AT&T's Troubling Trends

The company logged big gains thanks to Apple iPhone sales, but customers are disconnecting local lines quickly and broadband growth slowed

At first glance, third-quarter results from telecom giant AT&T (T) appear strong. The Dallas-based phone service provider posted net income of $3.23 billion, or 55¢ a share, a 5.5% increase from $3.06 billion, or 50¢ a share, a year earlier. Revenue gained 4%, to $31.3 billion, led by a notable 15.4% increase in wireless sales. To boot, the wireless business logged a whopping 2 million net new customers, giving AT&T nearly 75 million subscribers nationwide.

But troubling signals lie just beneath the surface. Customers are disconnecting phone lines at an alarming rate. Too few are signing on for broadband connections, and though the number of new wireless subscribers is impressive, AT&T's wireless margins are getting squeezed. All of this comes in the face of a weakening economic outlook that's forcing consumers to cut household budgets and banks to rein in lending. Worried shareholders traded AT&T stock down 7.6%, to about 23.78, after the results were released on Oct. 22. "The market is telling you there is a lot of risk out there for AT&T," says Timothy Horan, an analyst for Oppenheimer & Co.

And what's risky for AT&T may prove just as ominous for the rest of the telecom sector. Analysts expect Verizon Communications (VZ), Sprint (S), and other phone service providers to show similar signs of weakness when they report results in the coming days. In fact, AT&T is something of a proxy for the broader economy. As a huge provider of services to major businesses, AT&T's customer list contains businesses of every stripe. It is instructive that the carrier's enterprise services unit saw sales dip 1.4% from a year ago. "That is troubling as you head into the teeth of the recession," says Sanford C. Bernstein analyst Craig Moffett, who adds that the view of AT&T's financial future right now is "as clear as mud."

Existing strains in AT&T's local-phone business were accentuated in the third quarter. The number of consumer voice lines in service fell 10.5%, to 28.33 million, from a year ago. Things are not much better in the broadband arena. Last year at this time, AT&T added nearly 500,000 digital subscriber lines. This year, it added 148,000, a decline of more than 70%. "These are obviously challenging times," AT&T Chief Financial Officer Rick Lindner said on an Oct. 22 conference call with analysts.

Trying TV

AT&T's strategy is to offset declines in AT&T's land-line business by feverishly marketing U-verse, the Internet-based television service. Some of the loss in basic phone service is no doubt going to AT&T's cable rivals. And only a robust TV offering of its own can help AT&T even the score. To that end, the carrier added 232,000 U-verse TV subscribers, up from 170,000 in the second quarter.

Lindner held to a pledge that AT&T will end the year with more than 1 million U-verse customers. That's still a sliver of the almost 95 million cable subscribers AT&T is competing for. So Lindner continues to count on AT&T's ace: wireless service. The wireless business generated $12.6 billion in revenue, led by sales of the new iPhone 3G. AT&T, the exclusive iPhone distributor in the U.S., began selling the updated Apple (AAPL) device in July. The company logged 2.4 million activations of the phone in the quarter. And the smartphone delivered high-value subscribers that helped boost wireless data revenue 50.5%, to $2.7 billion. "The iPhone 3G is having a strong impact," Ralph de la Vega, CEO of AT&T Mobility and Consumer Markets, told analysts on the call. He said consumer visits to stores rose 7% during a preholiday time when it's normally slow. "Traffic is encouraging, given the economic climate that we face," he said.

Even wireless sales carry a disadvantage. Because AT&T is heavily subsidizing its up-front purchase of Apple's iPhone, higher sales of the device actually cut earnings growth. Strong iPhone sales reduced adjusted profit by about 10¢ a share in the quarter, AT&T said. In the long run the company expects to recoup its up-front costs, as consumers pay relatively high monthly bills.

Increased Competition

Most analysts, however, say margin weakness was also the result of stiffening competition in the larger wireless market. Since the debut of the iPhone 3G, Sprint has been pushing the Samsung Instinct, Verizon Wireless has announced the BlackBerry Storm from Research In Motion (RIMM), and T-Mobile USA is poised to introduce a phone based on the Google (GOOG)-backed Android operating system. Furthermore, as the economy slows, "you wonder whether the iPhone runs any risk of tilting from being the next cool gadget to suddenly being a symbol of excess," says Moffett.

Lindner acknowledged last month that AT&T experienced some difficulty obtaining short-term loans to fund expenses. The company now says the problems were temporary. Still, he told analysts that the company would have access to cash flow and pay down debt—cautionary behavior, for sure. "It sounds like they are worried about the credit world if they are paying down debt," Horan says.

A sober Lindner appears to understand the challenges before his company and the entire telecom sector. "In this environment, it's prudent to be conservative…and preserve cash," he admits. But he's intent on bucking the odds by continuing to tap AT&T's prized relationships—namely the iPhone exclusive—to continue spurring growth.

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