AT&T and Verizon Research From Morgan Stanley, Morningstar, Citibank Research and Credit Suisse

2010 Headwinds to Outpace Sizeable Deal Synergies

Investment conclusion: Overall, we do not anticipate earnings growth for 2010. Indeed, the fact that management sees few signs of economic recovery yet its 2010 plan hinges on a macro turnaround in 2H 2010 raises concerns. This is especially true for its wireline segment where an improvement in business activity is key given the profitability pressure coming from FiOS. That said, cost cutting initiatives, particularly the 13K
workforce reductions announced for 2010, along with a more measured FiOS expansion should lower wireline opex and mitigate part of the pressure. In wireless, the handset line-up (Droid, Palm Pre and Pixi, Nexus One this Spring) should help accelerate smartphone adoption and boost top line growth but may impact profitability in the short term given higher related subsidies/marketing costs. The sizeable Alltel synergies ($1B to $1.1B), however, should offset margin pressure. Positively, we were encouraged to hear the $16.8B to
$17.2B capex guidance, which could eventually come down once all the divestitures/spin-offs take place.

What's new: 4Q EPS came in-line with us and consensus. It excluded $0.77 from various items, the largest was a $3B (or $0.66 cent) charge related to workforce reductions, ~$850M of which were cash severance. We lowered ‘10 EPS to $2.36 from $2.43; we do not include 11 cents in spin-off/divestiture pressure. Where we differ: We have an Attractive rating on the Telecom sector in part due to attractive valuations, particularly dividend yields. While Verizon yields 6.4%, well above its bond yield, we currently rate the stock Equal-weight because of concerns about pressure on 2010 estimates from pension and divestiture pressure, slowing wireless business, and risks from the transition from CDMA to LTE. Lastly, we think Apple’s choice not
to produce a CDMA iPad lowers the chances of a Verizon iPhone this year.


What’s Next: (1) Closing of the two deals involving Alltel divestitures (one with AT&T and one with Atlantic Tele
Networks); (2) Regulatory approval for the divestiture of lines to Frontier; (3) VZ’s 10K filing later in Feb should
provide more color into pension/OPEB funding. [morgan stanley]

Wireline Revenue Pressures May Ease Heading Into 2010

While we expect significant wireline revenue headwinds to continue from secular and competitive pressures in FY10, we are encouraged by 4Q results that showed an easing in sequential revenue pressures with fewer quarterly lines lost, a slower rate of Global Business revenue, and the expansion of its marketed footprint for U-verse. We believe a stabilization or improvement in employment levels can provide upside potential to our expectations as soon as 2H/10.

Wireline results were solid in 4Q, as revenue of $16.16 million was better than our estimate of $15.90 million on stable access line losses at roughly (9.8%) yoy, which remained in the (9.7%)-(10.0%) range for the fourth consecutive quarter. Revenue showed signs of sequential improvement, as the rate of revenue erosion for AT&T Business Solutions slowed to a sequential drop of 40 bps vs. the last three quarters with sequential declines that ranged between (1.1%) and (2.8%). We still expect business revenue trends to lag employment levels by roughly 6 months, while we find the potential stabilization of employment levels as an encouraging first step towards a business revenue recovery within the telecom sector. We anticipate a slower revenue burn of around 4% during 2010 within the Global Business segment that could have
upside potential in a recovering employment scenario.

Consumer trends were also encouraging as the unit losses in residential primary connections improved on a year-over-year basis for the third
consecutive quarter, suggesting that the peak of share loss to cable and wireless may have passed. Slowing rates of unit loss coupled with some ARPU improvements partly from U-Verse sales helped to slow the yoy rate of residential revenue erosion to (3.7%). Broadband net adds of 151k were light of our forecast of 225k, while U-Verse video was in-line at 248k versus our estimate at 250k. AT&T is still tracking toward rolling out U-Verse to 30 million homes by year-end'11, which carry a 90% broadband attach rate and 70% voice attach rate. Currently, U-Verse is at only 13% penetration and is averaging 20% in regions covered for 24-months or more.[citibank research]

The iPhone has benefited AT&T, but also adds uncertainty.

AT&T has performed relatively well over the past year in the face of economic pressure. Though consumers are
cutting fixed-line phone service as quickly as ever and business spending on telecom services is down sharply,
the firm has done a great job cutting costs to support margins and cash flow. The iPhone also continues to drive
growth in the wireless business. If the economy picks up, the next year or so could be solid for AT&T. Over the
longer term, however, we still have concerns.

AT&T's wireless unit, the firm's largest segment at 45% of sales, is its most attractive business. With Sprint Nextel continuing to struggle, AT&T and Verizon Wireless have emerged as the two firms with the financial resources and scale needed to dominate the industry. Management has done a good job over the past couple years of capitalizing
on the wireless unit's position, driving improvements in customer service, cutting costs, and securing exclusive rights to several phones, most notably Apple's iPhone. The results have been impressive, in our view. AT&T can now
boast that its postpaid customer base is nearly as loyal as Verizon Wireless', long the industry's distant leader. AT&T has also been able to steadily add higher-end customers, allowing average revenue per customer to grow, something Verizon Wireless can't claim. High phone subsidies have hit costs, especially around the launch of new iPhone models, but with efficiencies gained elsewhere in the business, margins have remained solid.

We see some problems with AT&T's position. The iPhone is now extremely important to the firm, with around one in five of its postpaid customers using the device. IPhone exclusivity will eventually end, and some customers, dissatisfied with the performance of AT&T's network under the strain of the data-hungry device, may flee to other carriers. AT&T is investing heavily in its wireless network to add data capacity, but these efforts point to another tricky issue, in our view. Right now, voice and text messaging services still provide the majority of revenue,
but smaller competitors, such as MetroPCS and Leap, have been cutting prices aggressively. Pricing for these services should naturally decline over time, in our view, with data services picking up the slack. Right now, though, the wireless industry is training customers to expect unlimited data service for around $30 per month. If voice pricing continues to fall and data pricing doesn't rise, AT&T will likely struggle to maintain wireless profitability.


Within the fixed-line business, we believe the firm enjoys a strong position in the business services market. The reach of AT&T's fixed-line networks is unmatched in the United States, and it has made a handful of niche acquisitions recently to augment its business service offerings. At the high end of this market, very few competitors can meet customer needs as well. We believe the cable companies won't be able to fully match AT&T's capabilities anytime soon and will be confined to the lower end of the market. AT&T's residential fixed-line business isn't as attractive, in our view. Though this business gets a lot of attention, it only accounts for about
a fifth of sales. Adding wireless service to the bundle will help, but we're still skeptical of this unit's ability to retain consumer customers, given the scale of customer losses the firm has already endured.[morning star research]

4Q09 Earnings: Reaction

■What is new: Guidance commentary mostly positive: We think the EPS “goal” is $2.22 -$2.24. Lindner suggested they could beat their plan by
$0.10 - $0.12 “with some very good execution on the cost side”. Working from a base of flat, it suggests EPS of $2.22 to $2.24. We think this
assumes a modest recovery in employment in 2H10, with upside if the economy snaps back faster than expected. Given that $0.05 of the increase should come from a pension tailwind, this does not seem like a stretch. We came in slightly below this range at $2.19 because we are not ready to bake a recovery in employment into our estimates yet.
■ FCF guidance was a little more disappointing at $13 - $13.5BN (“flat with 2008”). There are some impacts to cash from ops that are hard to predict,
like deferred tax and working cap swings; however, we cant get there – we are coming in higher at $14.1BN ($2.38 / share).
■ Impact to thesis: None yet. We acknowledged last night that there may be less risk to expectations than we previously thought. We are working to quantify the risk so that we can determine whether the change warrants a
shift in the thesis.
■Stock reaction: Not a ton of upside without a move in the group multiple.
Positives: AT&T should see a couple of benefits: 1) Apple / iPad / network
comments should ease a major overhang; 2) EPS revisions should be
relatively modest (consensus was $2.22 before the call; will likely end up at
$2.20 - $2.22). Offsetting this: 1) AT&T trades at a multiple point discount to
VZ on 2010E PE (perhaps with slightly more conservative assumptions), but
at a multiple point premium on FCF (with a FCF est. that is above guidance).
AT&T certainly has better EPS trends into 2010; however, while [credit suisse]
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