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Business Context and Reporting Period

This Form 10-Q covers SBC Communications Inc. for the quarterly and six-month periods ended June 30, 2004. SBC operates in the communications services industry, providing wireline and wireless telecommunications services, directory advertising, and publishing services. The company manages five reportable segments: Wireline, Cingular (wireless joint venture), Directory, International, and Other. At July 30, 2004, there were approximately 3.31 billion common shares outstanding.

Key Financial Metrics

Note: The 2003 Net Income and EPS figures include a significant cumulative effect of accounting changes ($2,541 million net of tax) related to FAS 143 and directory accounting method changes, which are not present in 2004 results.

Material Changes vs. Prior Period

• Revenue: Operating revenues increased 0.8% in Q2 2004 compared to Q2 2003, driven by growth in Data (+9.5%) and Long-distance voice (+33.2%). However, Voice revenues declined 6.5% due to the loss of retail access lines to competitors utilizing UNE-P (Unbundled Network Element-Platform) rules.
• Operating Income: Declined 14.6% in Q2 2004 and 16.3% for the six-month period. This was primarily caused by the loss of voice revenues and increased expenses related to strike preparation and labor settlements (approx. $263 million charge in Q2).
• Net Income: Decreased 15.9% in Q2 2004. The six-month decrease of 51.4% is largely attributable to the one-time accounting gains recorded in the first half of 2003.
• Segment Performance:
  • Wireline: Operating income fell 8.8% in Q2 due to access line losses and labor costs.
  • Cingular: Operating income fell 10.1% in Q2 due to higher expenses from network upgrades, handset subsidies, and redundant network operations (GSM/TDMA), despite a 10.6% increase in customer base.
  • Directory: Operating income declined slightly (2.4%) due to lower demand for Yellow Pages advertising.
  • International: Equity in net income of affiliates decreased 31.0% in Q2 but increased 83.2% for the six months, driven by a gain on the sale of Belgacom interest by TDC.
• Dispositions: SBC sold portions of its stakes in TDC (Danish telecom) and Telkom (South African telecom) in June 2004, resulting in net losses of $191 million and $68 million respectively, but generating significant cash proceeds.

Guidance, Outlook, and Risks

• Outlook: Management expects combined net pension and postretirement costs for 2004 to range between $1,000 million and $1,400 million. Capital spending for 2004 is expected to be between $5,000 million and $5,500 million (excluding Cingular).
• Strategic Initiatives:
  • Cingular Acquisition: Cingular is acquiring AT&T Wireless for approximately $41,000 million. SBC expects to contribute $25,000 million. The transaction is subject to regulatory approval and expected to close in 2004.
  • Fiber Strategy: Announced a potential $4,000 million to $6,000 million investment over five years to deploy fiber networks for digital TV, broadband, and VoIP.
  • Directory Sale: Agreed to sell its Illinois and northwest Indiana directory business to R.H. Donnelley for $1,450 million, expecting a net gain of $1,350 million in Q3 2004.
• Risks and Contingencies:
  • Regulatory Environment: Significant uncertainty remains regarding UNE-P rates and unbundling rules following a D.C. Circuit court decision overturning FCC rules. State commissions are still adjusting rates, which may remain below cost.
  • Competition: Continued loss of retail access lines to competitors and alternative technologies (cable, wireless, VoIP).
  • Labor: New five-year contracts with CWA and IBEW unions were ratified, impacting future benefit costs.
  • Accounting Changes: Restatement of Q1 2004 results due to FSP FAS 106-2 regarding the Medicare Act, though the impact was immaterial ($11 million).

Investor Verification Checklist

• UNE-P Impact: Verify the extent of retail access line losses and the effectiveness of new commercial agreements with competitors following the D.C. Circuit ruling.
• Cingular Merger: Monitor regulatory approval status for the AT&T Wireless acquisition and the associated $25 billion funding requirement.
• Directory Sale: Confirm the closing of the Illinois directory sale to R.H. Donnelley and the recognition of the expected $1.35 billion gain in Q3.
• Pension Costs: Track actual pension and postretirement costs against the $1,000-$1,400 million guidance, particularly regarding investment returns and medical cost trends.
• Capital Expenditures: Assess whether the announced fiber strategy will lead to capital spending exceeding the current $5.0-$5.5 billion guidance.