Why did reported net income rise so sharply in 2010 while operating income declined?

Net income was boosted by an $8.3 billion income tax benefit from a September 2010 settlement with the IRS over the tax basis of assets from a 2008 wireless restructuring, which reduced income tax expense to a benefit of $1.2 billion. Operating income fell 6.8% to $19.6 billion, partly due to a $2.5 billion pension and postretirement actuarial loss. Investors should treat the tax benefit as non-recurring when evaluating earnings power.

How is AT&T's new pension accounting change expected to affect future reported results?

In January 2011, AT&T elected to recognize actuarial gains and losses immediately in operating results rather than amortizing them over time through equity. This increases earnings volatility, since these gains and losses are generally measured at year-end and recorded in the fourth quarter. The company applied the change retrospectively, so prior-period figures are restated, but future operating income will swing with market returns and discount rate changes.

Is AT&T's wireline business still a viable growth area?

The wireline voice business continues to decline, with voice revenue down 12.4% in 2010 as access lines fell 11.6%. However, wireline data revenue grew 7.5%, driven by IP data services, U-verse, and business services, and about 70% of data customers had migrated to IP-based services. Management expects continued access line losses in 2011 and is relying on bundling and data growth to offset them, so wireline is best viewed as a stabilizing data business rather than a growth segment.

What are the main risks to AT&T's wireless growth thesis?

Key risks include industry saturation that moderates customer growth, rising handset subsidy and equipment costs tied to integrated device sales, and pressure on voice ARPU (down 8.6% in 2010). Competition from Verizon Wireless, Sprint, T-Mobile and regional carriers remains intense, and management expects the expiration of some handset exclusivity arrangements could raise churn. Continued access to additional spectrum, including the pending Qualcomm purchase, is also critical to sustaining network quality.

How strong is AT&T's balance sheet and capital return capacity?

Total debt declined to $66.2 billion from $72.1 billion, and the debt ratio improved to 37.1% from 41.4%. Cash and equivalents were $1.4 billion at year-end, and the company holds a $5.0 billion four-year and $3.0 billion 364-day revolving credit facility, both undrawn. Management plans to fund 2011 dividends, debt repayment and potential share repurchases primarily from operating cash flow and debt issuance.

AT&T INC. 10-K Filed Mar 1, 2011

01—Abstract

Summary

Summary of the 10-K filed March 1, 2011. Cited figures are marked; the original filing is the authoritative source.

AT&T's 2010 10-K shows a company whose top-line growth is coming from wireless data and IP-based wireline services, while its legacy voice business continues to shrink.

Operating revenues rose 1.4% to $124.3 billion^a, driven by wireless service revenue (up 10.2%) and wireline data (up 7.5%), offsetting a 12.4% decline in wireline voice revenue. Reported operating income fell 6.8% to $19.6 billion, but that comparison is distorted by a new pension accounting policy adopted in January 2011 that immediately recognizes actuarial gains and losses in operating results; the $2.5 billion actuarial loss in 2010 weighed on reported operating income. Net income attributable to AT&T rose 63.7% to $19.9 billion, boosted largely by an $8.3 billion income tax benefit from a 2010 IRS settlement on wireless restructuring, so the earnings jump should not be read as a run-rate improvement.

Balance sheet and cash flow remain the core of the investment case. Operating cash flow was $35.0 billion^b and capital expenditures were $19.5 billion, leaving substantial free cash flow to fund dividends of $9.9 billion. Total debt fell to $66.2 billion from $72.1 billion, and the debt ratio improved to 37.1% from 41.4%.

Management guided to 2011 capex in the low-to-mid $19 billion^c range, a $1.9 billion Lower 700 MHz spectrum purchase from Qualcomm, a dividend increase to $0.43 per quarter, and a new authorization to repurchase up to 300 million shares. Key risks flagged include continued access line losses (total switched lines down 11.6%), pricing pressure in wireless as the industry matures, U-verse deployment and municipal franchise disputes, and evolving FCC net neutrality and universal service rules.

For investors, the main questions are whether wireless data growth can keep offsetting wireline erosion and whether margins stabilize as subsidized smartphone and integrated device costs rise. The company's 2011 outlook calls for revenue growth and an improved operating margin, but management also cautioned that a weak economy could pressure pricing and margins further.

02—Key points

Key Highlights

Operating revenues grew 1.4% to $124.3 billion, led by wireless service revenue (+10.2% to $53.5 billion) and wireline data revenue (+7.5% to $27.5 billion), partly offset by a 12.4% decline in wireline voice revenue.
Net income attributable to AT&T rose 63.7% to $19.9 billion, but this was driven largely by an $8.3 billion income tax benefit from a 2010 IRS settlement rather than underlying operating improvement.
Reported operating income fell 6.8% to $19.6 billion, with operating margin at 15.7% versus 17.1% in 2009, reflecting a $2.5 billion non-cash pension and postretirement actuarial loss.
Wireless remains the growth engine: 95.5 million customers, 8.9 million net additions, churn improved to 1.31%, and the Wireless segment generated 67% of 2010 total segment income.
Wireline faces structural pressure, with total switched access lines down 11.6% to 43.7 million, though U-verse video customers grew 44.6% to about 3.0 million.
Free cash flow was strong: operating cash flow of $35.0 billion against $19.5 billion of capital expenditures, supporting $9.9 billion in dividends and a debt reduction of about $5.9 billion.
Management plans a $1.9 billion Lower 700 MHz spectrum purchase from Qualcomm, guides 2011 capex to the low-to-mid $19 billion range, raises the quarterly dividend to $0.43, and authorizes up to 300 million share repurchases.

03—Questions

Frequently Asked Questions

Why did reported net income rise so sharply in 2010 while operating income declined?
Net income was boosted by an $8.3 billion income tax benefit from a September 2010 settlement with the IRS over the tax basis of assets from a 2008 wireless restructuring, which reduced income tax expense to a benefit of $1.2 billion. Operating income fell 6.8% to $19.6 billion, partly due to a $2.5 billion pension and postretirement actuarial loss. Investors should treat the tax benefit as non-recurring when evaluating earnings power.
How is AT&T's new pension accounting change expected to affect future reported results?
In January 2011, AT&T elected to recognize actuarial gains and losses immediately in operating results rather than amortizing them over time through equity. This increases earnings volatility, since these gains and losses are generally measured at year-end and recorded in the fourth quarter. The company applied the change retrospectively, so prior-period figures are restated, but future operating income will swing with market returns and discount rate changes.
Is AT&T's wireline business still a viable growth area?
The wireline voice business continues to decline, with voice revenue down 12.4% in 2010 as access lines fell 11.6%. However, wireline data revenue grew 7.5%, driven by IP data services, U-verse, and business services, and about 70% of data customers had migrated to IP-based services. Management expects continued access line losses in 2011 and is relying on bundling and data growth to offset them, so wireline is best viewed as a stabilizing data business rather than a growth segment.
What are the main risks to AT&T's wireless growth thesis?
Key risks include industry saturation that moderates customer growth, rising handset subsidy and equipment costs tied to integrated device sales, and pressure on voice ARPU (down 8.6% in 2010). Competition from Verizon Wireless, Sprint, T-Mobile and regional carriers remains intense, and management expects the expiration of some handset exclusivity arrangements could raise churn. Continued access to additional spectrum, including the pending Qualcomm purchase, is also critical to sustaining network quality.
How strong is AT&T's balance sheet and capital return capacity?
Total debt declined to $66.2 billion from $72.1 billion, and the debt ratio improved to 37.1% from 41.4%. Cash and equivalents were $1.4 billion at year-end, and the company holds a $5.0 billion four-year and $3.0 billion 364-day revolving credit facility, both undrawn. Management plans to fund 2011 dividends, debt repayment and potential share repurchases primarily from operating cash flow and debt issuance.

04—Continue

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