in consolidated results. Therefore, these items are not included in the calculation of each segment’s percentage of our consolidated results. As a result of our November 18, 2005 acquisition of ATTC we have revised our segment reporting to represent how we now manage our business, restating prior periods to conform to the current segments. We have four reportable segments: (1) wireline, (2) Cingular, (3) directory and (4) other.

The wireline segment provides both retail and wholesale landline telecommunications services, including local and long-distance voice, switched access, internet protocol and internet access data, messaging services, managed networking to business customers and satellite television services through our agreement with EchoStar Communications Corp.

The Cingular segment reflects 100% of the results reported by Cingular, our wireless joint venture. Although we analyze Cingular’s revenues and expenses under the Cingular segment, we eliminate the Cingular segment in our consolidated financial statements. In our consolidated financial statements, we report our 60% proportionate share of Cingular’s results as equity in net income of affiliates.

The directory segment includes our directory operations, which publish Yellow and White Pages directories and sell directory and internet-based advertising. Our portion of the results from YELLOWPAGES.COM (YPC), a joint venture with BellSouth Corporation (BellSouth), is recorded in this segment as equity in net income of affiliates.

The other segment includes results from Sterling Commerce Inc. and all corporate and other operations. This segment also includes our portion of the results from our international equity investments and from Cingular as equity in net income of affiliates, as discussed above.

In the following tables, we show how our segment results are reconciled to our consolidated results reported in accordance with GAAP. The Wireline, Cingular, Directory and Other columns represent the segment results of each such operating segment. The Wireline column includes revenues from services sold to Cingular (see Note 6). Since we account for Cingular using the equity method of accounting, these revenues are not eliminated upon consolidation and as such, remain in consolidated revenue. The Consolidation and Elimination column adds in those line items that we manage on a consolidated basis only: interest expense, interest income and other income (expense) – net. This column also eliminates any intercompany transactions included in each segment’s results. Since our 60% share of the results from Cingular is already included in the Other column, the Cingular Elimination column removes the results of Cingular shown in the Cingular segment.

AT&T INC.

JUNE 30, 2006

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued

Dollars in millions except per share amounts

For the three months ended June 30, 2006

Wireline

Cingular

Directory

Other

Consolidation
and Elimination

Cingular
Elimination

Consolidated
Results

Revenues from external customers

29,472

18,198

1,810

323

(18,198)

31,605

Intersegment revenues

(132)

Total segment operating revenues

29,489

18,198

1,848

400

(132)

(18,198)

31,605

Operations and support expenses

20,746

13,096

882

336

(132)

(13,096)

21,832

Depreciation and amortization expenses

4,857

3,278

121

(1)

(3,278)

4,978

Total segment operating expenses

25,603

16,374

883

457

(133)

(16,374)

26,810

Segment operating income

3,886

1,824

965

(57)

(1,824)

4,795

Interest expense

595

936

(595)

936

Interest income

180

(7)

180

Equity in net income (loss) of affiliates

(11)

800

789

Other income (expense) – net

(76)

Segment income before income taxes

3,886

1,160

954

743

(729)

(1,160)

4,854

Segment Assets

104,344

78,944

4,229

132,119

(96,342)

(78,944)

144,350

AT&T INC.

JUNE 30, 2006

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued

Dollars in millions except per share amounts

For the three months ended June 30, 2005

		Wireline		Cingular		Directory		Other		Consolidation and Elimination		Cingular Elimination		Consolidated Results
Revenues from external customers	$	9,249	$	8,609	$	901	$	167	$	-	$	(8,609)	$	10,317
Intersegment revenues		8		-		24		11		(43)		-		-
Total segment operating revenues		9,257		8,609		925		178		(43)		(8,609)		10,317
Operations and support expenses		6,453		6,476		432		147		(42)		(6,476)		6,990
Depreciation and amortization expenses		1,757		1,629		1		51		-		(1,629)		1,809
Total segment operating expenses		8,210		8,105		433		198		(42)		(8,105)		8,799
Segment operating income		1,047		504		492		(20)		(1)		(504)		1,518
Interest expense		-		326		-		-		349		(326)		349
Interest income		-		18		-		-		100		(18)		100
Equity in net income (loss) of affiliates		-		1		-		182		(1)		(1)		181
Other income (expense) – net		-		(26)		-		-		34		26		34
Segment income before income taxes	$	1,047	$	171	$	492	$	162	$	(217)	$	(171)	$	1,484

For the six months ended June 30, 2005

		Wireline		Cingular		Directory		Other		Consolidation and Elimination		Cingular Elimination		Consolidated Results
Revenues from external customers	$	18,423	$	16,838	$	1,806	$	322	$	-	$	(16,838)	$	20,551
Intersegment revenues		16		-		48		25		(89)		-		-
Total segment operating revenues		18,439		16,838		1,854		347		(89)		(16,838)		20,551
Operations and support expenses		12,746		12,916		876		307		(86)		(12,916)		13,843
Depreciation and amortization expenses		3,530		3,304		3		103		(2)		(3,304)		3,634
Total segment operating expenses		16,276		16,220		879		410		(88)		(16,220)		17,477
Segment operating income		2,163		618		975		(63)		(1)		(618)		3,074
Interest expense		-		664		-		-		702		(664)		702
Interest income		-		36		-		-		209		(36)		209
Equity in net income (loss) of affiliates		-		3		(1)		124		-		(3)		123
Other income (expense) – net		-		(40)		-		-		81		40		81
Segment income before income taxes	$	2,163	$	(47)	$	974	$	61	$	(413)	$	47	$	2,785

AT&T INC.

JUNE 30, 2006

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued

Dollars in millions except per share amounts

NOTE 6. TRANSACTIONS WITH CINGULAR

We and BellSouth, the two owners of Cingular, have each made a subordinated loan to Cingular (shareholder loans). Our shareholder loan to Cingular totaled $4,108 at June 30, 2006 and December 31, 2005. This loan bears interest at an annual rate of 6.0% and matures in June 2008. We earned interest income on this loan of $61 in the second quarter and $122 for the first six months of 2006 and $87 in the second quarter and $174 for the first six months of 2005.

We and BellSouth agreed to finance Cingular’s capital and operating cash requirements to the extent Cingular requires funding above the level provided by operations. We and BellSouth also entered into a revolving credit agreement with Cingular to provide short-term financing for operations on a pro rata basis at an interest rate of LIBOR (London Interbank Offered Rate) plus 0.05%, which expires July 31, 2007. This agreement provides for the repayment of our and BellSouth’s shareholder loans made to Cingular in the event there are no outstanding amounts due under the revolving credit agreement and to the extent Cingular has excess cash, as defined by the agreement.

Our net advances to Cingular under the revolving credit agreement totaled $16 in the second quarter and $715 for the first six months of 2006. Our share of advances to Cingular under the revolving credit agreement is reflected in “Investments in and Advances to Cingular Wireless” on our Consolidated Balance Sheets and totaled $1,022 at June 30, 2006 and $307 at December 31, 2005.

We generated revenues of $365 in the second quarter and $747 for the first six months of 2006 and $205 in the second quarter and $387 for the first six months of 2005 for services sold to Cingular. These revenues were primarily from access and long-distance services sold to Cingular on a wholesale basis, and commissions revenue related to customers added through AT&T sales sources. The offsetting expense amounts are recorded by Cingular, and 60% of these expenses are included in our “Equity in net income of affiliates” line on our Consolidated Statements of Income when we report our 60% proportionate share of Cingular’s results.

AT&T INC.

JUNE 30, 2006

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued

Dollars in millions except per share amounts

NOTE 7. PENSION AND POSTRETIREMENT BENEFITS

Substantially all of our employees are covered by one of various noncontributory pension and death benefit plans. We also provide certain medical, dental and life insurance benefits to substantially all retired employees under various plans and accrue actuarially determined postretirement benefit costs as active employees earn these benefits. Our objective in funding these plans, in combination with the standards of the Employee Retirement Income Security Act of 1974, as amended (ERISA), is to accumulate assets sufficient to meet the plans’ obligations to provide benefits to employees upon their retirement. No significant cash contributions are required under ERISA regulations during 2006.

The following details pension and postretirement benefit costs included in operating expenses (in cost of sales and selling, general and administrative expenses) in the accompanying Consolidated Statements of Income. We account for these costs in accordance with Statement of Financial Accounting Standards No. 87, “Employers’ Accounting for Pensions” and Statement of Financial Accounting Standards No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” In the following table, gains are denoted with parentheses and losses are not.

	Three months ended				Six months ended
	June 30,				June 30,
	2006		2005			2006		2005
Pension cost:
Service cost – benefits earned during the period	$	265	$	196	$	525	$	392
Interest cost on projected benefit obligation		626		404		1,254		807
Expected return on assets		(993)		(636)		(1,984)		(1,272)
Amortization of prior service cost and transition asset		38		46		75		93
Recognized actuarial loss		87		40		180		79
Net pension cost	$	23	$	50	$	50	$	99

Postretirement benefit cost:
Service cost – benefits earned during the period	$	109	$	96	$	218	$	195
Interest cost on accumulated postretirement
benefit obligation		478		355		972		722
Expected return on assets		(233)		(189)		(467)		(378)
Amortization of prior service benefit		(89)		(84)		(179)		(164)
Recognized actuarial loss		109		105		235		219
Postretirement benefit cost	$	374	$	283	$	779	$	594

Combined net pension and postretirement cost	$	397	$	333	$	829	$	693

Our combined net pension and postretirement cost increased $64 in the second quarter and $136 for the first six months of 2006 compared with the same periods in 2005. Net pension and postretirement costs in 2006 reflect the November 2005 acquisition of ATTC, changes in our actuarial assumptions, which included the reduction of our discount rate from 6.00% to 5.75% (an increase to expense) and net losses on plan assets in prior years. In accordance with GAAP, we recognize actual gains and losses on pension and postretirement plan assets equally over a period of not more than five years. In the second quarter of 2006, we finalized our participant data analysis and now expect annual combined net pension and postretirement costs of between $1,600 and $1,700 in 2006.

As part of our acquisition of ATTC, we acquired certain non-U.S. operations. Net pension cost for non-U.S. plans, which is not included in the table above, was $6 in the second quarter and $14 for the first six months of 2006.

AT&T INC.

JUNE 30, 2006

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued

Dollars in millions except per share amounts

We also provide senior- and middle-management employees with nonqualified, unfunded supplemental retirement and savings plans. Net supplemental retirement pension benefits cost, which is not included in the table above, was $37 in the second quarter and $75 for the first six months of 2006, of which $25 and $51 was interest cost, respectively. Net supplemental retirement pension benefits cost was $27 in the second quarter and $54 for the first six months of 2005, of which $17 and $34 was interest cost, respectively.

NOTE 8. PENDING ACQUISITION OF BELLSOUTH

On March 4, 2006, we agreed to acquire BellSouth in a transaction in which each share of BellSouth common stock will be exchanged for 1.325 shares of AT&T common stock. Based on the average closing price of AT&T shares for the two days prior to, including, and two days subsequent to the public announcement of the acquisition (March 5, 2006) of $27.32, the total transaction is valued, for purchase accounting purposes, at approximately $65,000.

We and BellSouth jointly own Cingular and the internet-based publisher YPC. In the Cingular joint venture, we hold a 60 percent economic interest and BellSouth holds a 40 percent interest and in the YPC joint venture we hold a 66 percent economic interest and BellSouth holds a 34 percent interest. For each joint venture control is shared equally (i.e., 50/50). We and BellSouth each account for the joint ventures under the equity method of accounting, recording the proportional share of Cingular’s and YPC’s income as equity in net income of affiliates on the respective consolidated statements of income and reporting the ownership percentage of Cingular’s net assets as “Investments in and Advances to Cingular Wireless” and the ownership percentage of YPC’s net assets as “Investments in Equity Affiliates” on the respective consolidated balance sheets. After the BellSouth acquisition, BellSouth, Cingular and YPC will be wholly-owned subsidiaries of AT&T.

The acquisition has been approved by the Board of Directors and stockholders of each company. The transaction also is subject to review by the U.S. Department of Justice and approval by the Federal Communications Commission and various other regulatory authorities. We expect the transaction to close in the fall of 2006.

AT&T INC.

JUNE 30, 2006

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Dollars in millions except per share amounts

RESULTS OF OPERATIONS

For ease of reading, AT&T Inc. is referred to as “we,” “AT&T,” or the “Company” throughout this document and the names of the particular subsidiaries and affiliates providing the services generally have been omitted. AT&T is a holding company whose subsidiaries and affiliates operate in the communications services industry both domestically and internationally providing wireline and wireless telecommunications services and equipment as well as directory advertising and publishing services. You should read this discussion in conjunction with the consolidated financial statements, accompanying notes and management’s discussion and analysis of financial condition and results of operations included in our Annual Report on Form 10-K for the year ended December 31, 2005. In the tables throughout this section, percentage increases and decreases that equal or exceed 100% are not considered meaningful and are denoted with a dash.

Consolidated Results We completed our acquisition of AT&T Corp. (ATTC) on November 18, 2005. Consolidated results for the second quarter and six month period ended June 30, 2006 include results from ATTC. In accordance with U.S. generally accepted accounting principles (GAAP), operating results for ATTC prior to our acquisition, including the second quarter and six months ended June 30, 2005, are not included in our operating results and are therefore not discussed. Our financial results in the second quarter and for the first six months of 2006 and 2005 are summarized as follows:

Second Quarter

Six-Month Period

2006

2005

Percent
Change

2006

2005

Percent
Change


Operating revenues	$15,810	$10,317	53	.2%	$31,605	$20,551	53	.8%
Operating expenses	13,206	8,799	50	.1	26,810	17,477	53	.4
Operating income	2,604	1,518	71	.5	4,795	3,074	56	.0
Income before income taxes	2,697	1,484	81	.7	4,854	2,785	74	.3
Net Income	1,808	1,000	80	.8	3,253	1,885	72	.6

Overview

Operating income As noted above, 2006 revenues and expenses reflect the addition of ATTC’s results while our 2005 results do not include ATTC. Accordingly, the following discussion of changes in our revenues and expenses is significantly affected by the ATTC acquisition. Our operating income increased $1,086, or 71.5%, in the second quarter and $1,721, or 56.0%, for the first six months of 2006 and our operating income margin increased from 14.7% to 16.5% in the second quarter and from 15.0% to 15.2% for the first six months. Operating income increased primarily due to expense reduction through merger synergies, slightly offset by additional amortization expense on those intangibles identified at the time of our acquisition of ATTC and by the negative effects of a continued decline in access lines.

Retail access lines continued to decline due to increased competition, as customers disconnected both primary and additional lines and began using wireless and Voice over Internet Protocol (VoIP) technology offered by competitors and cable instead of phone lines for voice and data. Access line trends are further discussed in our Wireline segment discussion.

Operating revenues Our operating revenues increased $5,493, or 53.2%, in the second quarter and $11,054, or 53.8%, for the first six months of 2006 primarily due to our acquisition of ATTC. The increase was slightly offset by continued pressure in voice, reflecting access line decreases in our traditional SBC Communications (SBC) 13-state region (“in-region”) and decreased demand for wholesale services. Operating revenues in the quarter were essentially flat when compared with the first quarter of 2006. Operating revenue changes are discussed in greater detail in our “Segment Results” sections.

AT&T INC.

JUNE 30, 2006

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued

Dollars in millions except per share amounts

Operating expenses Our operating expenses increased $4,407 or 50.1%, in the second quarter and $9,333, or 53.4%, for the first six months of 2006 primarily due to our acquisition of ATTC, and also included merger integration costs of $156 in the second quarter and $422 for the first six months and amortization expense on intangible assets identified at the time of the ATTC merger of $241 in the second quarter and $507 for the first six months. Our expenses in 2006 also include decreases related to workforce reductions, reflecting a decline of nearly 7,000 employees from December 31, 2005, of which 3,580 were in the second quarter. As of June 30, 2006 we were on schedule with our targeted workforce reductions associated with the ATTC acquisition. Expenses in the quarter decreased 2.9% from the first quarter, reflecting progress with the integration of ATTC and other cost-reduction initiatives. Our significant expense changes are discussed in greater detail in our “Segment Results” sections.

Interest expense increased $123, or 35.2%, in the second quarter and $234, or 33.3%, for the first six months of 2006. The increase was primarily due to interest expense on ATTC’s outstanding debt. We expect continued increases in interest expense during 2006 as a result of increased debt levels attributable to the ATTC acquisition.

Interest income decreased $5, or 5.0%, in the second quarter and $29, or 13.9%, for the first six months of 2006. The decrease in interest income was primarily due to the pay-down by Cingular Wireless (Cingular) of our shareholder loan to them.

Equity in net income of affiliates increased $274 in the second quarter and $666 for the first six months of 2006. The increase was primarily due to our proportionate share of Cingular’s improved results of $236 in the second quarter and $593 for the first six months.

We account for our 60% economic interest in Cingular under the equity method of accounting and therefore include our proportionate share of Cingular’s results in our “Equity in net income (loss) of affiliates” line item on our Consolidated Statements of Income. Cingular’s operating results are discussed in detail in the “Cingular Segment Results” section. Our accounting for Cingular is described in more detail in Note 5. Our equity investments are discussed in greater detail in the “Other Segment Results” section.

Other income (expense) – net We had other income of $15 in the second quarter and $26 for the first six months of 2006, as compared to other income of $34 in the second quarter and $81 for the first six months of 2005. Results for the first six months of 2006 included a gain of $10 on the sale of Covad Communications Group Inc. shares.

Other income in the second quarter of 2005 primarily consisted of other income related to the transfer of wireless properties to Cingular of $24 and gains of $9 on the sale of shares of Yahoo! (Yahoo). Results for the first six months of 2005 primarily included a gain of $77 on the sale of shares of Amdocs Limited, SpectraSite, Inc and Yahoo and the above-mentioned $24 from the transfer of wireless properties to Cingular. These gains were partially offset by a charge of $21 related to the other-than-temporary decline in the value of various cost investments.

Income taxes increased $405, or 83.7%, in the second quarter and $701, or 77.9%, for the first six months of 2006. The increase in income taxes in the second quarter and for the first six months of 2006 was due to higher income before income taxes. Our effective tax rates were 33.0% in the second quarter of 2006 compared to 32.6% in the second quarter of 2005, and 33.0% for the first six months of 2006 compared to 32.3% for the first six months of 2005.

AT&T INC.

JUNE 30, 2006

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued

Dollars in millions except per share amounts

Selected Financial and Operating Data

	June 30,
	2006	2005
Debt ratio¹	35.5%	38.3%
In-region network access lines in service (000)²	47,911	51,032
In-region wholesale lines (000)²	4,358	5,977
In-region DSL lines in service (000)²	7,774	5,968
Number of AT&T employees³	182,980	157,610
Cingular Wireless customers (000)⁴	57,308	51,442

¹ See our “Liquidity and Capital Resources” section for discussion.

² In-region represents access lines served by AT&T’s incumbent local exchange companies (ILECs).

³ Number of employees at December 31, 2005 was 189,950.

⁴ Amounts represent 100% of the cellular/PCS customers of Cingular.

Segment Results

Our segments represent strategic business units that offer different products and services and are managed accordingly. Our operating segment results presented in Note 5 and discussed below for each segment follow our internal management reporting. We analyze our various operating segments based on segment income. Interest expense, interest income and other income (expense) – net, are managed only on a total company basis and are, accordingly, reflected only in consolidated results. Therefore, these items are not included in the calculation of each segment’s percentage of our total segment income. As a result of our November 18, 2005 acquisition of ATTC, we have revised our segment reporting to represent how we now manage our business, restating prior periods to conform to the current segments. We have four reportable segments: (1) wireline; (2) Cingular; (3) directory; and (4) other.

The wireline segment provides both retail and wholesale landline telecommunications services, including local and long-distance voice, switched access, internet protocol (IP) and internet access data, messaging services, managed networking to business customers and satellite television services through our agreement with EchoStar Communications Corp. (“AT&T | DISH Network” offering).

The Cingular segment reflects 100% of the results reported by Cingular, our wireless joint venture. In our consolidated financial statements, we report our 60% proportionate share of Cingular’s results as equity in net income of affiliates.

The directory segment includes our directory operations, which publish Yellow and White Pages directories and sell directory and internet-based advertising. Our portion of the results from YELLOWPAGES.COM (YPC) is recorded in this segment as equity in net income of affiliates.

The other segment includes results from Sterling Commerce Inc. (Sterling) and all corporate and other operations. The other segment also includes our portion of the results from our international equity investments and from Cingular as equity in net income of affiliates, as discussed above. Although we analyze Cingular’s revenues and expenses under the Cingular segment, we record our portion of Cingular’s results as equity in net income of affiliates in the other segment.

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.”

AT&T INC.

JUNE 30, 2006

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued

Dollars in millions except per share amounts

Wireline

Segment Results

		Second Quarter					Six-Month Period
					Percent					Percent
		2006		2005	Change		2006		2005	Change
Segment operating revenues
Voice	$	8,618	$	5,760	49.6%	$	17,340	$	11,612	49.3%
Data		4,477		2,438	83.6		8,919		4,829	84.7
Other		1,655		1,059	56.3		3,230		1,998	61.7
Total Segment Operating Revenues		14,750		9,257	59.3		29,489		18,439	59.9
Segment operating expenses
Cost of sales		6,655		4,139	60.8		13,511		8,262	63.5
Selling, general and administrative		3,534		2,314	52.7		7,235		4,484	61.4
Depreciation and amortization		2,427		1,757	38.1		4,857		3,530	37.6
Total Segment Operating Expenses		12,616		8,210	53.7		25,603		16,276	57.3
Segment Income	$	2,134	$	1,047	-	$	3,886	$	2,163	79.7%

Operating Margin Trends

Our wireline segment operating income margin was 14.5% in the second quarter of 2006, compared to 11.3% in the second quarter of 2005, and 13.2% for the first six months of 2006, compared to 11.7% for the first six months of 2005. Our wireline segment operating income increased $1,087 in the second quarter of 2006 and $1,723 for the first six months of 2006 reflecting incremental revenue and expenses from our acquisition of ATTC. Exclusive of the results attributable to the acquisition of ATTC, operating income increased primarily due to lower expenses as a result of merger synergies partially offset by lower voice revenue as a result of continued in-region access line declines due to customers continuing to disconnect primary and additional lines and switching to competitors’ alternative technologies, such as wireless, VoIP and cable for voice and data. Increasing shifts to competitors’ alternative technologies and facilities-based competition will continue to pressure our operating margins.

Wireline Operating Results

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

Voice revenues increased $2,858, or 49.6%, in the second quarter and $5,728, or 49.3%, for the first six months of 2006 primarily due to the acquisition of ATTC. Included in voice revenues are revenues from long-distance, local voice and local wholesale services. Voice revenues do not include any of our VoIP revenues, which are included in data revenues.

•

Long-distance revenues increased $2,692 in the second quarter and $5,544 for the first six months of 2006 driven almost entirely by the increase in long-distance customers due to the acquisition of ATTC. Also contributing to the increases were higher long-distance penetration levels and sales of combined long-distance and local calling fixed-fee offerings (referred to as “bundling”) when compared to the prior year. However, our long-distance revenue growth continued to slow, decreasing approximately 3% from first-quarter 2006 results, reflecting continuing market maturity since we began providing service to all of our in-region states in late 2003 and a continuing decline in ATTC’s mass-market customers.

AT&T INC.

JUNE 30, 2006

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued

Dollars in millions except per share amounts

•

Local voice revenues increased $316 in the second quarter and $510 for the first six months of 2006 primarily reflecting our acquisition of ATTC. However, we expect that revenues from ATTC’s mass-market customers will continue to decline on a sequential quarterly basis. Local voice revenues were also negatively impacted by continued declines in customer demand, calling features (e.g., Caller ID and voice mail), inside wire and retail payphone revenues. We expect our local voice revenue to continue to be negatively affected by increased competition, including customers shifting to competitors’ wireless, VoIP technology and cable offerings for voice, and the disconnection of additional lines for DSL service and other reasons. Partially offsetting these demand-related declines were revenue increases related to pricing increases for calling features.

•

Lower demand for wholesale services, primarily due to the decline in Unbundled Network Element-Platform (UNE-P) lines provided to competitors, decreased revenue $150 in the second quarter and $326 for the first six months of 2006. Lines provided under the former UNE-P rules (which ended in March 2006) declined, as competitors moved to alternate arrangements to serve their customers or their customers chose an alternative technology. Competitors who represented a majority of our UNE-P lines have signed commercial agreements with us and therefore remain our wholesale customers. For the remaining UNE-P lines, we believe, based on marketing research, that customers primarily switched to competitors using alternative technologies or their own networks as opposed to returning as our retail customers. While we lose some revenue when a wireline customer shifts from one of our retail lines to a competitor that relies on a resale or wholesale product, we lose all revenue when a wireline customer shifts to a competitor using an alternative technology such as cable, wireless or VoIP, or their own network facilities.

Data revenues increased $2,039, or 83.6%, in the second quarter and $4,090, or 84.7%, for the first six months of 2006. The increase in data revenues was due to increases in IP data of $775 in the second quarter and $1,554 for the first six months, increases in transport of $681 in the second quarter and $1,347 for the first six months and increases in packet switched services of $583 in the second quarter and $1,189 for the first six months, all of which increased almost entirely due to the acquisition of ATTC. Data revenues accounted for approximately 28% of our operating revenues in the second quarter and for the first six months of 2006 and 24% of revenues in the second quarter and for the first six months of 2005.

Included in IP data revenues are DSL, dedicated internet access, virtual private network and other hosting services. Contributing to the increase in IP data services was continued growth in DSL, our broadband internet-access service. DSL internet service increased data revenues $101 in the second quarter and $204 for the first six months of 2006, reflecting an increase in DSL lines in service, which was partially driven by lower-priced promotional offerings as a response to competitive pricing pressures.

Our transport services, which include DS1s and DS3s (types of dedicated high-capacity lines), and SONET (a dedicated high-speed solution for multi-site businesses), represented approximately 50% of total data revenues in the second quarter and for the first six months of 2006, and 64% of total data revenues in the second quarter and for the first six months of 2005.

Our packet switched services includes frame relay, asynchronous transfer mode (ATM) and managed packet services. As customers continue to shift from this traditional technology to IP-based technology, we expect these services to decline as a percentage of our overall data revenues.

Other operating revenues increased $596 in the second quarter and $1,232 for the first six months of 2006, primarily due to incremental revenue from our acquisition of ATTC. Major items included in other operating revenues are integration services and customer premises equipment, outsourcing, directory and operator assistance services and government-related services. Our co-branded AT&T | DISH Network satellite TV service increased revenue $10 in the second quarter and $25 for the first six months of 2006. Revenue also increased $70 from intellectual property license fees in the second quarter and for the first six months. Partially offsetting these revenue increases was lower demand for equipment sales and related network integration services, which decreased revenue $103 in the second quarter and for the first six months of 2006. Lower demand for directory and operator assistance, billing and collection services provided to other carriers, wholesale and other miscellaneous products and services decreased revenue $42 in the second quarter and $84 for the first six months of 2006.

AT&T INC.

JUNE 30, 2006

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued

Dollars in millions except per share amounts

Cost of sales expenses increased $2,516, or 60.8%, in the second quarter and $5,249, or 63.5%, for the first six months of 2006, primarily related to the acquisition of ATTC. Cost of sales consists of costs we incur to provide our products and services, including costs of operating and maintaining our networks. Costs in this category include our repair technicians and repair services, certain network planning and engineering expenses, operator services, information technology, property taxes related to elements of our network and payphone operations. Pension and postretirement costs, net of amounts capitalized as part of construction labor, are also included to the extent that they are allocated to our network labor force and other employees who perform the functions listed in this paragraph.

Benefit expenses, consisting primarily of our combined net pension and postretirement cost, increased $44 in the second quarter and $79 for the first six months of 2006, primarily due to changes in our actuarial assumptions, which included the reduction of our discount rate from 6.00% to 5.75%, and net losses on plan assets in prior years. Nonemployee-related expenses such as contract services, agent commissions and materials and supplies costs, increased $25 in the second quarter while decreasing $35 for the first six months. Traffic compensation expense (for access to another carrier’s network), down slightly in the second quarter, increased $108 for the first six months of 2006, due primarily to growth in long-distance service, and as a result of decreased costs recorded in the first quarter of 2005 related to a carrier settlement. Salary and wage merit increases and other bonus accruals increased expense $29 for the first six months of 2006.

Partially offsetting these increases were lower costs associated with equipment sales and related network integration services which decreased $146 in the second quarter and $180 for the first six months of 2006 primarily due to lower demand and as a result of the September 2005 amendment of our agreement for our co-branded AT&T | DISH Network satellite TV service. Prior to restructuring our relationship with EchoStar in September 2005, our co-branded AT&T | DISH Network satellite TV service had relatively high initial acquisition costs. Costs associated with equipment for large-business customers (as well as DSL and, previously, video) typically are greater than costs associated with services that are provided over multiple years.

Lower employee levels decreased expenses, primarily salary and wages, $81 in the second quarter and $120 for the first six months of 2006. Expenses also decreased for the first six months of 2006 resulting from repair costs of approximately $100 incurred in the first quarter of 2005 related to severe weather in-region.

Selling, general and administrative expenses increased $1,220, or 52.7%, in the second quarter and $2,751, or 61.4%, for the first six months of 2006, primarily due to the ATTC acquisition. Selling, general and administrative expenses consist of our provision for uncollectible accounts; advertising costs; sales and marketing functions, including our retail and wholesale customer service centers; centrally managed real estate costs, including maintenance and utilities on all owned and leased buildings; credit and collection functions; and corporate overhead costs, such as finance, legal, human resources and external affairs. Pension and postretirement costs are also included to the extent they relate to employees who perform the functions listed in this paragraph.

Other wireline segment costs increased $362 in the second quarter and $636 for the first six months of 2006 primarily due to advertising costs related to promotion of the AT&T brand name. In addition, advertising expense increased $32 in the second quarter and $57 for the first six months of 2006. Benefit expenses, consisting primarily of our combined net pension and postretirement cost, increased $21 in the second quarter and $40 for the first six months of 2006.

Partially offsetting these increases were lower employee levels, which decreased expenses, primarily salary and wages, $65 in the second quarter and $134 for the first six months of 2006. Nonemployee related expenses, such as contract services, agent commissions and materials and supplies costs, decreased $42 in the second quarter and $12 for the first six months of 2006. Our provision for uncollectible accounts decreased $22 in the second quarter and $50 for the first six months of 2006 as we experienced fewer losses from our retail customers and a decrease in bankruptcy filings by our wholesale customers. Expenses also decreased

AT&T INC.

JUNE 30, 2006

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued

Dollars in millions except per share amounts

$236 in the second quarter and for the first six months of 2006 due to a charge we incurred in the second quarter of 2005 to terminate existing agreements with WilTel Communications, which will continue to provide transitional and out-of-market long distance services under an agreement that commenced in November 2005 as a result of our acquisition of ATTC.

Depreciation and amortization expenses increased $670 in the second quarter and $1,327 for the first six months of 2006 primarily related to our acquisition of ATTC. The expense increase included amortization of intangible assets identified at the time of the ATTC merger, primarily customer lists and relationships, of $241 in the second quarter and $507 for the first six months.

Supplemental Information

Access Line Summary

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

In-Region ¹
Switched Access Lines	June 30,
			% Increase
(in 000’s)	2006	2005	(Decrease)

Retail Consumer
Primary	22,310	23,036	(3.2)%
Additional	3,680	4,108	(10.4)
Retail Consumer Subtotal	25,990	27,144	(4.3)

Retail Business	17,282	17,513	(1.3)
Retail Subtotal	43,272	44,657	(3.1)
Percent of total switched access lines	90.3%	87.5%

Sold to ATTC	1,388	1,956	(29.0)
Sold to other CLECs ²	2,970	4,021	(26.1)
Wholesale Subtotal	4,358	5,977	(27.1)
Percent of total switched access lines	9.1%	11.7%

Payphone (Retail and Wholesale)	281	398	(29.4)
Percent of total switched access lines	0.6%	0.8%

Total Switched Access Lines	47,911	51,032	(6.1)%

DSL Lines in Service	7,774	5,968	30.3%

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

²Competitive local exchange carriers (CLECs)

AT&T INC.

JUNE 30, 2006

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued

Dollars in millions except per share amounts

Cingular

Segment Results

		Second Quarter					Six-Month Period
					Percent					Percent
		2006		2005	Change		2006		2005	Change
Segment operating revenues
Service revenues	$	8,295	$	7,719	7.5%	$	16,300	$	15,138	7.7%
Equipment revenues		923		890	3.7		1,898		1,700	11.6
Total Segment Operating Revenues		9,218		8,609	7.1		18,198		16,838	8.1
Segment operating expenses
Cost of services and equipment sales		3,846		3,523	9.2		7,493		6,962	7.6
Selling, general and administrative		2,757		2,953	(6.6)		5,603		5,954	(5.9)
Depreciation and amortization		1,598		1,629	(1.9)		3,278		3,304	(0.8)
Total Segment Operating Expenses		8,201		8,105	1.2		16,374		16,220	0.9
Segment Operating Income		1,017		504	-		1,824		618	-
Interest Expense		298		326	(8.6)		595		664	(10.4)
Equity in net income (loss) of
affiliates – net		-		1	-		-		3	-
Other – net		(37)		(8)	-		(69)		(4)	-
Segment Income (Loss)	$	682	$	171	-	$	1,160	$	(47)	-

Accounting for Cingular

We account for our 60% economic interest in our Cingular joint venture under the equity method of accounting in our consolidated financial statements. This means that our consolidated results include Cingular’s results in the “Equity in net income of affiliates” line. However, when analyzing our segment results, we evaluate Cingular’s results on a stand-alone basis using information provided by Cingular during the year. Including 100% of Cingular’s results in our segment operations (rather than 60% in equity in net income of affiliates) affects the presentation of this segment’s revenues, expenses, operating income, nonoperating items and segment income but does not affect our consolidated net income. We discuss Cingular’s liquidity and capital expenditures under the heading “Cingular” within “Liquidity and Capital Resources.”

Cingular’s Customer and Operating Trends

As of June 30, 2006, Cingular served 57.3 million cellular/PCS (wireless) customers compared to 51.4 million at June 30, 2005. Cingular’s increase in customer gross additions in the second quarter and for the first six months of 2006 compared to 2005 was primarily driven by an increase in reseller and prepaid customer growth, combined with its larger distribution network, broad range of service offerings and advertising over the past year. This growth was partially offset by a decline in postpaid customer growth due to the streamlining of operations, such as the reduction of retail stores and agents. Cingular’s net subscriber additions increased 57.4% in the second quarter and 37.0% for the first six months of 2006.

Competition and the slowing rate of new wireless users as the wireless market matures will continue to impact Cingular’s gross additions, revenue growth, expenses and put pressure on margins. Cingular expects that future revenue growth will become increasingly dependent on minimizing customer turnover (customer churn) and increasing average revenue per user/customer (ARPU).

AT&T INC.

JUNE 30, 2006

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued

Dollars in millions except per share amounts

Cingular’s ARPU has weakened over the past several years as it has offered a broader array of plans to expand its customer base and responded to increasing competition, resulting in pricing reductions. While Cingular’s ARPU has somewhat stabilized recently, Cingular expects continued pressure on ARPU notwithstanding increasing revenue from data services.

Cingular expects its cost of services to continue increasing due to higher network system usage, which includes the costs Cingular is now paying T-Mobile USA (T-Mobile) for the use of its network in California and Nevada, higher costs associated with integrating the AT&T Wireless Services Inc. (AT&T Wireless) network and operations, and, to a lesser extent, increased expenses related to operating, maintaining and decommissioning Time Division Multiple Access (TDMA) networks that duplicated Global System for Mobile Communication (GSM) networks while integrating the networks acquired from AT&T Wireless. Cingular’s remaining purchase commitment to T-Mobile was $310 at June 30, 2006. Operating costs will substantially increase in the event that Cingular’s network expansion in California and Nevada is not completed prior to fulfilling the purchase commitment with T-Mobile. However, this network expansion is proceeding on schedule, and as of June 30, 2006, approximately 79% of Cingular’s customers in California and Nevada were on the Cingular network.

ARPU decreased 3.3% in the second quarter and 2.8% for the first six months of 2006. The decline in ARPU was due to a decrease in local service, net roaming revenue and other revenue per customer partially offset by an increase in average data revenue per customer, which increased 38.7% in the second quarter and 39.9% for the first six months. Local service revenue per customer declined primarily due to an increase in reseller customers which provide significantly lower ARPU than non-reseller customers, customer shifts to all-inclusive rate plans that offer lower monthly charges, Cingular’s free mobile-to-mobile plans that allow Cingular customers to call other Cingular customers at no charge and to a lesser extent “rollover” minutes.

The effective management of wireless customer churn is critical to Cingular’s ability to maximize revenue growth and maintain and improve margins. Cingular’s wireless customer churn rate is calculated by dividing the aggregate number of wireless customers (prepaid and postpaid) who cancel service during each month in a period by the total number of wireless customers at the beginning of each month in that period. Cingular’s churn rate was 1.7% in the second quarter and 1.8% for the first six months of 2006, down from 2.2% in the second quarter and for the first six months of 2005.

The churn rate for Cingular’s postpaid customers was 1.5% in the second quarter and for the first six months of 2006, down from 1.8% in the second quarter and 1.9% for the first six months of 2005. The decline in postpaid churn reflects benefits from the acquisition of AT&T Wireless, including more affordable rate plans, broader network coverage, higher network quality, exclusive devices and free mobile-to-mobile calling among 57.3 million customers.

In June 2006, the Federal Communications Commission (FCC) increased the safe harbor for contributions to the Universal Service Fund (USF) by wireless carriers, which establishes a presumption that a specific percentage of a wireless carrier’s revenues are derived from providing interstate telecommunications services, and thus are subject to USF contributions. Cingular previously has contributed to the fund based on the wireless safe harbor, but likely will begin to contribute based on its actual interstate revenues in light of the increase in the wireless safe harbor. For additional information on the order, see our “Competitive and Regulatory Environment” section.

Cingular’s Operating Results

Our Cingular segment operating income margin was 11.0% in the second quarter and 10.0% for the first six months of 2006, which improved over margins of 5.9% in the second quarter and 3.7% for the first six months of 2005. The higher margin in 2006 was primarily due to revenue growth of $609 in the second quarter and $1,360 for the first six months.

AT&T INC.

JUNE 30, 2006

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued

Dollars in millions except per share amounts

Service revenues are comprised of local voice and data services, roaming, long-distance and other revenue. Service revenues increased $576, or 7.5%, in the second quarter and $1,162, or 7.7%, for the first six months of 2006 and consisted of:

•

Local voice revenues increased $295, or 4.7%, in the second quarter and $634, or 5.1%, for the first six months, primarily due to an increase in Cingular’s average number of wireless customers of 11.3% in the second quarter and 10.9% for the first six months, partially offset by a decline in local service ARPU of 5.9%.

•

Data service revenues increased $335, or 51.2%, in the second quarter and $638, or 52.1%, for the first six months, due to an increase of nearly 40.0% in average data revenue per customer and increased use of text messaging and internet access services. Data service revenues represented 10.7% of Cingular’s total revenues in the second quarter and 10.2% for the first six months.

•

Roaming revenues from Cingular customers and other wireless carriers for use of Cingular’s network decreased $70, or 12.3%, in the second quarter and $102, or 9.9%, for the first six months.

•

Long-distance and other revenue increased $16, or 8.8%, in the second quarter primarily as a result of increased international long distance usage and decreased $8, or 2.1%, for the first six months primarily due to a decline in property management fees, which were partially offset by increased international and domestic long-distance usage.

Equipment revenues increased $33, or 3.7%, in the second quarter and $198, or 11.6%, for the first six months of 2006 due to increased handset revenues as a result of higher priced handsets and increases in upgrades by existing customers, partially offset by a decline in gross prepaid customer additions.

Cost of services and equipment sales expenses increased $323, or 9.2%, in the second quarter and $531, or 7.6%, for the first six months of 2006 primarily due to increases in network usage and associated network system expansion.

Cost of services increased $204, or 8.9%, in the second quarter and $380, or 8.6%, for the first six months of 2006 primarily due to the following:

•

Increases in network usage with an increase in minutes of use of 19.2% in the second quarter and 20.9% for the first six months.

•

Higher roaming and long-distance costs were partially offset by a decline in reseller expenses. The reseller decrease resulted from a decrease in minutes of use on the T-Mobile network of 49.0% in the second quarter and 46.0% for the first six months.

Equipment sales expense increased by $119, or 9.7%, in the second quarter and $151, or 6.0%, for the first six months of 2006 due to handset unit sales (including upgrades) associated with an increase in the average cost per unit sold of about 2 to 7 percent in the second quarter and 5 to 13 percent for the first six months, partially offset by a decline in gross prepaid customer additions. Total equipment costs continue to be higher than equipment revenues due to Cingular’s sale of handsets below cost, through direct sales sources, to customers who committed to one-year or two-year contracts or in connection with other promotions.

Selling, general and administrative expenses decreased $196, or 6.6%, in the second quarter and $351, or 5.9%, for the first six months of 2006 due to decreases in general and administrative expenses of $139, or 8.3%, in the second quarter and $262, or 7.7%, for the first six months, as well as selling expenses of $57, or 4.5%, in the second quarter and $89, or 3.5%, for the first six months.

Decreases in selling, general and administrative expenses were primarily due to the following:

•

Billing, bad debt and other customer maintenance expense decreased $92 in the second quarter and $119 for the first six months primarily due to fewer account write-offs and cost savings related to transitioning to one billing system, partially offset by an increase in equipment maintenance expenses.

•

Selling expense decreased $57 in the second quarter and $89 for the first six months mainly from declines in commissions (including a decline in agent subsidies), marketing and advertising costs.

AT&T INC.

JUNE 30, 2006

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued

Dollars in millions except per share amounts

•

Customer service expenses decreased $41 in the second quarter and $87 for the first six months of 2006 due to a decline in employee-related expenses associated with Cingular’s reduced headcount and a decline in the number of call center outsourced professional services.

•

Other administrative expenses decreased $30 in the second quarter and $80 for the first six months of 2006 due to a decline in employee costs and employee-related benefits due to a decrease in headcount and an accrued federal excise tax refund.

Depreciation and amortization expenses decreased $31, or 1.9%, in the second quarter and $26, or 0.8%, for the first six months of 2006. Depreciation expense increased $89, or 7.6%, in the second quarter and $235, or 10.0%, for the first six months of 2006, primarily due to depreciation associated with the property, plant and equipment related to Cingular’s ongoing capital spending associated with its GSM network. Additionally, depreciation expense increased due to accelerated depreciation on certain TDMA network assets based on Cingular’s projected transition of network traffic to GSM technology and accelerated depreciation on certain other network assets. Substantially all of Cingular’s TDMA assets are anticipated to be fully depreciated by the end of 2007.

Amortization expense decreased $120, or 26.1%, in the second quarter and $261, or 27.0%, for the first six months of 2006 primarily due to declining amortization of the AT&T Wireless customer contracts and other intangible assets acquired, which are amortized using the sum of the months digits method of amortization.

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Segment Results

Second Quarter

Six-Month Period

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