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    connect AT&T INC. 2007 ANNUAL REPORT

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    Our Vision Connect people with their world, everywhere they live and work, and do it better than anyone else.

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    Randall Stephenson Chairman, Chief Executive Officer and President To AT&T Investors Connect. At AT&T, that’s what we do. Our industry is in the early stages of an unprecedented explosion in connectivity. The technologies that make it possible are That’s how we deliver for customers, becoming more pervasive, mobile and accessible. Customer demand for connectivity has increased dramatically. And it’s all drive growth and create value for playing out on a global scale. stockholders. We connect people with Against this backdrop, our industry’s growth potential has never been greater. people, information and entertainment. These industry dynamics have driven a major transformation of We connect businesses to customers, our company. We’ve added critical assets, scale, technical ability, new applications and expertise. We’ve also transformed AT&T into data and other businesses. We make a brand that stands for trust and reliability—as it always has—but communications simple, mobile that now also stands for mobility and innovation. As a result, today AT&T is one of the few companies prepared to deliver on the full and seamless. promise of this new era of global connectivity. 2007 AT&T Annual Report | 1 2007 AT&T Annual Report | 1

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    AT&T is led by proven executives with broad, diverse operational experience. They are the industry’s best. AT&T SENIOR OFFICERS Standing (left to right): Forrest Miller, Group President-Corporate Strategy and Development; John Stankey, Group President- Telecom Operations; Cathy Coughlin, Senior Executive Vice President and Global Marketing Officer; Randall Stephenson, Chairman, Chief Executive Officer and President; Ron Spears, Group President-Global Business Services; Jim Callaway, Senior Executive Vice President-Executive Operations. Sitting (left to right): Bill Blase Jr., Senior Executive Vice President-Human Resources; Rick Lindner, Senior Executive Vice President and Chief Financial Officer; Ray Wilkins Jr., Group President-Diversified Businesses; Jim Cicconi, Senior Executive Vice President-External and Legislative Affairs; Wayne Watts, Senior Executive Vice President and General Counsel; Ralph de la Vega, President and Chief Executive Officer-AT&T Mobility. A Strong 2007 A clear focus on our opportunities, combined with All of these achievements drove outstanding strong execution, helped make 2007 a terrific year for financial results: our company. Wireless growth accelerated as we added • Total revenues increased to nearly $119 billion. more than 9 million subscribers. Our enterprise business • Adjusted earnings per share grew at a strong executed a major turnaround, with enterprise service double-digit pace. revenues returning to growth in the second half of the year. We grew our business with small and midsize firms, • Cash from operating activities topped $34 billion, expanded our lead among U.S. broadband providers a record for our company. and began an aggressive ramp of our next-generation • Our total return for the year (stock price appreciation television service. plus dividends paid) was 20.6 percent—nearly four times the return of the S&P 500. Meanwhile, we exceeded our expense control targets as we integrated formerly separate operations to improve In December 2007, AT&T’s Board of Directors raised our performance. In fact, through mergers and other initiatives, quarterly dividend by 12.7 percent and approved a new we've saved more than $5 billion in operational costs over repurchase of 400 million shares—both the largest in the past two years. That operating cost advantage serves us our company’s history. These actions demonstrate our well in every market and economic condition. commitment to stockholders. And, in a time of some 2 | 2007 AT&T Annual Report

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    uncertainty and volatility in the global economy, they AT&T 2007 PRO FORMA also demonstrate the strength of our operations and CUSTOMER REVENUE MIX the confidence we have in the future of our business. Transformation in a Growth Industry Beyond our financial results, AT&T’s most important achievement has been to transform our company for industry leadership in four key areas. FIRST, we have built the United States’ largest wireless business while delivering the industry’s greatest improvement in wireless operating metrics. Just over three years ago, Cingular Wireless, in which we owned a majority stake, acquired AT&T Wireless. That acquisition gave Cingular nationwide coverage. Then the BellSouth acquisition gave us 100 percent ownership of Cingular. Today, AT&T operates the nation’s largest wireless digital voice and data network, with more than 70 million subscribers and the broadest international reach. 2007 AT&T Annual Report | 3

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    AT&T WIRELESS SUBSCRIBERS Over these same three years, we’ve delivered the industry’s largest improvement IN SERVICE in customer loyalty and led the industry in bringing innovative smartphones to Wireless subscribers have increased market, including collaborating with Apple on the highly successful, exclusive by nearly 43 percent since 2004. U.S. launch of their iPhone. In that time, we’ve also added more wireless subscribers than any other U.S. provider. In the process, we have positioned our company as the leader in defining the next generation of wireless products and services. SECOND, we have energized and expanded the industry’s premier enterprise business. Just over two years ago, our acquisition of the former AT&T Corp. gave us a world-class set of assets to serve large U.S. and multinational companies. In the second half of 2007, we saw enterprise service revenues return to growth a year ahead of plan, and we anticipate growth in overall enterprise revenues in 2008. We’ve invested in new capabilities and have executed well, and business customers have responded enthusiastically to the total range of innovative services we deliver with world-class reliability. And thanks to customer demand for more AT&T BROADBAND mobile communications, more Internet-based applications and expansive global SUBSCRIBERS IN SERVICE connectivity, we have additional growth opportunities in 2008 and beyond. AT&T is the No. 1 U.S. broadband provider. THIRD, we have greatly expanded broadband access to the Internet. Broadband is becoming the primary connection for linking consumers and businesses to entertainment and information. We lead the industry with more than 14 million broadband subscribers, and through the broadest U.S. Wi-Fi footprint, we’re making high speed Internet access mobile. And by the end of 2008, our Wi-Fi footprint will include more than 7,000 Starbucks locations in the U.S. Broadband usage is ramping. Customers are demanding higher speeds for such bandwidth-hungry applications as video. And there’s substantial growth potential ahead as we make broadband access increasingly seamless across wired and mobile devices. LAST, we are well under way with a major network transformation to build a seamless all-Internet Protocol (IP) infrastructure as the foundation EARNINGS PER SHARE for future growth. In a connectivity-driven world, IP is the future. It creates a AT&T has delivered 11 consecutive quarters of year-over-year platform for wired and wireless services that truly work together for our customers. double-digit growth in adjusted EPS. AT&T is building the fastest Internet backbone in the U.S., and we are the only major U.S. communications company deploying a pure, 100 percent IP video network. Our next-generation AT&T U-verseSM service—which delivers interactive TV, broadband and voice—ramped throughout 2007 to more than 231,000 TV customers. We expect to end 2008 with more than 1 million U-verse TV customers and to expand our network deployment to 30 million customer locations by the end of 2010. These major transformations form the foundation of AT&T’s future as an integrated wireless, wired, voice, data and video company that connects our customers to their world, everywhere they live and work. And we’ll do that better than anyone else. That’s because at every level—local, national, global—we’ve shaped ourselves around meeting our customers’ total needs. We’ve built a company around our customers. That’s the new AT&T. 4 | 2007 AT&T Annual Report

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    This couldn’t be a more exciting time to lead our company, as we move forward in an environment in which our scale, resources and commitment to financial discipline are critical strengths. Connecting With Communities Our vision of connecting people also shapes our role to lead the more than 300,000 talented men and women as a corporate citizen. For us, corporate citizenship who are the heart and hands of our company. begins with investing in our own employees. We’re In June 2007, Edward E. Whitacre Jr. retired after serving proud to work with unions like the Communications as our company’s chairman and chief executive officer Workers of America and International Brotherhood for more than 17 years. Ed Whitacre led our company of Electrical Workers to create and preserve jobs with great integrity, vision and wisdom. As the architect that pay well and have good benefits and ample of the new AT&T, he transformed our business and, in opportunities for training and advancement. the process, an entire industry. On behalf of our Board We also work hard to strengthen our communities of Directors and employees, we thank Ed for his and help sustain the world we all share. Going forward, many contributions. we’ll be placing an even sharper focus on supporting Most of all, I want to thank you, our stockholders, for your education and workforce readiness. Alarming high confidence. We have rich opportunities ahead of us—and school dropout rates in the United States threaten the I look forward to reporting to you on our continuing nation’s economic vitality. As America’s parents, progress. There’s much, much more to come. teachers, administrators and community leaders continue to do their part, we believe that it’s important Sincerely, for businesses to step up, too. And we will. The AT&T Team This couldn’t be a more exciting time to lead our company, as we move forward in an environment in which our scale, Randall Stephenson resources and commitment to financial discipline are Chairman, Chief Executive Officer and President critical strengths. February 8, 2008 It’s an environment that puts a premium on having an outstanding employee team. AT&T is led by proven executives with broad, diverse operational experience. They are the industry’s best, and together we are honored 2007 AT&T Annual Report | 5

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    The Desire to Connect 6 |62007 | 2007 AT&T Annual AT&T Report Annual Report

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    AT&T isn’t just prepared for the future of connectivity. We’re shaping and defining it. Our global IP networks connect people across all three screens they rely on— the mobile handset, the PC and the TV. The Desire to Connect … So, What’s Internet Protocol? It’s a fundamental human need. Connectivity improves our Imagine how much simpler, clearer and more effective quality of life. It accelerates the velocity of commerce and human communications would be if everyone spoke the ideas. It drives prosperity and strength for individuals, same language. In the digital world, Internet Protocol—IP companies and nations. It defines AT&T’s business—as we for short—is that one, common language. IP-based help families keep in touch and as we help businesses connectivity enables everything from laptops to televisions serve their customers down the street and in far-flung to ATM machines, and it helps people and businesses overseas markets. communicate seamlessly, easily and accurately across town or around the world. Today, technology has magnified and globalized the human desire to share information. The demand for connectivity To deliver on the great promise of IP, we are well under continues to grow swiftly. And few companies in the world way with the transformation of our wireless and wired can meet that need on a global scale as effectively as AT&T. networks. We’re using IP to extend our ability to connect and power the latest generation of communications Our business network connects more than 160 countries. applications. As we drive IP technology through our We power 32 of the world’s top 100 Web destinations. networks, we can make communications more seamless, Our network handles two-thirds of the credit and debit more interactive and more mobile. card transactions in the United States. And we’re staying ahead of the evolution of personal and business connectivity We’re also adding more bandwidth to stay ahead of rapidly by building the world’s most extensive IP backbone. expanding customer needs. IP traffic on our backbone network has more than doubled in the past two years. We More than 1 billion devices worldwide connect to our are deploying the world’s largest next-generation network, network. And that number will only grow. But the real which carries traffic at four times the speed of previous magic is in the expanding array of applications we can connections. Continued growth of this network will give deliver through those connections. That’s the future us the capacity to meet customer expectations for years of connectivity. to come. 2007 AT&T Annual Report | 7

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    Wireless Our wireless capabilities play a critical role in delivering on the promise of mobility for our customers. As a result, wireless is now our fastest-growing and largest revenue driver, accounting for nearly 36 percent of our company’s total revenue. Customers use mobile devices to surf the Internet, monitor business operations while on the road and access video through a wireless Internet connection. In all of these ways and more, we give customers the freedom to choose when, where and how they communicate. To that end, we are focused on three key areas in our wireless business. FIRST, we continue to expand and improve our networks. We offer the United States’ largest digital voice and data network, covering 290 million people. We offer the most open and widely available wireless technology, GSM, which is used by 2.7 billion people around the world. And we offer the largest international roaming footprint of any U.S. carrier. Today, we’re taking the industry’s most expansive and capable network and making it faster as we aggressively expand our third-generation, or 3G, network to deliver downlink speeds of between 600 and 1,400 kilobits per second. By the end of 2008, this high-velocity 3G capability Because we use GSM wireless will be available in nearly 350 major U.S. metropolitan technology, the world standard, our customers can seamlessly areas, including all of the nation’s 100 largest cities. connect from locations in more than 200 countries, including London’s Heathrow Airport. We’re reshaping our entire business to meet the rising customer demand for mobility—to make our wireless, broadband, TV and local search capabilities work together for people at home, at work and on the go. 8 |82007 | 2007 AT&T AT&T Annual Annual Report Report

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    WIRELESS DATA TRAFFIC Wireless data traffic is growing exponentially, with usage quadrupling every year. 2007 AT&T Annual Report | 9

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    Text Messaging—The “Native Tongue” of Today’s Teens … But more and more adults are catching on as well. Take Janet Sturley. Thanks to her houseful of teenagers— 19-year-old Ryan, 17-year-old Mark and 13-year-old Paige—she’s now fluent in this mobile language. “We’ll be waiting for a table at a restaurant, and I’ll look over Ralph de la Vega shows off the and see all three of them on their phones,” said Janet. “It’s features of an AT&T smartphone at an AT&T Experience Store. amazing—they can fill any downtime with texting.” Paige alone sends about 2,000 text messages a month. So, Janet signed up for an unlimited text-messaging plan last fall and now sends text messages to keep tabs on her teens. SECOND, as we build a great network, we’re also building upon our history of industry-leading innovation to put “If Ryan is spending the night with a friend, he sends me a together the best lineup of wireless devices we’ve ever text message rather than calling,” said Janet. “That way I’m offered. Our launch with Apple of their iPhone is a classic not awakened at odd hours of the night, but I can check success story of an alliance between two of the world’s my phone at any time and know where he is.” leading technology firms. The iPhone’s success also raised Her kids like texting because the messages are short and the profile for our expanding array of smartphones, which direct and can be sent when a phone call isn’t convenient. customers can use to send e-mail, access the Internet, get directions, take pictures, download video and music “If I’m at a friend’s house and I’m bored, I’ll go into another and play games. room and text my mom to come and get me,” said Paige. “Or, if I don’t want to go somewhere, I can just text ‘No, I THIRD, for both business customers and consumers, we’re can’t’ to the person who invited me instead of having to focused on improving the customer experience. We’ve make up an excuse. That way, nobody’s feelings get hurt.” made it easier than ever for customers to do business with us. Our 2,200 AT&T retail locations, our always-open online Texting helps keep the Sturley family connected. And for store (att.com) and our relationships with retailers such as Janet, it’s a comfort to know that, even as her kids grow Wal-Mart, Best Buy and RadioShack give us an unmatched up and move out of the house, it won’t be “goodbye”— ability to place our products into customers’ hands. it’ll just be “ttyl.” That’s textspeak for “talk to you later.” And that lineup now includes a growing number of AT&T ExperienceSM stores. They bring the concept of mobility to life, giving people the chance to learn firsthand how our products—wired and wireless—work together to connect customers to their world. 1010| 2007 | 2007AT&T AT&T Annual Annual Report Report

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    Brian Norwood Has Never Camped Out for Anything in His Life Not for concert tickets. Not for sporting events. And certainly not for a new phone. But when the 36-year-old Atlanta native heard about the world’s most advanced mobile phone, he wanted to be a part of history. Like many others, he instinctively knew that the iPhone was going to help change his life. First, Brian switched his carrier to AT&T because the company was the only U.S. provider of the iPhone. He asked his boss for four days off at the end of June. In 2007, through strong internal Then, just a few days before the launch, he bought a folding chair, packed a cooler of food, grabbed a stack growth combined with strategic of magazines and headed for an AT&T store in midtown Atlanta. When the doors swung open at 6 p.m. June 29, Brian—who endured rain, 48 hours with little sleep acquisitions, we expanded our and a news media onslaught—was among the first Americans to get his revolutionary new mobile phone. subscriber base by more than In the first 30 hours of sales, customers like Brian activated 9 million. 146,000 iPhones. By the end of 2007, approximately 2 million U.S. consumers were enjoying a groundbreaking As the largest provider of prepaid mobile phones, we’re mobile experience on a brilliant screen with a simple flick also expanding access to mobility to consumers who of their finger. might not want—or can’t afford—an ongoing service plan. “Surfing the net on a phone with a full browser has been In 2007, through strong internal growth combined with unlike any other portable Web experience,” Brian said. strategic acquisitions, we expanded our subscriber base “The calendar contains my life. I love calling up maps and by more than 9 million. And, as we’ve enhanced network directions when I’m lost while driving, and I’m constantly performance and introduced more data-capable devices, taking photos. It’s been so great, I decided to spread the the revenues have followed. Our service revenues were iPhone love by buying one for my dad—and I’m saving up nearly 15 percent in 2007, and our annual data revenue up to buy one for my mom!” growth exceeded 63 percent. June 29, 2007. It didn’t just change Brian Norwood’s day-to-day life. It helped AT&T change the game—and the face of an industry. 2007 AT&T Annual Report | 11

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    Broadband and Advanced TV Our customers demand fast broadband connections to the Internet wherever they go. That’s why, at AT&T, we’re all about finding new ways to help customers access the Internet with speed, reliability and performance. And it’s why we’re the United States’ No. 1 broadband provider, with 14.2 million subscribers. Broadband subscribers, revenues and usage all continue to generate solid double-digit growth, and more and more customers are selecting higher broadband speeds. At the end of 2007, nearly half of all AT&T broadband customers had signed up for download speeds of up to 3.0 Mbps or greater. And in early 2008, we rolled out a 10.0 Mbps offer to U-verse subscribers. We’re upgrading and expanding our global network to deliver a more consistent and reliable broadband experience. And for millions of customers in rural and remote areas, we have significantly expanded our satellite-based broadband service to provide a better alternative to dial-up access. A growing number of customers are using BROADBAND TRAFFIC Consumer broadband AT&T high speed services on their mobile traffic volumes have grown 350 percent since 2004. devices in addition to their PCs—as we deliver a fresh, integrated approach to communications and entertainment. | 2007 12 12 | 2007 AT&T AT&T Annual Annual Report Report

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    More than 12 million AT&T broadband subscribers enjoy free Wi-Fi access at thousands of locations in the U.S., and by the end of 2008 our U.S. Wi-Fi network will include more than 7,000 Starbucks locations. John Stankey gets a demonstration of video being sent from a wireless device to a PC and a TV screen—just one of the many innovations being developed at the AT&T Labs. AT&T U-VERSE LIVING UNITS PASSED Our U-verse network deployment is expected to pass 30 million living Like mobile phones in the 1980s and broadband in units by the end of 2010. the 1990s, video now represents a once-in-a-decade opportunity to build our next billion-dollar business. 2007 AT&T Annual Report | 13

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    Customers rely on AT&T broadband throughout the country Advanced TV From AT&T and around the world. By the end of 2008, more than We have dramatically ramped our growth in video 12 million AT&T broadband customers will have free services. AT&T Advanced TV services, such as AT&T access to more than 17,000 AT&T Wi-FiSM hot spots in the U-verse TV, AT&T | DISH Network and DIRECTV® service, United States alone, including Starbucks locations and present customers with a new and superior TV choice Barnes & Noble bookstores. Worldwide, we now deliver that offers better control and richer content than cable Wi-Fi access at more than 64,000 locations in 89 countries. with more High Definition (HD) channels in nearly every And a new multiyear agreement with Yahoo!, announced market we serve. in January 2008, will deliver an even richer and more innovative online experience for our customers—whether Delivered through our fiber-rich IP network, U-verse they are at home or on the go. service offers television, broadband and voice over a single connection, along with unique features and unmatched flexibility. | 2007 14 14 | 2007 AT&T AT&T Annual Annual Report Report

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    AT&T Advanced TV services offer better control and richer content than cable with more HD channels in nearly every market we serve. Satellite TV service from DISH Network and DIRECTV on a mobile device—no matter where they are. In 2007, is available in markets where we offer wired voice and we launched exclusive new features such as U-bar, which broadband, giving customers the ability to include brings Internet content such as sports, traffic and weather television service as part of an AT&T bundle. information to the TV screen, and YELLOWPAGES.COM TV, which gives U-verse TV customers the power to search for AT&T U-verse TV Is Our local business information from their TV. More integrated Next-Generation Video Service features are on the way in 2008. It doesn’t take U-verse TV customers long to experience Customers clearly like what they see: As 2007 drew to a the IP difference. For example, when they want to set a close, we had 231,000 AT&T U-verse video subscribers in recording on their DVR, they no longer have to be in front service. And we expect to top 1 million U-verse subscribers of the television. They can access their channel guides by the end of 2008. and set recordings from any Web connection—including 2007 AT&T Annual Report | 15

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    Business Services For today’s businesses, communications is a competitive imperative. Whether it’s a global enterprise expanding to new countries or a startup down the street adding its second location, AT&T helps businesses generate new revenues, reach new customers, interact with suppliers and enter new markets faster and more efficiently. Through our innovative solutions, our industry-leading portfolio of services and a dedicated business support team that anticipates customer needs, we provide customers with anytime, anywhere connectivity. And we deliver the content distribution, hosting, security and collaboration products and services that today’s marketplace demands to stay connected. Global Solutions for Global Enterprises Our business customers rely on AT&T network services in more than 160 countries on six continents. We’ve added to our network around the world and have opened six new Internet data centers. Our 38 data centers, located around the globe, make us the world’s largest network-based hosting provider. Ron Spears and his business services team secured AT&T’s contract with AT&T wireless customers enjoy the largest international the U.S. Department of the Treasury to build a secure enterprise network that roaming footprint available, covering more than 90 percent will facilitate the convergence of data, of the globe. voice and video technologies into a single network infrastructure. AT&T delivers global IP-based network capabilities that are widely regarded as unsurpassed in the marketplace and that support a broad array of communications devices, including the mobile handsets that enable our customers to connect on the move. | 2007 16 16 | 2007 AT&T AT&T Annual Annual Report Report

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    RECURRING AT&T ENTERPRISE SERVICE REVENUE GROWTH RATES Recurring enterprise service revenues returned to growth a year ahead of schedule. 2007 AT&T Annual Report | 17

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    “Helping people who are helping people …” That’s how Charlotte Anderson portrays the vital role that AT&T plays for ADDS Health Services. This St. Louis-based in-home health care provider serves hundreds of patients, many of whom are poverty-stricken and elderly. It’s a 24 x 7 x 365 calling. And that’s where AT&T comes in. AT&T’s hosting solutions allow Marriott Vacation Club International (MVCI) Asia “When we prepared to open our doors, the very first call Pacific members access to a collection we made was to AT&T,” said Anderson, who has served of MVCI properties globally, like this as operations manager since the company was founded one in Phuket, Thailand. in 2000. “We are licensed and certified with Medicare and Medicaid, and that carries with it a lot of privacy and security responsibilities. AT&T was the one company we We continually innovate and add new services. For example, could trust to manage those needs—plus the need to link to help our business customers boost productivity and our office staff of eight with our 40 employees in the field.” stay even more connected, last year we introduced AT&T Connect—a solution that allows customers to move ADDS relies on a combination of wireless, broadband and seamlessly among voice conference calls, video wired services. “AT&T keeps us all connected,” Anderson conferencing, document sharing and instant messaging. said. “Our smartphones are lifesavers when we’re out in the field. Many of the patients don’t have home phones, In 2007, our ability to deliver compelling customer so we rely on ours for everything—including access to solutions was a key factor in winning three new major the Internet and e-mail.” Anderson also noted that mobile contracts, each worth up to $1 billion: phones are the single most important communications • The U.S. Department of the Treasury tapped AT&T to tool in ADDS’ state-required disaster plan. build its next-generation enterprise network to connect 100,000 employees at more than 1,000 locations. According to Anderson, ADDS’ broadband service is crucial for transmitting and storing patient information • General Motors selected AT&T for a five-year and for electronic billing. It’s also a pipeline for staff contract—one of the largest commercial contracts training, much of which is done via teleconference. And in our history—to provide next-generation global AT&T’s local search and directory services fuel many of telecommunications capabilities. ADDS’ referrals. • IBM chose AT&T as its global primary managed network services provider for the next five years. “To make a difference, you have to have a lot of heart— but also a lot of help,” Anderson said. "And we always know And in April 2007, through our affiliate in India, AT&T became that AT&T is right there with us." the first foreign telecom company to offer service in the Indian market. We also launched a new business in Vietnam in 2007 to support the growing number of multinational customers based there. | 2007 18 18 | 2007 AT&T AT&T Annual Annual Report Report

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    “Information technology is a key component of GM’s global business strategy, and AT&T's global reach, reliability and knowledge of our networks are helping us achieve our objectives. Their expertise allows us to stay focused on what we do best … build and sell great cars and trucks,” said Ralph Szygenda, group vice president and CIO of GM, pictured in a Chevrolet Malibu, 2008 North American Car of the Year. AT&T Connect allows our customers to collaborate better by moving easily among 10,000 Branches Across North America different services—including e-mail, chat, and the United Kingdom teleconferencing and document sharing. That’s the scope of financial services leader Edward Jones’ operations. Given the speed of the global economy, maintaining the company's focus on individual service across its entire network of offices demands fast connectivity solutions. In 2007, Edward Jones retired its 20-plus-year-old satellite system and teamed with AT&T to create the Global Branch Network to deliver voice communications, always-on Internet access and critical market data. No Business Is Too Small “The satellite system was no longer able to serve our for Big Solutions growing branch network,” said Vinny Ferrari, chief More than 3 million small and midsize businesses look information officer for Edward Jones. “We worked with to us for integrated communications solutions that deliver AT&T to design a technology upgrade that gives us the high quality, security and continuous innovation. For bandwidth we needed to ensure that our employees instance, in 2007, we introduced our Complete Office have access to applications and to complement our Solution bundle—unlimited local and nationwide calling, trademark face-to-face customer service.” wireless service, high speed Internet, AT&T Unified Messaging and an AT&T Real Yellow Pages listing, all on a single AT&T provides a global Virtual Private Network (VPN) consolidated bill. service that offers a single secure network to connect numerous business locations, such as branch offices, We’re also answering the call as more small and midsize headquarters and remote users. The results for Edward businesses demand mobility and integrated voice and Jones? Increased reliability, faster traffic flow, easier data solutions. We’ve expanded our popular IP Flexible management and the ability to expand quickly. Reach solution to integrate with existing analog telephone systems. That lets businesses use Voice over IP (VoIP) “We worked closely with Edward Jones to deploy a network technologies without replacing their existing systems. that is robust, resilient and redundant to support the And AT&T’s wireless leadership enables us to provide the ‘always-available’ nature of its business,” said AT&T’s José mobile voice and data solutions that businesses of all Gutiérrez, executive vice president of Enterprise Business sizes need to compete. Sales. “We give them an infrastructure that’s adaptable and expandable enough to meet their needs as their business grows.” 2007 AT&T Annual Report | 19

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    Ray Wilkins demonstrates YELLOWPAGES.COM mobile search, just one of the ways AT&T connects advertisers to ready-to-buy consumers in real time. Local Search When consumers need a plumber, florist, tailor or other local service, they want to be able to find the right person for the job quickly and easily. Today, in addition to their trusty AT&T Real Yellow Pages books, consumers also want to search via their PCs, mobile devices and televisions. No other company is better-positioned to connect these buyers to sellers—anytime, anywhere—than AT&T. People searched the AT&T Real Yellow Pages for a local business about 4 billion times in 2007, consulting the 175 million books we print in 22 states. AT&T’s YELLOWPAGES.COM online local search site connected buyers to sellers on mobile devices, PCs and U-verse TV screens more than 1.5 billion times in 2007. That was In 2008, we’re introducing a 50 percent year-over-year increase in the number of YELLOWPAGES.COM searches. a capability that enables advertisers to pay only for the calls generated by their AT&T ads, wherever they may appear. As more and more people search for local businesses while they’re on the run, we’re making the task even easier with YELLOWPAGES.COM applications for AT&T mobile devices, including the Apple iPhone. | 2007 20 20 | 2007 AT&T AT&T Annual Annual Report Report

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    Customers locate Chez Ben/Fahrenheit through AT&T’s print, online and mobile Yellow Pages ads. “The result is a full house every night,” said restaurant owner Ben Weiss. “You Should Taste Our Steaks!” Ben Weiss of Providence, R.I., opened a steakhouse in his hometown featuring the same “je ne sais quoi”— and local paintings—as his favorite Paris bistro. To capture the unique atmosphere, he included a video with his YELLOWPAGES.COM listing. These days, business at Chez Ben/Fahrenheit is cooking. AT&T YELLOWPAGES.COM SEARCHES Local searches on AT&T’s YELLOWPAGES.COM network have increased 150 percent since 2004. 2007 AT&T Annual Report | 21

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    Employees and Communities At the heart of our commitment to good corporate citizenship is a simple idea: Connections build communities and drive prosperity. It starts with our community: the 309,000 talented AT&T employees around the world. We spent $200 million on training and $26 million on tuition assistance in 2007 to prepare our employees for the future and to ensure that they can deliver a superior experience to our customers every day. By combining our employees’ passion to serve with our innovative technology and financial resources, we make the communities in which we live and work stronger, smarter and healthier. Our deep commitment to the community is our heritage and our future. GIVING. In 2007, AT&T contributed more than $164 million to nonprofit organizations through corporate-, employee- and AT&T Foundation-sponsored giving. Our philanthropy AT&T Pioneers volunteer Keith Pounds works with student is focused on education and workforce readiness. The Emilee Story at Tucker Middle School in Tucker, Ga. Emilee AT&T Foundation—widely recognized as one of the most participates in Project Connect, a program supported by AT&T Pioneers around the U.S., which uses educational generous corporate foundations—provides more than computer games to improve students' math and science 55 percent of its grants to underserved populations. skills. In 2007, Emilee participated in an international Project Connect competition, winning desktop computers for herself and her school. At AT&T, we know that building connections spurs growth and creates new opportunities to help the world communicate. From our Board of Directors to our front-line employees, ours is a company where corporate citizenship and sustainability are everybody’s business. | 2007 22 22 | 2007 AT&T AT&T Annual Annual Report Report

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    VOLUNTEERING. Through the AT&T Pioneers, nearly 350,000 employees and retirees contributed more than 10 million hours of volunteer time to community outreach activities nationwide in 2007. In schools and neighborhoods, the Pioneers strengthen connections and build communities. DIVERSITY. AT&T’s diverse workforce and inclusive culture are central to our ability to serve our equally diverse AT&T has joined with Rock the global customer base. Forty-six percent of our U.S.-based Vote, a nonpartisan, nonprofit organization, to encourage employees are women; 38 percent are people of color. young people to register to vote We have a nearly 40-year legacy as a pioneer in supplier and participate in the upcoming U.S. presidential election. diversity and are one of only 12 U.S. companies that spend more than $1 billion annually with women-, minority- or disabled-veteran-owned businesses. AT&T’s commitment to diversity is widely recognized, including our selection YOUTH. More than 20 percent of eligible voters in the as one of the top three among DiversityInc magazine’s 2008 presidential election will be under 29—a demo- 2007 Top 50 Companies for Diversity. graphic that includes some of the heaviest users of mobile phones and text messaging. That’s why we’re THE ENVIRONMENT. We are committed to being good working with Rock the Vote, a nonpartisan, nonprofit stewards of the environment—that includes efficiently organization, to connect with these young citizens in connecting people and businesses worldwide with their “own tongue,” encouraging them to register to vote innovative communications. Our products help reduce and receive news and reminders about the election by the need for carbon emission-intensive travel by facilitating sending a text message. They can also download video conferencing, telecommuting and online local exclusive celebrity ringtones that promote the search, among others. We work hard to conserve energy importance of voting. in company buildings and are committed to purchasing, when possible, low or partial zero emission vehicles for our fleet. And we encourage our customers to reuse and recycle wireless devices and accessories and our AT&T Real Yellow Pages directories —which are printed on paper that contains at least 40 percent recycled material. 2007 AT&T Annual Report | 23

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    Going beyond the call to keep their community connected: Inaugural Whitacre Award winners Melissa Lucht and Ed Stauth. Sometimes, even a global company can follow the Winds up to 205 mph killed 10 lead of a couple of teenagers with a big idea. people, snapped trees and utility poles and flattened or damaged nearly every building in town. Every American Military Member Protecting Our Freedom Overseas May 4, 2007: The Tornado Hit Greensburg, Should Be Able to Call Home Kansas, Just Before 10 P.M. That is the basic principle on which Massachusetts Melissa Lucht and Ed Stauth, Greensburg’s only AT&T teenagers Brittany and Robbie Bergquist founded Cell employees, rode out the storm in their basements—then Phones for Soldiers (CPFS). The charity they created headed to the AT&T Central Office (CO). collects and recycles wireless phones, then uses the proceeds to buy prepaid phone cards to send to U.S. The CO was severely damaged. Much of the roof was gone, troops serving overseas. In just three years, the Bergquists and rain pelted telephone switching and transport have raised more than $1 million and have sent more equipment. Ankle deep in water, Lucht and Stauth slung than 400,000 phone cards to the troops. tarps and worked together through the night to keep the CO operating until help arrived. Thanks to their efforts, the Since 2007, AT&T has aided in the effort. All of our retail people of Greensburg stayed connected—to the voices stores across the nation serve as CPFS recycling drop-off of concerned friends and loved ones, to emergency locations. We’ve also contributed 60,000 prepaid phone services, to the Internet. By daybreak, AT&T was providing cards—valued at more than $500,000. And we’re awarding vital communications support to emergency responders. four-year college scholarships, worth up to $100,000 each, to Brittany and Robbie. For their heroic work to keep customers connected in the best AT&T tradition, Lucht and Stauth became the first Why would a global company like AT&T get involved with winners of the new Whitacre Award. Named for retired a charity run by a couple of teenagers? It’s simple. When Chairman and CEO Ed Whitacre—a tireless advocate for Brittany e-mailed us to ask for our help, we recognized serving customers—the annual Whitacre Award will honor that we shared a common belief in the importance of AT&T employees who go above and beyond to provide keeping military families connected. world-class customer service. 24 | 2007 AT&T Annual Report 24 | 2007 AT&T Annual Report

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    AT&T Inc. Financial Review 2007 Selected Financial and Operating Data 26 Management’s Discussion and Analysis of Financial Condition and Results of Operations 27 Consolidated Financial Statements 53 Notes to Consolidated Financial Statements 57 Report of Management 80 Report of Independent Registered Public Accounting Firm 81 Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting 82 Board of Directors 83 Senior Officers 84 2007 AT&T Annual Report | 25

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    Selected Financial and Operating Data Dollars in millions except per share amounts At December 31 or for the year ended: 2007 20062 20053 2004 2003 1 Financial Data Operating revenues $118,928 $ 63,055 $ 43,764 $ 40,733 $ 40,498 Operating expenses $ 98,524 $ 52,767 $ 37,596 $ 34,832 $ 34,214 Operating income $ 20,404 $ 10,288 $ 6,168 $ 5,901 $ 6,284 Interest expense $ 3,507 $ 1,843 $ 1,456 $ 1,023 $ 1,191 Equity in net income of affiliates $ 692 $ 2,043 $ 609 $ 873 $ 1,253 Other income (expense) – net $ 615 $ 393 $ 397 $ 1,414 $ 2,370 Income taxes $ 6,253 $ 3,525 $ 932 $ 2,186 $ 2,857 Income from continuing operations $ 11,951 $ 7,356 $ 4,786 $ 4,979 $ 5,859 Income from discontinued operations, net of tax4 $ — $ — $ — $ 908 $ 112 Income before extraordinary item and cumulative effect of accounting changes $ 11,951 $ 7,356 $ 4,786 $ 5,887 $ 5,971 Net income5 $ 11,951 $ 7,356 $ 4,786 $ 5,887 $ 8,505 Earnings per common share: Income from continuing operations $ 1.95 $ 1.89 $ 1.42 $ 1.50 $ 1.77 Income before extraordinary item and cumulative effect of accounting changes $ 1.95 $ 1.89 $ 1.42 $ 1.78 $ 1.80 Net income5 $ 1.95 $ 1.89 $ 1.42 $ 1.78 $ 2.56 Earnings per common share – assuming dilution: Income from continuing operations $ 1.94 $ 1.89 $ 1.42 $ 1.50 $ 1.76 Income before extraordinary item and cumulative effect of accounting changes $ 1.94 $ 1.89 $ 1.42 $ 1.77 $ 1.80 Net income5 $ 1.94 $ 1.89 $ 1.42 $ 1.77 $ 2.56 Total assets $275,644 $270,634 $145,632 $110,265 $102,016 Long-term debt $ 57,255 $ 50,063 $ 26,115 $ 21,231 $ 16,097 Construction and capital expenditures $ 17,717 $ 8,320 $ 5,576 $ 5,099 $ 5,219 Dividends declared per common share6 $ 1.47 $ 1.35 $ 1.30 $ 1.26 $ 1.41 Book value per common share $ 19.09 $ 18.52 $ 14.11 $ 12.27 $ 11.57 Ratio of earnings to fixed charges 4.91 5.01 4.11 6.32 6.55 Debt ratio 35.7% 34.1% 35.9% 40.0% 32.0% Weighted-average common shares outstanding (000,000) 6,127 3,882 3,368 3,310 3,318 Weighted-average common shares outstanding with dilution (000,000) 6,170 3,902 3,379 3,322 3,329 End of period common shares outstanding (000,000) 6,044 6,239 3,877 3,301 3,305 Operating Data Wireless customers (000)7 70,052 60,962 54,144 49,132 24,027 In-region network access lines in service (000)8 61,582 66,469 49,413 52,356 54,683 Broadband connections (000)9 14,156 12,170 6,921 5,104 3,515 Number of employees 309,050 304,180 189,950 162,700 168,950 1 Amounts in the above table have been prepared in accordance with U.S. generally accepted accounting principles. 2 Our 2006 income statement amounts reflect results from BellSouth Corporation (BellSouth) and AT&T Mobility LLC (AT&T Mobility), formerly Cingular Wireless LLC, for the two days following the December 29, 2006 acquisition. Our 2006 balance sheet and end-of-year metrics include 100% of BellSouth and AT&T Mobility. Prior to the December 29, 2006 BellSouth acquisition, AT&T Mobility was a joint venture in which we owned 60% and was accounted for under the equity method. 3 Our 2005 income statement amounts reflect results from AT&T Corp. for the 43 days following the November 18, 2005 acquisition. Our 2005 balance sheet and end-of-year metrics include 100% of AT&T Corp. 4 Our financial statements reflect results from our sold directory advertising business in Illinois and northwest Indiana as discontinued operations. The operational results and the gain associated with the sale of that business are presented in “Income from discontinued operations, net of tax.” 5 Amounts include the following extraordinary item and cumulative effect of accounting changes: 2003, extraordinary loss of $7 related to the adoption of FIN 46 “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” and the cumulative effect of accounting changes of $2,541, which includes a $3,677 benefit related to the adoption of SFAS No. 143, “Accounting for Asset Retirement Obligations” and a $1,136 charge related to the January 1, 2003 change in the method in which we recognize revenues and expenses related to publishing directories from the “issue basis” method to the “amortization” method. 6 Dividends declared per common share in 2003 included three additional dividends totaling $0.25 per share above our regular quarterly dividend payout. 7 The number presented represents 100% of AT&T Mobility cellular/PCS customers. The 2004 number includes customers from the acquisition of AT&T Wireless Services, Inc. 8 In-region represents access lines serviced by our incumbent local exchange companies (in 22 states since the BellSouth acquisition and in 13 states prior to that acquisition). Beginning in 2006 the number includes BellSouth lines in service. 9 Broadband connections include in-region DSL lines, in-region U-verse high-speed Internet access and satellite broadband. 26 | 2007 AT&T Annual Report

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    Management’s Discussion and Analysis of Financial Condition and Results of Operations Dollars in millions except per share amounts 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 in the United States and internationally providing wireless and wireline telecommunications services and equipment as well as directory advertising and publishing services. You should read this discussion in conjunction with the consolidated financial statements and accompanying notes. A reference to a “Note” in this section refers to the accompanying Notes to Consolidated Financial Statements. 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. RESULTS OF OPERATIONS Consolidated Results Our financial results are summarized in the table below. We then discuss factors affecting our overall results for the past three years. These factors are discussed in more detail in our “Segment Results” section. We also discuss our expected revenue and expense trends for 2008 in the “Operating Environment and Trends of the Business” section. We completed our acquisition of BellSouth Corporation (BellSouth) on December 29, 2006. We thereby acquired BellSouth’s 40% economic interest in AT&T Mobility LLC (AT&T Mobility), formerly Cingular Wireless LLC (Cingular), resulting in 100% ownership of AT&T Mobility. Our consolidated results in 2006 include BellSouth’s and AT&T Mobility’s operational results for the final two days of the year. Prior to the acquisition, we reported the income from our 60% share of AT&T Mobility as equity in net income. We completed our acquisition of AT&T Corp. (ATTC) on November 18, 2005 and have included ATTC results during 2006 and for the 43-day period ended December 31, 2005. In accordance with U.S. generally accepted accounting principles (GAAP), operating results from BellSouth, AT&T Mobility and ATTC prior to their respective acquisition dates are excluded. Percent Change 2007 vs. 2006 vs. 2007 2006 2005 2006 2005 Operating revenues $118,928 $63,055 $43,764 88.6% 44.1% Operating expenses 98,524 52,767 37,596 86.7 40.4 Operating income 20,404 10,288 6,168 98.3 66.8 Income before income taxes 18,204 10,881 5,718 67.3 90.3 Net income 11,951 7,356 4,786 62.5 53.7 Diluted earnings per share 1.94 1.89 1.42 2.6 33.1 Overview Operating revenues increased $55,873, or 88.6%, in 2007 Operating income As noted above, 2007 revenues and and $19,291, or 44.1%, in 2006. These increases were primarily expenses reflect the addition of BellSouth’s and AT&T Mobility’s due to our acquisitions and to an increased demand for data results while our 2006 results only include two days of their products. The increases were slightly offset by continued results. Additionally, 2006 revenues and expenses reflect the pressure on voice revenues, reflecting access line decreases, addition of ATTC’s results while our 2005 results include only and by decreased demand for local wholesale services. 43 days. Accordingly, the following discussion of changes Operating expenses increased $45,757, or 86.7%, in in our revenues and expenses is significantly affected by 2007 and $15,171, or 40.4%, in 2006, primarily due to our these acquisitions. acquisitions. Operating expenses included merger integration Our operating income increased $10,116, or 98.3%, in 2007 costs of $1,272 in 2007 and $774 in 2006, and amortization and $4,120, or 66.8%, in 2006. Our operating income margin expense on intangible assets identified at the time of increased from 14.1% in 2005 to 16.3% in 2006 and to 17.2% in acquisition of $5,921 in 2007 and $943 in 2006. We are 2007. Operating income in 2007 increased primarily due to the amortizing these intangibles using the sum-of-the-months- acquisition of BellSouth and increased in 2006 primarily due to digits method, which means that we will record higher the acquisition of ATTC. The increased operating margins reflect expenses in earlier periods. Partially offsetting these expense reductions through merger synergies, the addition of increases were merger synergies of approximately $3,000 the higher-margined wireline operations at BellSouth in 2007 in 2007 and $1,000 in 2006, reflecting progress with the and operational improvements partially offset by additional integration of BellSouth, AT&T Mobility and ATTC, workforce amortization expense on those intangibles identified at the reductions and other cost-reduction initiatives. time of our acquisitions and by non-merger severance. As we Interest expense increased $1,664, or 90.3%, in 2007 and amortize several merger-related intangible assets using the $387, or 26.6%, in 2006. The increase in 2007 was primarily sum-of-the-months-digits method, amortization expense due to higher average debt balances resulting from the decreases as the amount of time we hold the asset increases. inclusion of BellSouth and AT&T Mobility outstanding debt Our operating income was slightly offset by the continued on our consolidated balance sheet. The increase in 2006 decline of our retail access lines due to increased competition, was primarily due to recording a full year of interest expense as customers continued to disconnect both primary and on ATTC outstanding debt. additional lines and switched to competitors’ wireless, Voice Equity in net income of affiliates Investments in partner- over Internet Protocol (VoIP) and cable offerings for voice and ships, joint ventures and less-than-majority-owned subsidiaries data. While we lose the wireline voice revenues, we have the where we have significant influence are accounted for under opportunity to increase wireless service revenue should the equity method. Prior to the December 29, 2006 BellSouth customers choose AT&T Mobility as their alternative provider. acquisition (see Note 2), we accounted for our 60% economic 2007 AT&T Annual Report | 27

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    Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) Dollars in millions except per share amounts interest in AT&T Mobility under the equity method since we Income taxes increased $2,728, or 77.4%, in 2007 and shared control equally with BellSouth. AT&T Mobility is now $2,593 in 2006. The increase in income taxes in 2007 was a wholly-owned subsidiary of AT&T, and wireless results primarily due to higher operating income in 2007 reflecting are reflected in operating revenues and expenses in our the addition of BellSouth’s and its share of AT&T Mobility’s consolidated statements of income. operating results. Our effective tax rate in 2007 was 34.4%, Equity in net income of affiliates decreased $1,351 in compared to 32.4% in 2006 and 16.3% in 2005. The increase 2007. The decrease in 2007 was a result of the change in in our effective tax rate for 2007 was primarily due to the accounting for AT&T Mobility to a wholly-owned subsidiary, consolidation of AT&T Mobility and an increase in income partially offset by improved results from our investments in before income taxes. Prior to the consolidation of AT&T América Móvil S.A. de C.V. (América Móvil) and Teléfonos Mobility, our income before income taxes included our equity de México, S.A. de C.V. (Telmex). Equity in net income of in AT&T Mobility’s after-tax net income. With consolidation, affiliates increased $1,434 in 2006. The increase in 2006 the AT&T Mobility income tax expense that was previously was primarily due to AT&T Mobility’s improved results, of netted in income before income taxes is now included in which $1,308 was our proportionate share. our consolidated income tax expense. Other income (expense) – net We had other income of The increase in income tax expense in 2006 compared to $615 in 2007, $393 in 2006 and $397 in 2005. Results for 2005 was primarily due to the higher income before income 2007 included gains of $409 related to a wireless spectrum taxes in 2006 and our agreement in December 2005 with license exchange, $166 in interest income, $148 from the sale the Internal Revenue Service (IRS) to settle certain claims of administrative buildings and other non-strategic assets and principally related to the utilization of capital losses and tax $88 from other non-operating activities. These gains were credits for tax years 1997 – 1999. The settlement reduced partially offset by $196 in minority interest expense. income tax expense by $902 in 2005, which also lowered Other income for 2006 included interest income of $377. our effective tax rate for 2005. (See Note 10) There were no individually significant other income or expense transactions during 2006. Results for 2005 primarily included Supplemental Information interest income of $383, a gain of $108 on the sales of shares To provide improved comparability versus previous results, of Amdocs Limited, American Tower Corp. (American Tower) below is a supplemental table providing pro forma and Yahoo! Inc. and other miscellaneous gains. These gains consolidated operating revenues for 2005 and 2006, were partially offset by other 2005 expenses of $126 to assuming the closing date for the BellSouth and ATTC reflect an increase in value of a third-party minority holder’s acquisitions was January 1, 2005. interest in an AT&T subsidiary’s preferred stock and other miscellaneous expenses. Supplemental Consolidated Operating Revenues Information Percent Change Actual Pro Forma Pro Forma 2007 vs. 2006 vs. 2007 2006 2005 2006 2005 Segment operating revenues Voice $ 40,798 $ 43,505 $ 46,849 (6.2)% (7.1)% Data 23,206 22,173 21,326 4.7 4.0 Wireless service 38,568 33,692 30,673 14.5 9.8 Directory 4,806 5,823 5,689 (17.5) 2.4 Other 11,550 11,861 12,268 (2.6) (3.3) Total Operating Revenues $118,928 $117,054 $116,805 1.6% 0.2% The pro forma voice revenue decline is consistent with trends and 3.3% in 2006, and packet-switched data revenues, which and is due to access line declines reflecting competition and include frame relay and asynchronous transfer mode (ATM) substitution of alternative technologies, pricing pressures services, were down 7.0% and 12.5%, respectively, consistent due to competition, anticipated shifts of traffic by major with the industry trend of customers switching to IP-based consolidated carriers to their own networks and a continuing services from traditional circuit-based services. decline in the number of ATTC’s mass-market customers, Pro forma wireless service growth was driven by subscriber which represent consumer and small business. growth and strong increases in data usage, including Pro forma data growth was led by an increase in Internet increased messaging, browsing, downloads, media bundles Protocol (IP) data revenues of 13.3% in 2007 and 14.1% and laptop and smartphone connectivity. We have historically in 2006, with strength in high-speed Internet, managed discussed our wireless segment results on a basis that Internet, Virtual Private Network (VPN) and hosting services. included 100% of AT&T Mobility results, and a detailed Data transport service revenues were up 0.7% in 2007 wireless service revenue discussion can be found in our “Wireless Segment Results” section. 28 | 2007 AT&T Annual Report

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    Directory results were lower in 2007 due to the purchase including local and long-distance voice, switched access, accounting treatment of directories delivered by BellSouth’s IP and Internet access data, messaging services, managed advertising and publishing businesses in the 12 months prior networking to business customers, AT&T U-verseSM TV service to the merger (see Note 4). In accordance with GAAP, the (U-verse) and satellite television services through our deferred revenues from these books were not included in the agency agreements with EchoStar Communications Corp. opening balance sheet and are therefore not included in the (EchoStar) and the DIRECTV Group, Inc. (DIRECTV). 2007 consolidated directory revenues. Had those deferred With the BellSouth acquisition, we now provide local revenues been included in 2007, directory revenues would service in 22 states (“in-region”). have increased by $964. The pro forma revenues for 2005 The advertising & publishing segment accounted for and 2006 do not reflect this purchase accounting treatment approximately 5% of our 2007 total segment operating of deferred directory revenues. revenues as compared to 4% in 2006 and 9% of our 2007 Pro forma other revenues decreased in 2007 and 2006 total segment income as compared to 12% in 2006. This due to our decision to de-emphasize sales of lower-margin, segment includes our directory operations, which publish stand-alone customer premises equipment. Yellow and White Pages directories and sell directory and Internet-based advertising. This segment also includes Segment Results the results of our Internet-based advertising business, Our segments are strategic business units that offer different YELLOWPAGES.COM (YPC), which was a joint venture with products and services and are managed accordingly. As a BellSouth prior to the December 29, 2006 acquisition and result of our acquisitions of BellSouth and ATTC, we revised is now a wholly-owned subsidiary of AT&T. For segment our segment reporting to represent how we now manage reporting disclosure, we have carried forward the deferred our business, restating prior periods to conform to the revenue and deferred cost balances for BellSouth at the current segments. Our operating segment results presented acquisition date in order to reflect how the segment is in Note 4 and discussed below for each segment follow managed. This is different from consolidated reporting our internal management reporting. We analyze our various purposes as under Statement of Financial Accounting operating segments based on segment income before Standards No. 141, “Business Combinations” (FAS 141), income taxes (see Note 4). Each segment’s percentage of BellSouth deferred revenue and expenses from directories total segment operating revenue and income calculations published during the 12-month period ending with the is derived from our segment results table in Note 4 December 29, 2006 acquisition date are not recognized and reflects amounts before eliminations. We have four and therefore were not included in the opening balance reportable segments: (1) wireless, (2) wireline, sheet. For management reporting purposes, we continue (3) advertising & publishing and (4) other. to amortize these balances over the life of the directory The wireless segment accounted for approximately 35% (typically 12 months). Thus, our advertising & publishing of our 2007 total segment operating revenues as compared segment results for 2007 include revenues of $964 and to 37% in 2006 and 32% of our 2007 total segment income expenses of $308, related to directories published in the as compared to 27% in 2006. This segment offers wireless Southeast region during 2006, prior to our acquisition voice and data communications services across the United of BellSouth. These amounts are eliminated in our States, providing cellular and PCS services. This segment consolidated results (see Note 4). reflects 100% of the results reported by AT&T Mobility, which The other segment accounted for approximately 1% of was our wireless joint venture with BellSouth prior to the our 2007 total segment operating revenues as compared December 29, 2006 acquisition and is now a wholly-owned to 2% in 2006 and 4% of our 2007 total segment income subsidiary of AT&T. Prior to the acquisition, although we as compared to 14% in 2006. This segment includes results analyzed AT&T Mobility’s revenues and expenses under the from Sterling Commerce, Inc. (Sterling), customer information wireless segment, we eliminated the wireless segment in services, payphone, and all corporate and other operations. our consolidated financial statements. In our 2006 and prior Additionally, this segment includes our portion of the consolidated financial statements we reported our 60% results from our international equity investments. Prior to proportionate share of AT&T Mobility’s results as equity in December 29, 2006, this segment also included our results net income of affiliates. from AT&T Mobility as equity in net income of affiliates, as The wireline segment accounted for approximately 59% discussed above. of our 2007 total segment operating revenues as compared The following tables show components of results of to 57% in 2006 and 55% of our 2007 total segment income operations by segment. We discuss significant segment as compared to 47% in 2006. This segment provides both results following each table. We discuss capital expenditures retail and wholesale landline communications services, for each segment in “Liquidity and Capital Resources.” 2007 AT&T Annual Report | 29

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    Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) Dollars in millions except per share amounts Wireless Segment Results Percent Change 2007 vs. 2006 vs. 2007 2006 2005 2006 2005 Segment operating revenues Service $38,678 $33,788 $30,673 14.5% 10.2% Equipment 4,006 3,749 3,795 6.9 (1.2) Total Segment Operating Revenues 42,684 37,537 34,468 13.7 8.9 Segment operating expenses Cost of services and equipment sales 15,991 15,057 14,388 6.2 4.6 Selling, general and administrative 12,594 11,446 11,645 10.0 (1.7) Depreciation and amortization 7,079 6,462 6,608 9.5 (2.2) Total Segment Operating Expenses 35,664 32,965 32,641 8.2 1.0 Segment Operating Income 7,020 4,572 1,827 53.5 — Equity in Net Income (Loss) of Affiliates 16 40 (11) (60.0) — Minority Interest1 (198) (169) (103) (17.2) (64.1) Segment Income $ 6,838 $ 4,443 $ 1,713 53.9% — 1 Minority interest is recorded as “Other Income (Expense) – Net” in the consolidated statements of income. Accounting for AT&T Mobility customer additions, and 75% of these additions were postpaid The wireless segment reflects 100% of the results reported customer additions. Contributing to our net additions and by AT&T Mobility (formerly Cingular), which was our wireless retail customer growth was improvement in customer joint venture with BellSouth prior to the December 29, 2006 turnover (customer churn) levels due to our strong network acquisition, at which time it became a wholly-owned performance and attractive products and services offerings, subsidiary of AT&T. Prior to the BellSouth acquisition (see including the Apple iPhone, which were partially offset by Note 2), we accounted for our 60% economic interest in AT&T a slowing growth rate of new wireless users reflecting a Mobility under the equity method since we shared control maturing domestic wireless industry. The improvement in equally with BellSouth. This means that our consolidated churn levels benefited from network and customer service results in 2006 and 2005 included our 60% share of AT&T improvements and continued high levels of advertising. Mobility’s results in “Equity in net income of affiliates” in our Also contributing to the increase in net additions was a consolidated statements of income. Following the BellSouth significant increase in prepaid gross additions. Gross acquisition, AT&T Mobility became a wholly-owned subsidiary customer additions were 20.1 million in 2007, 19.2 million and AT&T Mobility’s results are included as operating revenues in 2006 and 18.5 million in 2005. Postpaid customer gross and expenses in our consolidated statements of income. additions declined primarily due to higher postpaid market Accordingly, results from this segment for the last two days penetration and market maturation, as well as lower of 2006 were included in our operating revenues and industry postpaid churn. expenses and not in the “Equity in net income (loss) of As the wireless industry continues to mature, we believe affiliates” line. However, for all the periods presented, the that future wireless growth will become increasingly wireless segment reflects 100% of the results reported by dependent on our ability to offer innovative services, AT&T Mobility based on the management of the business. which will encourage existing customers to upgrade their current services and handsets and will attract customers Dobson Acquisition from other providers, as well as on our ability to minimize In November 2007, we acquired Dobson Communications customer churn. Average service revenue per user/customer Corporation (Dobson). Dobson marketed wireless services (ARPU) increased 2.2% compared to 2006 primarily due to under the Cellular One brand and had provided roaming increased data services ARPU growth. In 2007, data services services to AT&T subsidiaries since 1990. Dobson had ARPU grew 46.9% compared to 2006. The continued increase 1.7 million subscribers across 17 states, mostly in rural in data revenue was related to increased use of text and suburban areas with a population covered of more messaging, Internet access, e-mail and other data services, than 12.6 million people. Dobson was incorporated into which we expect to grow as we continue expanding our our wireless operations subsequent to our acquisition. third-generation (3G) services. The growth in data ARPU Our 2007 results included net revenue of $141 and was partially offset by a decline in voice service ARPU of expense of $109 from Dobson. 4.1% compared to 2006, reflecting a higher percentage of prepaid and reseller customers, which provide significantly Wireless Customer and Operating Trends lower ARPU than postpaid customers, and continued shifts As of December 31, 2007, we served 70.1 million wireless to all-inclusive rate plans that offer lower monthly charges. customers, compared to 61.0 million at December 31, 2006 We expect continued pressure on voice service ARPU. and 54.1 million at December 31, 2005. Approximately 70% ARPU declined 1.1% in 2006 due to decreases in local of our wireless customer net additions in 2007 were retail service, net roaming and other revenue per customer mostly 30 | 2007 AT&T Annual Report

  • Page 33

    offset by a 44.8% increase in data ARPU and increased wireless customers of approximately 12.1%, partially long-distance revenue per customer. In 2006, local service offset by a decline in voice ARPU of 4.1%. The increase revenue per customer declined primarily due to the two in 2006 was primarily due to an increase in the average reasons discussed above as well as free mobile-to-mobile number of wireless customers of 11.5%, partially offset plans that allow our wireless customers to call other by competitive pricing pressures and the impact of AT&T Mobility customers at no charge and, to a lesser various all-inclusive calling and prepaid plans. Included extent, Rollover® minutes. An increase in customers on in voice revenues for both periods were increases in Rollover plans tends to lower ARPU, since unused minutes long-distance and net roaming revenue due to increased (and associated revenue) are deferred until subsequent international usage. months for up to one year. Equipment revenues increased $257, or 6.9%, in 2007 and The effective management of customer churn also is decreased $46, or 1.2%, in 2006. The increase in 2007 was critical to our ability to maximize revenue growth and to due to higher handset revenues reflecting increased gross maintain and improve margins. Customer churn is calculated customer additions and customer upgrades to more advanced by dividing the aggregate number of wireless customers who handsets, partially offset by increased equipment discounts cancel service during each month in a period by the total and rebate activity. The slight decrease in 2006 was due to a number of wireless customers at the beginning of each month decline in handset revenues as a result of increased rebates in that period. Our customer churn rate was 1.7% in 2007, and equipment return credits and lower priced handsets, down from 1.8% in 2006 and 2.2% in 2005. The churn rate mostly offset by increased sales of handset units, handset for postpaid customers was 1.3% in 2007, down from 1.5% upgrades and accessories. in 2006 and 1.9% in 2005. The decline in postpaid churn Cost of services and equipment sales expenses increased reflects higher network quality, more affordable rate plans $934, or 6.2%, in 2007 and $669, or 4.6%, in 2006. The 2007 and broader network coverage as well as exclusive devices increase was primarily due to increased equipment sales and free mobile-to-mobile calling among our wireless expense of $1,140 due to the overall increase in sales as well customers. Churn levels were slightly negatively impacted as an increase in sales of higher-cost 3G devices, the intro- by ongoing transition of customers from our older analog duction of the Apple iPhone handset and an increase in the and Time Division Multiple Access (TDMA) platforms to our number and per-unit cost of handset accessory sales. Total advanced Global System for Mobile Communication (GSM) equipment costs continue to be higher than equipment network. We plan to cease operating our analog and TDMA revenues due to the sale of handsets below cost, through networks in early 2008. The increasing mix of prepaid and direct sales sources, to customers who committed to one-year reseller customers in our customer base are also expected or two-year contracts or in connection with other promotions. to pressure churn rates in the future. Cost of services declined $206 in 2007. This decline was due to lower interconnect, roaming and long-distance Wireless Operating Results expenses related to network and systems integration and Our wireless segment operating income margin was 16.4% cost-reduction initiatives, as well as cost reductions from the in 2007, 12.2% in 2006 and 5.3% in 2005. The higher margin continued migration of network usage from the T-Mobile in 2007 was primarily due to revenue growth of $5,147, which USA (T-Mobile) network in California and Nevada to our exceeded our increase in operating expenses of $2,699. networks in these states. Our remaining purchase The higher margin in 2006 was primarily due to revenue commitment to T-Mobile for this transition period was growth of $3,069, which exceeded our increase in operating $51 at December 31, 2007. These decreases were partially expenses of $324. offset by higher network usage, with increases in total system Service revenues are comprised of local voice and data minutes of use (MOU) of 13.5%, and associated network services, roaming, long-distance and other revenue. Service system expansion and increased network equipment costs. revenues increased $4,890, or 14.5%, in 2007 and $3,115, Expenses increased in 2006 primarily due to increases in or 10.2%, in 2006 and consisted of: network usage and associated network system expansion. • Data revenue increases of $2,692, or 63.3%, in 2007 Cost of services increased $492, or 5.3%, in 2006 due to and $1,579, or 59.0%, in 2006. The increase in 2007 is the following: primarily due to the increased number of data users • Increases in network usage with a total system MOU and an increase in data ARPU of 46.9%, which primarily increase of 20.6% related to the increase in customers. resulted from increased use of text messaging, e-mail, Additionally, average MOUs per customer increased 8.2%. data access and media bundling services. Our significant • Higher roaming and long-distance costs, partially offset data growth also reflects an increased number of by a decline in reseller expenses. The reseller decrease subscribers using our 3G network. The increase in resulted from a decrease in MOUs on the T-Mobile 2006 was related to increased use of text messaging network of more than 50% for 2006. and Internet access services, which resulted in an • Integration costs, primarily for network integration, increase in data ARPU of 44.8%. Data service revenues of $229. represented approximately 18.0% of our wireless Equipment sales expenses increased $177, or 3.5%, in 2006 segment service revenues in 2007 and 12.6% in 2006. due to increased handset upgrades of 11.2% and an increase • Voice revenue increases of $2,135, or 7.3%, in 2007 in the average cost per upgrade and accessory sold, partially and $1,592, or 5.8%, in 2006. The increase in 2007 was offset by a decline in the average cost per handset sold to primarily due to an increase in the number of average new customers. 2007 AT&T Annual Report | 31

  • Page 34

    Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) Dollars in millions except per share amounts Selling, general and administrative expenses increased • Increases in selling expense of $96 due to an increase $1,148, or 10.0%, in 2007 and decreased $199, or 1.7%, in sales expense, partially offset by a decrease in net in 2006. commission expenses. The decline in net commission The increase in selling, general and administrative expense was due to reductions in average activation and expenses in 2007 was due to the following: agent branding expense, partially offset by an increase • Increases in selling expenses of $572 due to increases in direct commission expense. in sales and advertising expenses and Apple iPhone- The expenses above also include merger integration related costs, partially offset by a decrease in net costs of $123 in 2006, such as employee-termination costs, commission expense, which was consistent with the rebranding and advertising and customer service and increase in prepaid plan sales as a percentage of total systems integration costs. retail sales. Depreciation and amortization increased $617, or 9.5%, • Increases of $572 in customer service and other expenses in 2007 and decreased $146, or 2.2%, in 2006. The increase primarily due to increased bad-debt expense of $338 and in 2007 was primarily due to an increase of $1,522 in other support costs of $234, partially offset by a decline amortization of identifiable intangible assets related to our of $191 in billing expenses, lower information technology acquisition of BellSouth’s 40% ownership interest, partially (IT) costs and customer service expenses. offset by declining amortization of identifiable AT&T Wireless • Increases in upgrade commission and residual expenses Services, Inc. (AWE) intangible assets acquired by AT&T of $195 due to increased prepaid plan costs and higher Mobility in 2004, which are principally amortized using the handset upgrade activity. sum-of-the-months-digits method of amortization. Expenses The decline in selling, general and administrative expenses also increased due to accelerated depreciation on TDMA in 2006 was due to the following: assets and ongoing capital spending for network upgrades • Decreases in billing and bad-debt expense of $378 and expansion. The 2007 increase was partially offset by primarily due to fewer account write-offs and cost- decreases in depreciation expense of $905 in 2007 due savings related to transitioning to one billing system. to certain network assets becoming fully depreciated and • Decreases in other administrative expense of $106 due purchase accounting adjustments on certain network to a decline in legal-related expenses, lower employee assets related to acquiring BellSouth’s 40% ownership costs and employee-related benefits due to a decrease interest of AT&T Mobility. in the number of employees, lower IT and other The decline in 2006 was due to a decline in amortization professional services expense and a federal excise expenses of $449 attributable to the AWE intangible assets tax refund accrual. mentioned above, which are amortized using an accelerated • Decreases in customer service expense of $87 due method of amortization. This decline was partially offset by an to a decline in the number of outsourced call center increase in depreciation expense of $303 in 2006 primarily professionals and lower billing expenses. due to depreciation associated with the property, plant and • Increases of $147 primarily related to increased prepaid equipment related to ongoing capital spending for our GSM card replenishment costs and higher migration and network, which was slightly offset by expense declines due upgrade transaction costs. to equipment that had become fully depreciated in 2006. • Increases in other expense of $129 due to higher warranty, refurbishment and freight costs. Wireline Segment Results Percent Change 2007 vs. 2006 vs. 2007 2006 2005 2006 2005 Segment operating revenues Voice $41,630 $33,714 $24,180 23.5% 39.4% Data 24,075 18,317 10,783 31.4 69.9 Other 5,872 5,447 3,491 7.8 56.0 Total Segment Operating Revenues 71,577 57,478 38,454 24.5 49.5 Segment operating expenses Cost of sales 30,214 26,693 17,464 13.2 52.8 Selling, general and administrative 16,180 13,185 9,875 22.7 33.5 Depreciation and amortization 13,411 9,676 7,426 38.6 30.3 Total Segment Operating Expenses 59,805 49,554 34,765 20.7 42.5 Segment Income $11,772 $ 7,924 $ 3,689 48.6% — 32 | 2007 AT&T Annual Report

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    Operating Margin Trends distance revenue increase was also partially offset by Our wireline segment operating income margin was 16.4% in competitive pricing for large-business customers and 2007, compared to 13.8% in 2006 and 9.6% in 2005. Our a decrease in demand for prepaid calling cards. wireline segment operating income increased $3,848, or • Local wholesale revenues increased $324, or 20.9%, 48.6%, in 2007 and $4,235 in 2006 primarily reflecting the in 2007 and decreased $548, or 26.1%, in 2006. addition of BellSouth’s operating results in 2007 and ATTC’s The increase in 2007 was primarily due to the acquisition operating results in 2006. Results for 2007 reflect lower of BellSouth, which increased local wholesale revenues expenses as a result of merger synergies and the addition of approximately $615. Wholesale revenue decreased in higher-margined operations of BellSouth, partially offset by 2007 and 2006 due to industry consolidation as certain merger-related charges and additional amortization expense customers moved more traffic to their own networks. on those intangibles identified at the time of our acquisitions We expect this trend to stabilize during 2008, absent of BellSouth and ATTC. Our operating income continued additional consolidation. to be pressured by access line declines due to increased Data revenues increased $5,758, or 31.4%, in 2007 competition, as customers disconnected both primary and primarily due to the acquisition of BellSouth, which increased additional lines and switched to alternative technologies, data revenues approximately $5,230, and increased $7,534, such as wireless, VoIP and cable for voice and data. or 69.9%, in 2006 primarily due to the acquisition of ATTC. Our strategy is to offset these line losses by increasing Data revenues accounted for approximately 34% of our non-access-line-related revenues from customer connections wireline operating revenues in 2007, 32% in 2006 and for data, video and voice. For example, we have the 28% in 2005. Data revenues include transport, IP and opportunity to increase wireless segment revenues if packet-switched data services. customers choose AT&T Mobility as an alternative provider. IP data revenues increased $3,080, or 47.6%, in 2007 Operating income and margins increased in 2006 primarily primarily due to the acquisition of BellSouth, which increased due to lower expenses as a result of merger synergies IP data approximately $2,235, and increased $3,044, or 88.7%, partially offset by additional amortization expense on those in 2006 primarily due to the acquisition of ATTC. Included in intangibles identified at the time of our acquisition of ATTC IP data revenues are DSL, dedicated Internet access, VPN and and lower voice revenue as a result of continued in-region other hosting services. VPN, hosting and dedicated Internet access line declines due to the reasons mentioned above. access services contributed to IP data growth in 2007 and Voice revenues increased $7,916, or 23.5%, in 2007 and 2006 due to continued growth in the customer base and $9,534 or 39.4%, in 2006 primarily due to the acquisitions of migration from other traditional circuit-based products. BellSouth and ATTC. Included in voice revenues are revenues Our transport services, which include DS1s and DS3s from local voice, long-distance and local wholesale services. (types of dedicated high-capacity lines) and SONET (a Voice revenues do not include VoIP revenues, which are dedicated high-speed solution for multisite businesses), included in data revenues. increased $2,640, or 29.7%, in 2007 almost entirely due • Local voice revenues increased $6,831, or 38.4%, in 2007 to the acquisition of BellSouth, which increased transport and $826, or 4.9%, in 2006. The increase in 2007 was services revenues $2,730. In 2007, SONET and other primarily due to the acquisition of BellSouth, which transport data revenues increased due to continuing increased local voice revenues approximately $8,040. high-speed volume growth. These increases were almost Local voice revenues also increased in 2007 due to entirely offset by DS1 and DS3 revenue decreases due to pricing increases for regional telephone service, custom continuing industry pricing pressures and higher levels of calling features and inside wire maintenance agreements. customer adjustments. In 2006, transport services revenues Local voice revenues in 2007 and 2006 were negatively increased $2,362, or 36.3%, primarily due to the acquisition impacted by expected declines in revenues from ATTC’s of ATTC. mass-market customers to which no proactive marketing Our packet-switched services include frame relay, ATM occurs and from customer demand-related declines for and managed packet services and increased $38, or 1.3%, calling features and inside wire agreements. We expect in 2007 primarily due to the acquisition of BellSouth, which our local voice revenue to continue to be negatively increased packet-switched service revenues $265. This affected by increased competition, including customers increase was almost entirely offset by both competitive shifting to competitors’ alternative technologies and the pricing and lower demand as customers continue to shift disconnection of additional lines for DSL service and to IP-based technology. We expect these services to other reasons. continue to decline as a percentage of our overall data • Long-distance revenues increased $761, or 5.3%, in 2007 revenues. Packet-switched services increased $2,128 in primarily due to the acquisition of BellSouth, which 2006 primarily due to the acquisition of ATTC. increased long-distance revenues approximately $2,075 Other operating revenues increased $425, or 7.8%, in and $9,256 in 2006, primarily due to the acquisition of 2007 and $1,956, or 56.0%, in 2006. The increases were ATTC. Contributing to the revenue increases in 2007 and due to incremental revenue from our acquisitions of BellSouth 2006 were continuing higher long-distance penetration in 2007 and ATTC in 2006. Major items included in other levels in our original 13-state region. These increases operating revenues are integration services and customer were primarily offset by a continuing decrease in demand premises equipment, government-related services, for long-distance service, mostly due to an expected outsourcing and state and municipal fees, which account decline in ATTC’s mass-market customers. Our long- for more than 67% of total revenue for all periods. 2007 AT&T Annual Report | 33

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    Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) Dollars in millions except per share amounts Equipment sales and related network integration and • Higher benefit expenses, consisting primarily of our management services decreased $274 in 2007 and $176 combined net pension and postretirement cost, increased in 2006 primarily due to less emphasis on the sale of expense $159, primarily due to changes in our actuarial lower-margin equipment. Revenue also decreased by $70 assumptions, which included the reduction of our discount in 2007 due to the recognition of intellectual property rate from 6.00% to 5.75% (which increases expense), and license fees in 2006 that did not recur in 2007. amortization of net losses on plan assets in prior years. Cost of sales expenses increased $3,521, or 13.2%, in • Higher traffic compensation expenses (for access 2007 and $9,229, or 52.8%, in 2006. The increases were to another carrier’s network) of $109 primarily due primarily due to incremental expenses resulting from our to increased volume of local traffic (telephone calls) acquisitions of BellSouth in 2007 and ATTC in 2006. Cost terminating on competitor networks and wireless of sales consists of costs we incur in order to provide customers. our products and services, including costs of operating Partially offsetting these increases, cost of sales in 2006 and maintaining our networks and personnel costs, such decreased due to: as salary, wage and bonus accruals. Costs in this category • A reduction in equipment sales and related network include our repair technicians and repair services, certain integration services of $418, primarily due to lower network planning and engineering expenses, operator demand and as a result of the September 2005 services, information technology and property taxes related amendment of our agreement for our co-branded to elements of our network. Pension and postretirement AT&T | DISH Network satellite TV service. Prior to costs, net of amounts capitalized as part of construction restructuring our relationship with EchoStar in labor, are also included to the extent that they are associated September 2005, we had been recording both with these employees. revenue and expenses for AT&T | DISH Network In addition to the impact of the BellSouth acquisition, cost satellite TV customers, resulting in relatively high of sales in 2007 increased due to the following: initial customer-acquisition costs. • Higher nonemployee-related expenses, such as contract • Lower employee levels, which decreased expenses, services, agent commissions and materials and supplies primarily salary and wages, by $296. costs, of $605. • A change made during 2006 in our policy regarding • Higher expenses of $225 in 2007 due to a 2006 change the timing for earning vacation days decreased in our policy regarding the timing for earning vacation expenses $225. days, which reduced expense in 2006. • Merger severance expenses in 2005 were higher than • Salary and wage merit increases and other bonus accrual in 2006 by $176. adjustments of $165. • In-region weather-related repair costs incurred in 2005 Partially offsetting these increases, cost of sales in 2007 that did not recur in 2006, which decreased expenses decreased due to: $100 in 2006. • Lower traffic compensation expenses (for access to • Non-merger-related severance expenses in 2005, another carrier’s network) of $831 primarily due to which were higher than in 2006 by $73. migration of long-distance calls onto our network and Selling, general and administrative expenses increased a lower volume of calls from ATTC’s declining national $2,995, or 22.7%, in 2007 and $3,310, or 33.5%, in 2006. mass-market customer base. The increases were primarily due to incremental expenses • Lower net pension and postretirement cost of $398, resulting from our acquisitions of BellSouth in 2007 and primarily due to changes in our actuarial assumptions, ATTC in 2006. Selling, general and administrative expenses including the increase of our discount rate from 5.75% to consist of our provision for uncollectible accounts; advertising 6.00% (a decrease to expense) and favorable investment costs; sales and marketing functions, including our retail and returns on plan assets resulting in a decrease in the wholesale customer service centers; centrally managed real recognition of net losses from prior years. estate costs, including maintenance and utilities on all owned • Lower cost of equipment sales and related network and leased buildings; credit and collection functions; and integration services of $300, primarily due to less corporate overhead costs, such as finance, legal, human emphasis on sales of lower-margin equipment. Costs resources and external affairs. Pension and postretirement associated with equipment for large-business customers costs are also included to the extent that they relate to (as well as DSL) typically are greater than costs those employees. associated with services that are provided over In addition to the impact of the BellSouth acquisition, multiple years. selling, general and administrative expenses in 2007 increased • Lower expenses of $163 in 2007 due to the discon- due to the following: tinuance of DSL Universal Service Fund fees in the • Salary and wage merit increases and other bonus accrual third quarter of 2006. adjustments of $102. In addition to the impact of the ATTC acquisition, cost of • Higher expenses of $96 in 2007 due to a 2006 change in sales in 2006 increased due to the following: our policy regarding the timing for earning vacation days, • Higher nonemployee-related expenses, such as contract which reduced expense in 2006. services, agent commissions and materials and supplies • Higher provision for uncollectible accounts of $80. costs, of $163. 34 | 2007 AT&T Annual Report

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    Partially offsetting these increases, selling, general and Partially offsetting these increases, selling, general and administrative expenses in 2007 decreased due to: administrative expenses in 2006 decreased due to: • Lower net pension and postretirement cost of $243, • ATTC merger-related asset impairment charges of $349 primarily due to changes in our actuarial assumptions, and merger-related severance expense of $107 during including the increase of our discount rate from 5.75% to 2005, which resulted in lower expenses in 2006. 6.00% (a decrease to expense) and favorable investment • Lower employee levels, which decreased expenses, returns on plan assets resulting in a decrease in the primarily salary and wages, by $239. recognition of net losses from prior years. • A charge of $236 in 2005 to terminate existing • Lower employee levels, which decreased expenses, agreements with WilTel Communications due to primarily salary and wages, by $222. our acquisition of ATTC. • Lower nonemployee-related expenses, such as contract • A change made during 2006 in our policy regarding services, agent commissions and materials and supplies the timing for earning vacation days, which decreased costs, of $148. expenses $96. In addition to the impact of the ATTC acquisition, selling, • Our provision for uncollectible accounts decreased general and administrative expenses in 2006 also increased $87, as we experienced fewer losses from our retail due to the following: customers and a decrease in bankruptcy filings by our • Other wireline segment costs of $809 primarily due to wholesale customers. advertising costs related to promotion of the AT&T brand Depreciation and amortization expenses increased name. In addition, other advertising expenses increased $3,735, or 38.6%, in 2007 and $2,250, or 30.3%, in 2006 $117. primarily due to higher depreciable and amortizable asset • Higher nonemployee-related expenses, such as contract bases as a result of the BellSouth acquisition in 2006 and services, agent commissions and materials and supplies the ATTC acquisition in 2005. costs of $103. • Higher benefit expenses, consisting primarily of our Supplemental Information combined net pension and postretirement cost, increased Access Line, Broadband Connections and Video expense $73, primarily due to changes in our actuarial Connections Summary Our in-region switched access assumptions, which included the reduction of our lines at December 31, 2007, 2006, and 2005 are shown discount rate from 6.00% to 5.75% (which increases below and access line trends are addressed throughout this expense) and net losses on plan assets in prior years. segment discussion. Because our acquisition of BellSouth has a significant effect on comparative information, we have included pro-forma amounts below as of 2006 for comparative purposes, as if the companies had been combined. Wireline In-Region1 Actual Pro Forma Actual Actual (in 000s) 2007 2006 2006 2005 Switched Access Lines Retail Consumer 35,047 37,120 25,308 26,683 Retail Business2 22,754 23,295 16,714 16,871 Retail Subtotal2 57,801 60,415 42,022 43,554 Percent of total switched access lines 93.9% 90.9% 90.7% 88.1% Sold to ATTC 242 1,293 1,044 1,638 Sold to other CLECs2,3 3,288 4,431 2,991 3,886 Wholesale Subtotal2 3,530 5,724 4,035 5,524 Percent of total switched access lines 5.7% 8.6% 8.7% 11.2% Payphone (Retail and Wholesale)4 251 330 250 335 Percent of total switched access lines 0.4% 0.5% 0.6% 0.7% Total Switched Access Lines 61,582 66,469 46,307 49,413 Total Broadband Connections2,5 14,156 12,170 8,538 6,921 Satellite service2,6 2,116 1,507 689 513 U-verse video 231 3 3 — Video Connections 2,347 1,510 692 513 1 Wireline in-region represents access lines served by AT&T’s incumbent local exchange companies (ILECs). 2 Prior period amounts restated to conform to current period reporting methodology. 3 Competitive local exchange carriers (CLECs). 4 Payphone lines are presented above as previously reported. Revenue from these lines is reported in the Other segment. 5 Broadband connections include DSL, U-verse high-speed Internet access and satellite broadband. 6 Satellite service includes connections under our agency and resale agreements with EchoStar and DIRECTV. 2007 AT&T Annual Report | 35

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    Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) Dollars in millions except per share amounts Advertising & Publishing Segment Results Percent Change 2007 vs. 2006 vs. 2007 2006 2005 2006 2005 Total Segment Operating Revenues $5,851 $3,685 $3,684 58.8% — Segment operating expenses Cost of sales 1,733 1,121 1,104 54.6 1.5 Selling, general and administrative 1,333 616 581 — 6.0 Depreciation and amortization 924 3 5 — (40.0) Total Segment Operating Expenses 3,990 1,740 1,690 — 3.0 Segment Operating Income 1,861 1,945 1,994 (4.3) (2.5) Equity in Net Income (Loss) of Affiliates — (17) (5) — — Segment Income $1,861 $1,928 $1,989 (3.5)% (3.1)% Ingenio Acquisition Operating revenues increased $2,166, or 58.8%, in 2007, In December 2007, we acquired Ingenio®, a provider of Pay primarily due to the addition of BellSouth’s operating results, Per Call® technology. Ingenio will be integrated with YPC which increased operating revenues approximately $2,220 in and will allow us to better serve business directory and 2007. The increase was largely driven by print advertising local search customers across our entire advertising and revenue of $1,859 and Internet advertising revenue of $200. publishing portfolio. Operating revenues in 2006 remained relatively unchanged. Operating expenses increased $2,250 in 2007 compared Accounting Impacts From the BellSouth Acquisition to $50, or 3.0%, in 2006 primarily due to the addition of Prior to the BellSouth acquisition (see Note 2), we accounted BellSouth’s operating results, which increased total operating for our 66% economic interest in YPC under the equity expenses by approximately $2,110 in 2007. The increase in method since we shared control equally with BellSouth. 2006 was primarily due to higher costs for Internet traffic, Following the BellSouth acquisition, YPC became a wholly- brand advertising and employee benefits. owned subsidiary of AT&T and its results are reflected in Cost of sales increased $612, or 54.6%, in 2007 compared operating revenues and expenses in our consolidated to $17, or 1.5%, in 2006, primarily due to the addition of statement of income. BellSouth’s operating results, which increased cost of sales by For segment disclosure purposes, we have carried forward approximately $550 in 2007. Publishing, commissions, paper deferred revenue and deferred cost balances for BellSouth in and printing costs represent the majority of cost of sales order to reflect how the segment is managed. This is different expenses in 2007. The increase in 2006 was primarily due from consolidated reporting purposes as under FAS 141 to higher costs for Internet traffic. BellSouth deferred revenue and expenses from directories Selling, general and administrative expenses increased published during the 12-month period ending with the $717 in 2007 compared to $35, or 6.0%, in 2006 primarily December 29, 2006 acquisition date are not recognized due to the addition of BellSouth’s operating results, which and therefore were not included in the opening balance increased selling, general and administrative expenses by sheet (see Note 4). For management reporting purposes, approximately $645 in 2007. Employee, uncollectible and we continued to amortize these balances over the life of advertising-related expenses represent the majority of the directory (typically 12 months). Thus, our advertising selling, general and administrative expenses in 2007. & publishing segment results include revenue of $964 and Increased expenses in 2006 were primarily due to increases expenses of $308 in 2007 related to directories published in other advertising & publishing segment costs, including in the Southeast region during 2006, prior to our acquisition brand advertising and employee benefits of $102, partially of BellSouth. offset by lower bad-debt expense of $74. Depreciation and amortization expenses increased Operating Results $921 in 2007, resulting from the amortization of customer Our advertising & publishing segment operating income lists acquired as a part of the BellSouth acquisition, which margin was 31.8% in 2007, 52.8% in 2006 and 54.1% in 2005. increased expenses by $915 in 2007. Depreciation and The decrease in the segment operating income margin in amortization expenses in 2006 remained relatively 2007 was primarily due to the addition of BellSouth’s unchanged. operating results, including the amortization of BellSouth’s customer lists acquired as a part of the acquisition. The decrease in the segment operating income margin in 2006 was primarily the result of increased operating expenses. 36 | 2007 AT&T Annual Report

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    Other Segment Results Percent Change 2007 vs. 2006 vs. 2007 2006 2005 2006 2005 Total Segment Operating Revenues $2,234 $1,878 $1,731 19.0% 8.5% Total Segment Operating Expenses 1,827 1,485 1,248 23.0 19.0 Segment Operating Income 407 393 483 3.6 (18.6) Equity in Net Income of Affiliates 676 2,020 629 (66.5) — Segment Income $1,083 $2,413 $1,112 (55.1)% — Our other segment operating results consist primarily of Sterling, Equity in net income of affiliates decreased $1,344 in customer information services, corporate and other operations. 2007 primarily due to a change in accounting for AT&T Sterling provides business-integration software and services. Mobility, the results of which are no longer included in In late 2007, we announced our intention to cease our retail equity in net income of affiliates in 2007 due to the payphone operations by the end of 2008, which is reflected acquisition of BellSouth. This decrease was partially offset in the operating revenues and expenses discussion below. by an increase of $150 from América Móvil and Telmex Operating revenues increased $356, or 19.0%, in 2007 and primarily due to improved operating results. Equity in net $147, or 8.5%, in 2006. The increase in 2007 was primarily due income increased $1,391 in 2006, primarily due to the to the addition of BellSouth’s other operations and increased improved operating results at AT&T Mobility. operating revenue at Sterling, partially offset by decreased revenues from our retail payphone operations. The increase in OPERATING ENVIRONMENT AND TRENDS OF THE BUSINESS 2006 was primarily due to increased intercompany revenue 2008 Revenue Trends We expect continued expansion of from our captive insurance company (shown as intersegment our operating revenues in 2008, reflecting continuing growth revenue in Note 4) and improved operating revenue at Sterling, in our wireless and broadband/data services. We expect our partially offset by a decrease in revenue as a result of the sale primary driver of growth to be wireless and that all our major of our paging subsidiary in November 2005. customer categories will continue to increase their use of Operating expenses increased $342, or 23.0%, in 2007 and Internet-based broadband/data services. For our enterprise $237, or 19.0%, in 2006. The increase in 2007 was primarily due (largest) business customers, we achieved positive growth in to the addition of BellSouth’s other operations and increased recurring service revenues beginning in the third quarter of operating expenses at Sterling, partially offset by decreased 2007 and expect total enterprise revenues to grow throughout expenses from our retail payphone operations. The increase in 2008. Revenue growth will also reflect the increased 2006 was primarily due to increased operating expenses at information and technology services to be provided for Sterling and at our captive insurance company, partially offset under our agreements with IBM. We also expect continued by management fees paid in 2005 that did not recur in 2006. revenue growth from our small and medium business Prior to the December 29, 2006 close of the BellSouth customers. We expect modest growth in our consumer wireline acquisition, our other segment included our 60% proportion- revenues with continuing declines in traditional access lines ate share of AT&T Mobility results as equity in net income being offset by growth in broadband and video services. of affiliates. As a result of the BellSouth acquisition, we own We expect solid growth in broadband revenues with 100% of AT&T Mobility and its results for the final two days improvement in ARPU as customers continue to choose of 2006 and for the year 2007 have been excluded from higher-speed services. We expect to continue to expand equity in net income of affiliates in this segment and in our U-verse service offerings with the goal of exceeding our consolidated statements of income. one million subscribers in service by the end of 2008. Our other segment also includes our equity investments in 2008 Expense Trends Acquisition and related merger international companies, the income from which we report as costs and the costs involved in providing services under equity in net income of affiliates. Our earnings from foreign the IBM agreements will adversely affect expenses in 2008. affiliates are sensitive to exchange-rate changes in the value We expect that our operating income margin, adjusted to of the respective local currencies. Our foreign investments are exclude these costs, will expand in 2008 due primarily to recorded under GAAP, which include adjustments for the expected improvement in our revenues and continued purchase method of accounting and exclude certain adjustments cost-control measures. In particular, we expect to continue required for local reporting in specific countries. Our equity in net workforce reductions and other previously identified net income of affiliates by major investment is listed below: merger synergies and to begin new cost-control initiatives in network operations, information technology and customer 2007 2006 2005 care. Expenses related to growth initiatives (see “Expected América Móvil $381 $ 274 $198 Growth Areas”) will apply some pressure to our operating Telmex 265 222 212 income margin. AT&T Mobility — 1,508 200 Other 30 16 19 Other Segment Equity in Net Income of Affiliates $676 $2,020 $629 2007 AT&T Annual Report | 37

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    Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) Dollars in millions except per share amounts OPERATING ENVIRONMENT OVERVIEW increasing competition and the growth of alternative AT&T subsidiaries operating within the U.S. are subject to technologies such as cable, wireless and VoIP have created federal and state regulatory authorities. AT&T subsidiaries significant challenges for our business. operating outside the U.S. are subject to the jurisdiction of national and supranational regulatory authorities in the Expected Growth Areas markets where service is provided, and regulation is generally We expect our wireless services and primary wireline products limited to operational licensing authority for the provision of to remain the most significant portion of our business and services to enterprise customers. have also discussed trends affecting the segments in which In the Telecommunications Act of 1996 (Telecom Act), we report results for these products (see “Wireless Segment Congress established a national policy framework intended to Results” and “Wireline Segment Results”). Over the next few bring the benefits of competition and investment in advanced years we expect an increasing percentage of our growth to telecommunications facilities and services to all Americans come from: (1) our wireless service, and (2) data/broadband, by opening all telecommunications markets to competition through existing and new services. We expect that our and reducing or eliminating burdensome regulation. Since previous acquisitions will enable us to strengthen the reach the Telecom Act was passed, the Federal Communications and sophistication of our network facilities, increase our Commission (FCC) and some state regulatory commissions large-business customer base and enhance the opportunity have maintained many of the extensive regulatory require- to market wireless services to that customer base. Whether, ments applicable to our traditional wireline subsidiaries. or the extent to which, growth in these areas will offset We are actively pursuing additional legislative and regulatory declines in other areas of our business is not known. measures to reduce or eliminate regulatory requirements Wireless Wireless is our fastest-growing revenue stream that inhibit our ability to provide the full range of services and we expect to deliver continued revenue growth in the demanded by our customers. For example, we are supporting coming years. We believe that we are at the beginning of the regulatory and legislative efforts that would offer a stream- wireless data growth curve and that there are substantial lined process for new video service providers to compete with opportunities available for next-generation converged services traditional cable television providers. In March 2007, the FCC that combine wireless, broadband, voice and video. released an order adopting rules that prohibit municipalities Our Universal Mobile Telecommunications System/High- from making unnecessary and unreasonable demands on Speed Downlink Packet Access 3G network technology covers competitive video service providers, and which require prompt most major metropolitan areas of the U.S. This technology action by such localities on cable franchise applications by provides superior speeds for data and video services, and it new entrants. In addition, states representing a majority of offers operating efficiencies by using the same spectrum and our local service access lines have adopted legislation that infrastructure for voice and data on an IP-based platform. enables new video entrants to acquire a statewide or state- Our wireless networks also rely on digital transmission approved (as opposed to municipal-approved) franchise to technologies known as GSM, General Packet Radio Services offer video services. We also are supporting efforts to update and Enhanced Data Rates for GSM Evolution for data commu- regulatory treatment for retail services. Passage of legislation nications. As of December 31, 2007, we served more than is uncertain and depends on many factors. 70 million customers and are the leading provider of mobile Our wireless operations are likewise subject to substantial wireless voice and data communications services in the U.S. governmental regulation. Wireless communications providers As the wireless industry continues to mature, we believe must be licensed by the FCC to provide communications that future wireless growth will become increasingly services at specified spectrum frequencies within specified dependent on our ability to offer innovative services that geographic areas and must comply with the rules and policies will encourage existing customers to upgrade their services, governing the use of the spectrum as adopted by the FCC. either by adding additional or new services, such as data While wireless communications providers’ prices and service enhancements, or through equipment upgrades, and will offerings are generally not subject to state regulation, an attract customers from other providers, as well as our ability increasing number of states are attempting to regulate or to minimize customer churn. We intend to accomplish these legislate various aspects of wireless services, such as in the goals by continuing to expand our network coverage, area of consumer protection. Additionally, we have noted our improve our network quality and offer a broad array of opposition to proposals to impose “net neutrality” access products and services, including exclusive devices such as regulation on wireless providers. We believe that the wireless the Apple iPhone and free mobile-to-mobile calling among industry is characterized by innovation, differentiation and our wireless customers. The effective management of competition among handset manufacturers, carriers and customer churn is critical to our ability to maximize revenue applications and that additional broadband regulation and growth and to maintain and improve our operating margins. new wholesale requirements are unnecessary given the state U-verse Services We are continuing to expand our of competition and may be appropriate only in the case of deployment of U-verse high-speed broadband and TV services. market failure. As of December 31, 2007, we have passed approximately We expect that our capital expenditures will continue to 8 million living units (constructed housing units as well as be in the midteens as a percentage of total revenues in 2008. platted housing lots) and are marketing the services to almost This amount includes capital for U-verse services, wireless 50 percent of those units. Our deployment strategy is to enter high-speed networks and merger-integration projects each market on a limited basis in order to ensure that all (discussed in “Expected Growth Areas”). Despite a more operating and back-office systems are functioning successfully positive regulatory outlook and these broadband opportunities, and then expand within each market as we continue to 38 | 2007 AT&T Annual Report

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    monitor these systems. In these market expansions, we expect reliability, interoperability and recovery of telecommunications to continue to use contracted outside labor in addition to our in future disasters. The original order required carriers to employees as installers; our rate of expansion will be slowed maintain backup power, for a specified number of hours, at if we cannot hire and train an adequate number of qualified certain points in the network, such as cell sites and remote contractors and technicians to keep pace with customer terminals. The FCC revised the backup power rule due to demand or if we cannot obtain all required local building numerous concerns raised by providers about feasibility of permits in a timely fashion. We also continue to work with compliance with the original rule. Although compliance with our vendors on improving, in a timely manner, the requisite the new rule will still require substantial effort by AT&T, it hardware and software technology. Our deployment plans gives us additional flexibility to meet our backup power could be delayed if we do not receive required equipment and obligations by gauging compliance with reference to the software on schedule. See our “Liquidity & Capital Resources” original design parameters of assets, exempting assets from discussion for an update on our U-verse capital spending. the backup power requirements where compliance is We believe that our U-verse TV service is subject to federal infeasible and permitting us to satisfy our obligations by oversight as a “video service” under the Federal Communi- creating a disaster recovery plan that relies on portable cations Act. However, some cable providers and municipalities generators and other backup power sources. have claimed that certain IP services should be treated E911 Order In September 2007, the FCC adopted an as a traditional cable service and therefore subject to the order (the E911 Order) that would substantially increase applicable state and local cable regulation. Certain accuracy requirements in connection with providing the municipalities have refused us permission to use our existing location of a caller to 911 to dispatchers of emergency right-of-ways to deploy or activate our U-verse-related services. The E911 Order will become effective in April 2008. services and products, resulting in litigation. Pending Under FCC rules, carriers are required to attempt to deliver negotiations and current or threatened litigation involving location data to Public Safety Answering Points (PSAPs) municipalities could delay our deployment plans in those when callers dial 911. We use a network-based location areas. If the courts having jurisdiction where we have solution that employs triangulation to estimate the location significant deployments of our U-verse services were to of the caller. Location data for this network-based solution decide that federal, state and/or local cable regulation must be accurate within 300 meters on 95 percent of all were applicable to our U-verse services, it could have a calls and within 100 meters on 67 percent of all calls. material adverse effect on the cost, timing and extent of The current rules permit these percentages to be calculated our deployment plans. based on all calls, network-wide, for purposes of measuring location accuracy. The E911 Order would require wireless REGULATORY DEVELOPMENTS carriers to achieve E911 location accuracy measured in Set forth below is a summary of the most significant develop- each of the local areas served by the approximately 6,000 ments in our regulatory environment during 2007. While these PSAPs across the country. Carriers would have until issues, for the most part, apply only to certain subsidiaries in September 2012 to achieve PSAP-level accuracy, and would our wireline segment, the words “we,” “AT&T” and “our” are have to demonstrate compliance with certain incremental used to simplify the discussion. The following discussions are location accuracy benchmarks in 2008 and 2010. The intended as a condensed summary of the issues rather than PSAP-level accuracy requirement in the E911 Order is not as a precise legal description of all of those specific issues. attainable throughout our wireless network using currently International Regulation Our subsidiaries operating available commercial technology. outside the U.S. are subject to the jurisdiction of regulatory We are considering all avenues for review of the E911 Order, authorities in the market where service is provided. Our including through an appeal or a petition for reconsideration. licensing, compliance and advocacy initiatives in foreign Depending on technological developments, the interpretation countries primarily enable the provision of enterprise of the final order and the resolution of any appeals, we could (i.e., large business) services. AT&T is engaged in multiple be required to make significant capital expenditures to efforts with foreign regulators to open markets to implement and maintain compliance with this order. competition, reduce network costs and increase our Wireless Universal Service Our wireless subsidiary, AT&T scope of fully authorized network services and products. Mobility, is currently an Eligible Telecommunications Carrier (ETC) for purposes of receiving federal universal service Federal Regulation A summary of significant 2007 federal support in certain states. To maintain these designations, the regulatory developments follows. state must certify that the carrier is entitled to receive the funds for the subsequent calendar year based on federal and Wireless applicable state ETC requirements. We are certified for each Wireless Broadband Order In March 2007, the FCC adopted relevant state for 2008. In May 2007, the Federal-State Joint a declaratory ruling stating that wireless broadband Internet Board on Universal Service recommended applying a funding access services are information services. The FCC’s decision cap to the amount of universal service support received by thus places wireless broadband Internet access service on competitive ETCs. Moreover, in order to obtain approval for the same largely-deregulated footing as cable and wireline our acquisition of Dobson, we agreed to a voluntary cap on broadband services. our receipt of federal universal service high-cost support. Order on Recommendations of the Hurricane Katrina The cap will be set at the amount of wireless universal Panel In October 2007, the FCC issued an order revising its service support we received as of June 30, 2007, which was previously adopted rule that was designed to improve the approximately $225. Additionally, the FCC is considering an 2007 AT&T Annual Report | 39

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    Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) Dollars in millions except per share amounts order that would adopt the Joint Board’s recommendation to and dominant carrier regulation (e.g., tariffing and price cap cap all competitive ETC high-cost funding. If the FCC adopts requirements), subject to certain limited conditions. As a result such an order, we anticipate that our company-specific cap on of the FCC’s order, our business units will be able to integrate high-cost support will be replaced with that industrywide cap. functions across organizations and jointly plan business operations more efficiently than previously possible. We Wireline anticipate that this relief will lower our administrative costs Video Service Order In March 2007, the FCC issued an and improve our responsiveness to customers. In addition, order adopting rules to implement the Cable Act’s prohibition the FCC eliminated the equal access scripting requirement, against local franchising authorities unreasonably refusing which had required AT&T’s customer service representatives to award competitive franchises for the delivery of cable to inform new local telephone service customers of the services, which it found had created unreasonable barriers to availability of long-distance service from other carriers and entry that impede the goals of increasing competition and to read a list of such carriers to the customer upon request. promoting broadband deployment. This order should facilitate our entry into the video market by reducing or removing State Regulation A summary of significant 2007 state entry barriers posed by municipalities that have refused us regulatory developments follows. permission to use our existing right-of-ways to deploy or activate our U-verse-related services and products. This order Video Service Legislation A number of states in which does not preempt state laws that streamline the franchising we operate have adopted legislation or issued clarifying process by, for example, establishing state-wide cable opinions that will make it easier for telecommunications franchises. Such laws have been enacted in over half of companies to offer video service. the states in which we operate. California High Cost Fund In June 2006, the California Video Program Access Order In October 2007, the FCC Public Utilities Commission (CPUC) opened a rulemaking to released an order and Further Notice of Proposed Rule Making review the California High Cost Fund B (CHCF-B). The CHCF-B addressing video programming issues. The order extends program was established in 1996 and was designed to for five years the exclusive contract prohibition of the support universal service goals by ensuring that basic Communications Act, which bans exclusive contracts for telephone service remains affordable in high-cost areas satellite cable programming and satellite broadcast within the service territories of the state’s major incumbent programming between vertically integrated programming local exchange carriers, such as our AT&T subsidiaries. In vendors and cable operators. The order also improves the September 2007, the CPUC adopted a decision that changed FCC’s program access complaint procedures by strengthening how the CHCF-B was calculated, which we estimate will the discovery rules and requiring production of information reduce our payments from the CHCF-B by approximately necessary to adjudicate a complaint. $160 in 2008 and $260 in 2009. In the same decision, the Special Access In January 2005, the FCC commenced a CPUC stated that AT&T and other carriers could recover lost broad examination of the regulatory framework applicable to payments from the fund by exercising pricing flexibility to interstate special access services provided by price-capped increase rates for services other than the basic residential local exchange carriers. In a July 2007 notice, the FCC invited rate (such as bundles), authorized an increase in the basic interested parties to update the record in that proceeding in residential rate by the Consumer Price Index in 2008 and a light of industry developments since 2005. If the FCC were lifting of the existing rate cap on the basic residential rate in to modify this regulatory framework (such as by mandating 2009. In a December 2007 decision in the same proceeding, further reductions in special access rates), it might negatively the CPUC established a $100 California Advanced Services impact our operating results. Fund to encourage the deployment of broadband facilities Broadband Forbearance Order In October 2007, the to unserved and underserved areas of California to become FCC adopted an order eliminating some regulations and effective sometime in 2008. We are unable at this time certain “Computer Inquiry” rules previously applicable to to determine the extent to which AT&T might be able to optical and packet-switched broadband transmission services qualify for payments from this fund. provided by our operating companies. Consequently, our operating companies will no longer be subject to, among COMPETITION other things, the FCC’s tariff filing requirements or price Competition continues to increase for telecommunications cap rules for Frame Relay, ATM, Ethernet, Remote Network and information services. Technological advances have Access, SONET, Optical Network or Wave-based broadband expanded the types and uses of services and products services. This order gives us substantial flexibility to offer available. In addition, lack of regulation of comparable individually tailored contractual arrangements that better alternatives (e.g., cable, wireless and VoIP providers) has meet our customers’ needs while enabling us to reduce lowered costs for alternative communications service costs and operate more efficiently. providers. As a result, we face heightened competition Long-Distance Non-Dominance Order In August 2007, as well as some new opportunities in significant portions the FCC adopted an order granting regulatory relief to AT&T, of our business. Verizon Communications Inc. (Verizon) and Qwest Communi- cations International Inc. and their independent incumbent Wireless local exchange carrier affiliates (e.g., AT&T Connecticut). We face substantial and increasing competition in all aspects This relief allows us to provide interstate long-distance of the wireless communications industry. Under current FCC services free from both structural separation requirements rules, six or more PCS licensees, two cellular licensees and 40 | 2007 AT&T Annual Report

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    one or more enhanced specialized mobile radio licensees may In addition to these wholesale rate and service regulations operate in each of our markets, which results in the presence noted above, our wireline subsidiaries (excluding rural carrier of multiple competitors. Our competitors are principally three affiliates) operate under state-specific elective “price-cap national (Verizon Wireless, Sprint Nextel Corp. and T-Mobile) regulation” for retail services (also referred to as “alternative and a larger number of regional providers of cellular, PCS regulation”) that was either legislatively enacted or authorized and other wireless communications services. by the appropriate state regulatory commission. Under We may experience significant competition from companies price-cap regulation, price caps are set for regulated services that provide similar services using other communications and are not tied to the cost of providing the services or to technologies and services. While some of these technologies rate-of-return requirements. Price-cap rates may be subject and services are now operational, others are being developed to or eligible for annual decreases or increases and also may or may be developed in the future. We compete for customers be eligible for deregulation or greater pricing flexibility if the based principally on price, service offerings, call quality, associated service is deemed competitive under some state coverage area and customer service. regulatory commission rules. Minimum customer service We are an eligible bidder in the FCC 700 MHz spectrum standards may also be imposed and payments required if auctions that began in January 2008, and in 2007, we agreed we fail to meet the standards. to purchase additional spectrum licenses covering 196 million We continue to lose access lines due to competitors people in the 700 MHz frequency band. (See “Wireless (e.g., wireless, cable and VoIP providers) who can provide Spectrum” discussed in “Other Business Matters”). The comparable services at lower prices because they are not availability of this additional spectrum from the auctions subject to traditional telephone industry regulation and could increase competition, the effectiveness of existing subsequently have lower cost structures. In response to these competition, or result in new entrants in the wireless arena. competitive pressures, for several years we have utilized a bundling strategy that rewards customers who consolidate Wireline their services (e.g., local and long-distance telephone, DSL, Our wireline subsidiaries expect continued competitive pressure wireless and video) with us. We continue to focus on in 2008 from multiple providers in various markets, including bundling wireline and wireless services, including combined wireless, cable and other VoIP providers, interexchange carriers packages of minutes and video service through our AT&T and resellers. At this time, we are unable to quantify the effect U-verse service and our relationships with satellite television of competition on the industry as a whole, or financially on this providers. We will continue to develop innovative products segment. However, we expect both losses of market share in that capitalize on our expanding fiber network. local service and gains resulting from business initiatives, Additionally, we provide local, domestic intrastate and especially in the area of bundling of products and services, interstate, international wholesale networking capacity including wireless and video, large-business data services, and switched services to other service providers, primarily broadband and long-distance service. large Internet Service Providers using the largest class of In most markets, we compete with large cable companies, nationwide Internet networks (Internet backbone), wireless such as Comcast Corporation, Cox Communications, Inc. and carriers, CLECs, regional phone ILECs, cable companies and Time Warner Inc., for local, high-speed Internet and video systems integrators. These services are subject to additional services customers and other smaller telecommunications competitive pressures from the development of new companies for both long-distance and local services customers. technologies and the increased availability of domestic Substitution of wireless and Internet-based services for and international transmission capacity. The introduction of traditional local service lines also continues to increase. new products and service offerings and increasing satellite, Our wireline subsidiaries remain subject to regulation by wireless, fiber-optic and cable transmission capacity for state regulatory commissions for intrastate services and by services similar to those provided by us continues to provide the FCC for interstate services. In contrast, our competitors competitive pressures. We face a number of international are often subject to less or no regulation in providing competitors, including Equant, British Telecom and SingTel; comparable voice and data services. Under the Telecom Act, as well as competition from a number of large systems companies seeking to interconnect to our wireline integrators, such as Electronic Data Systems. subsidiaries’ networks and exchange local calls enter into interconnection agreements with us. Any unresolved issues Advertising & Publishing in negotiating those agreements are subject to arbitration Our advertising & publishing subsidiaries face competition before the appropriate state commission. These agreements from approximately 100 publishers of printed directories in (whether fully agreed-upon or arbitrated) are then subject to their operating areas. Direct and indirect competition also review and approval by the appropriate state commission. exists from other advertising media, including newspapers, Recently, in a number of the states in which we operate radio, television and direct-mail providers, as well as from as an ILEC, state legislatures or the state public utility directories offered over the Internet. We actively compete commissions have concluded that the voice telecommuni- on the Internet through our wholly-owned subsidiary, YPC. cations market is competitive and have allowed for greater pricing flexibility for non-basic residential retail services, ACCOUNTING POLICIES AND STANDARDS including bundles, promotions and new products and services. Significant Accounting Policies and Estimates Because of While it has been a number of years since we have been the size of the financial statement line items they relate to, allowed to raise rates in certain states, some of these state some of our accounting policies and estimates have a more actions have been challenged by certain parties and are pending court review. 2007 AT&T Annual Report | 41

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    Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) Dollars in millions except per share amounts significant impact on our financial statements than others. Asset Valuations and Impairments We account for The policies below are presented in the order in which the acquisitions using the purchase method as required by topics appear in our consolidated statements of income. FAS 141. Under FAS 141, we allocate the purchase price to Allowance for Uncollectibles We maintain an allowance the assets acquired and liabilities assumed based on their for doubtful accounts for estimated losses that result from the estimated fair values. The estimated fair values of intangible failure of our customers to make required payments. When assets acquired are based on the expected discounted cash determining the allowance, we consider the probability of flows of the identified customer relationships, patents, trade- recoverability based on past experience, taking into account names and licenses. In determining the future cash flows we current collection trends; as well as general economic factors, consider demand, competition and other economic factors. including bankruptcy rates. Credit risks are assessed based on Customer relationships, which are finite-lived intangible historical write-offs, net of recoveries, and an analysis of the assets, are primarily amortized using the sum-of-the-months- aged accounts receivable balances with reserves generally digits method of amortization over the period in which those increasing as the receivable ages. Accounts receivable may relationships are expected to contribute to our future cash be fully reserved for when specific collection issues are flows. The sum-of-the-months-digits method is a process known to exist, such as pending bankruptcy or catastrophes. of allocation, not of valuation, and reflects our belief that The analysis of receivables is performed monthly and the we expect greater revenue generation from these customer bad-debt allowances are adjusted accordingly. A 10% change relationships during the earlier years of their lives. in the amounts estimated to be uncollectible would result Alternatively, we could have chosen to amortize customer in a change in uncollectible expense of approximately $140. relationships using the straight-line method, which would Pension and Postretirement Benefits Our actuarial allocate the cost equally over the amortization period. estimates of retiree benefit expense and the associated Amortization of other intangibles, including patents and significant weighted-average assumptions are discussed in amortizable tradenames, is determined using the straight- Note 11. One of the most significant of these assumptions is line method of amortization over the expected remaining the return on assets assumption, which was 8.5% for the year useful lives. We do not amortize indefinite-lived intangibles, ended December 31, 2007. This assumption will remain such as wireless FCC licenses or certain tradenames. unchanged for 2008. If all other factors were to remain (See Note 6) unchanged, we expect that a 1% decrease in the expected Goodwill is not amortized but is tested for impairment in long-term rate of return would cause 2008 combined accordance with Statement of Financial Accounting Standards pension and postretirement cost to increase $814 over 2007. No. 142, “Goodwill and Other Intangible Assets” (FAS 142). The 10-year return on our pension plan assets was 9.18% We review goodwill, indefinite-lived intangibles and other through 2007. Under GAAP, the expected long-term rate of long-lived assets for impairment under FAS 142 or Statement return is calculated on the market-related value of assets of Financial Accounting Standards No. 144, “Accounting for (MRVA). GAAP requires that actual gains and losses on the Impairment or Disposal of Long-Lived Assets” either pension and postretirement plan assets be recognized in the annually or whenever events or circumstances indicate MRVA equally over a period of up to five years. We use a that the carrying amount may not be recoverable over methodology, allowed under GAAP, under which we hold the the remaining life of the asset or asset group. In order to MRVA to within 20% of the actual fair value of plan assets, determine that the asset is recoverable, we verify that the which can have the effect of accelerating the recognition of expected future cash flows directly related to that asset excess actual gains and losses into the MRVA in less than exceed its fair value, which is based on the undiscounted five years. This methodology did not have a significant cash flows. The discounted cash flow calculation uses additional effect on our 2007, 2006 or 2005 combined various assumptions and estimates regarding future revenue, net pension and postretirement costs. Note 11 also discusses expense and cash flows projections over the estimated the effects of certain changes in assumptions related to remaining useful life of the asset. medical trend rates on retiree health care costs. Cost investments are evaluated to determine whether Depreciation Our depreciation of assets, including use of mark-to-market declines are temporary and reflected in other composite group depreciation and estimates of useful lives, is comprehensive income, or other than temporary and recorded described in Notes 1 and 5. We assign useful lives based on as an expense in the income statement. This evaluation is periodic studies of actual asset lives. Changes in those lives based on the length of time and the severity of decline in with significant impact on the financial statements must be the investment’s value. disclosed, but no such changes have occurred in the three Income Taxes Our estimates of income taxes and the years ended December 31, 2007. However, if all other factors significant items giving rise to the deferred assets and were to remain unchanged, we expect that a one-year liabilities are shown in Note 10 and reflect our assessment increase in the useful lives of the largest categories of our of actual future taxes to be paid on items reflected in the plant in service (which accounts for more than three-fourths financial statements, giving consideration to both timing and of our total plant in service) would result in a decrease of probability of these estimates. Actual income taxes could between approximately $1,810 and $1,860 in our 2008 vary from these estimates due to future changes in income depreciation expense and that a one-year decrease would tax law or results from the final review of our tax returns by result in an increase of between $2,230 and $2,330 in our federal, state or foreign tax authorities. We have considered 2008 depreciation expense. these potential changes and, for years prior to 2007, have provided amounts within our deferred tax assets and liabilities 42 | 2007 AT&T Annual Report

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    that reflect our judgment of the probable outcome of tax (EITF 06-4). EITF 06-4 covers endorsement split-dollar life contingencies (see Note 10). In 2007, we adopted Financial insurance arrangements (where the company owns and Accounting Standards Board Interpretation No. 48, controls the policy) and provides that an employer should “Accounting for Uncertainty in Income Taxes” (FIN 48) and recognize a liability for future benefits in accordance with began accounting for uncertain tax positions under the Statement of Financial Accounting Standards No. 106, provisions of FIN 48 (see Note 1). As required by FIN 48, we “Employers’ Accounting for Postretirement Benefits Other use our judgment to determine whether it is more likely than Than Pensions.” EITF 06-4 is effective for fiscal years not that we will sustain positions that we have taken on tax beginning after December 15, 2007. We are currently returns and, if so, the amount of benefit to initially recognize evaluating the impact EITF 06-4 will have on our financial within our financial statements. We regularly review our position and results of operations. uncertain tax positions and adjust our unrecognized tax benefits EITF 06-11 In June 2007, the EITF ratified the consensus in light of changes in facts and circumstances, such as changes on EITF 06-11, “Accounting for Income Tax Benefits of in tax law, interactions with taxing authorities and develop- Dividends on Share-Based Payment Awards” (EITF 06-11). ments in case law. These adjustments to our unrecognized EITF 06-11 provides that a realized income tax benefit from tax benefits may affect our income tax expense. Settlement dividends or dividend equivalents that are charged to retained of uncertain tax positions may require use of our cash. earnings and are paid to employees for nonvested equity- classified share-based awards and equity-classified New Accounting Standards outstanding share options should be recognized as an FAS 141(R) In December 2007, the Financial Accounting increase to additional paid-in capital rather than a reduction Standards Board (FASB) issued Statement of Financial of income tax expense. EITF 06-11 applies prospectively to Accounting Standards No. 141 (revised 2007), “Business the income tax benefits that result from dividends on Combinations” (FAS 141(R)). FAS 141(R) is a revision of equity-classified employee share-based payment awards FAS 141 and requires that costs incurred to effect the that are declared in fiscal periods beginning after acquisition (i.e., acquisition-related costs) be recognized December 15, 2007. EITF 06-11 will not have a material separately from the acquisition. In addition, in accordance impact on our financial position and results of operations. with FAS 141, restructuring costs that the acquirer expected but was not obligated to incur, which included changes to OTHER BUSINESS MATTERS benefit plans, were recognized as if they were a liability Spectrum Licenses In October 2007, we agreed to purchase assumed at the acquisition date. FAS 141(R) requires the spectrum licenses covering 196 million people in the 700 MHz acquirer to recognize those costs separately from the business frequency band from Aloha Partners, L.P. for $2,500. The combination. We are currently evaluating the impact that spectrum covers many major metropolitan areas, including FAS 141(R) has on our accounting for acquisitions prior to 72 of the top 100 and all of the top 10 markets in the U.S. the effective date of the first fiscal year beginning after We closed this transaction in February 2008. Additionally, December 15, 2008. we are an eligible bidder in the FCC wireless spectrum FAS 159 In February 2007, the FASB issued Statement auctions which began in January 2008. of Financial Accounting Standards No. 159, “The Fair Value Spectrum Sale In February 2007, we agreed to sell to Option for Financial Assets and Financial Liabilities” (FAS 159). Clearwire Corporation (Clearwire), a national provider of FAS 159 permits companies to choose to measure many wireless broadband Internet access, education broadband financial instruments and certain other items at fair value, service spectrum and broadband radio service spectrum thereby providing the opportunity to mitigate volatility in valued at $300. The transaction received the necessary reported earnings caused by measuring related assets and regulatory approvals and closed in May 2007. Sale of this liabilities differently without having to apply complex hedge spectrum was required as a condition to the approval of accounting provisions. FAS 159 is effective for fiscal years our acquisition of BellSouth. beginning after November 15, 2007. We elected not to Antitrust Litigation In 2002, two consumer class-action adopt the fair value option for valuation of those assets antitrust cases were filed in the United States District Court and liabilities which are eligible, therefore there is no impact for the Southern District of New York (District Court) against on our financial position and results of operations. SBC Communications Inc., Verizon, BellSouth and Qwest FAS 160 In December 2007, the FASB issued Statement Communications International Inc. alleging that they have of Financial Accounting Standards No. 160, “Noncontrolling violated federal and state antitrust laws by agreeing not to Interests in Consolidated Financial Statements, an amendment compete with one another and acting together to impede of ARB No. 51” (FAS 160). FAS 160 requires noncontrolling competition for local telephone services (Twombly v. Bell interests held by parties other than the parent in subsidiaries Atlantic Corp., et al.). In October 2003, the District Court be clearly identified, labeled, and presented in the granted the joint defendants’ motion to dismiss and the consolidated statement of financial position within equity, plaintiffs appealed. In October 2005, the United States Court but separate from the parent’s equity. FAS 160 is effective of Appeals for the Second Circuit Court (Second Circuit) for fiscal years beginning after December 15, 2008. We are reversed the District Court, thereby allowing the cases to currently evaluating the impact FAS 160 will have on our proceed. In June 2006, the Supreme Court of the United financial position and results of operations. States (Supreme Court) announced its decision to review the EITF 06-4 In March 2007, the Emerging Issues Task Force case. In May 2007, the Supreme Court reversed the Second (EITF) ratified the consensus on EITF 06-4, “Accounting for Circuit’s decision and remanded the case to the Second Circuit Deferred Compensation and Postretirement Benefit Aspects for further proceedings consistent with its opinion; we are of Endorsement Split-Dollar Life Insurance Arrangements” awaiting formal dismissal of the case. 2007 AT&T Annual Report | 43

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    Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) Dollars in millions except per share amounts Retiree Phone Concession Litigation In May 2005, we on their appeal is likely to be held later in the third quarter were served with a purported class action in U.S. District of 2008. Court, Western District of Texas (Stoffels v. SBC Communi- Broadcom Patent Dispute A number of our handsets, as cations Inc.), in which the plaintiffs, who are retirees of well as those provided by other wireless carriers, are subject Pacific Bell Telephone Company, Southwestern Bell, and to a patent dispute at the U.S. International Trade Commission Ameritech, contend that the telephone concession provided (ITC) between Broadcom Corporation and Qualcomm Incorpo- by the company is, in essence, a “defined benefit plan” within rated (Qualcomm). Currently, the U.S. ITC’s exclusion order the meaning of the Employee Retirement Income Security applicable to certain Qualcomm technology is stayed pending Act of 1974, as amended (ERISA). On October 3, 2006, the a decision by the appeals court. We anticipate a decision will Court certified two classes. The issue of whether the not occur before late in the second quarter of 2008. We concession is an ERISA pension plan was tried before the continue to take steps to mitigate the effects on us. However, judge the week of November 26, 2007. The court has if no resolution were to occur, future costs and availability of rendered no decision. We believe that an adverse outcome handsets using Qualcomm chips could be adversely affected. having a material effect on our financial statements in this case is unlikely, but will continue to evaluate the potential LIQUIDIT Y AND CAPITAL RESOURCES impact of this suit on our financial results as it progresses. We had $1,970 in cash and cash equivalents available at NSA Litigation There are 24 pending lawsuits that allege December 31, 2007. Cash and cash equivalents included cash that we and other telecommunications carriers unlawfully of $889 and money market funds and other cash equivalents provided assistance to the National Security Agency (NSA) in of $1,081. Cash and cash equivalents decreased $448 since connection with intelligence activities that were initiated December 31, 2006. During 2007, cash inflow was primarily following the events of September 11, 2001. In the first filed provided by cash receipts from operations, the issuance of case, Hepting et al v. AT&T Corp., AT&T Inc. and Does 1-20, long-term debt, net cash received from dispositions of a purported class action filed in U.S. District Court in the non-strategic real estate and the sale of marketable securities Northern District of California, plaintiffs allege that the and other assets. These inflows were offset by cash used to defendants have disclosed and are currently disclosing to meet the needs of the business including, but not limited to, the U.S. Government content and call records concerning payment of operating expenses, funding capital expenditures, communications to which Plaintiffs were a party. Plaintiffs repurchase of common shares, the repayment of debt, seek damages, a declaratory judgment, and injunctive relief dividends to stockholders and payment of interest on debt. for violations of the First and Fourth Amendments to the We discuss many of these factors in detail below. United States Constitution, the Foreign Intelligence Surveil- lance Act, the Electronic Communications Privacy Act, and Cash Provided by or Used in Operating Activities other federal and California statutes. We filed a motion to During 2007, cash provided by operating activities was dismiss the complaint. The United States asserted the “state $34,072 compared to $15,615 in 2006. Operating cash flows secrets privilege” and related statutory privileges and also increased primarily due to an increase in operating income filed a motion asking the court to either dismiss the complaint reflecting additional cash provided by the BellSouth or issue a summary judgment in favor of the defendants. acquisition and our success in achieving merger synergies The Court denied the Motions to Dismiss of both parties. and operational efficiencies, partially offset by increased Specifically, the Court ruled that the state secrets privilege interest payments of approximately $1,800 and tax payments does not prevent AT&T from asserting any statutory defense of $1,200. During 2007, tax payments were higher due it may have, as appropriate, regarding allegations that it primarily to a $1,000 deposit related to the IRS examination assisted the government in monitoring communication content. of our 2000 – 2002 income tax returns. The timing of cash However, with regard to the calling records allegations, the payments for income taxes, which is governed by the IRS Court noted that it would not require AT&T to disclose what and other taxing jurisdictions, will differ from the timing relationship, if any, it has with the government. We and the of recording tax expense and deferred income taxes, U.S. government filed interlocutory appeals in July 2006. The which are reported in accordance with GAAP. case was argued before a panel of the U.S. Court of Appeals During 2006, our primary source of funds was cash from for the Ninth Circuit on August 15, 2007. We are awaiting a operating activities of $15,615 compared to $12,974 in 2005. decision. Management believes these actions are without Operating cash flows increased primarily due to an increase merit and intends to vigorously defend these matters. in net income of more than $2,500 and additional cash Prepaid Calling Card Patent Litigation On September provided by the ATTC acquisition, partially offset by increased 14, 2007, a jury in Texas found that ATTC willfully infringed tax payments of $739 in 2006. Tax payments were higher two patents owned by TGIP Inc. (TGIP) relating to point-of- primarily due to increased income before income taxes. sale prepaid cards sold by ATTC and awarded TGIP $156 in Tax payments in 2006, include a refund from the completion damages. (TGIP Inc. v. AT&T Corp. et al., U.S. District Court for of the ATTC federal income tax audit covering 1997 – 2001. the Eastern District of Texas). The jury’s finding of willfulness also entitled TGIP to ask the judge to award additional Cash Used in or Provided by Investing Activities damages up to treble the jury verdict. On September 28, During 2007, cash used in investing activities consisted of: 2007, AT&T filed a motion requesting that the Court overturn • $17,717 in construction and capital expenditures. the jury’s verdict as a matter of law. On October 29, 2007, the • $2,200, net of cash acquired, related to the acquisition Court overturned the jury’s finding of infringement, the jury’s of Dobson, a provider of rural and suburban wireless $156 award of damages and the jury’s finding of willfulness. communications services. TGIP has appealed the Court’s decision and oral argument • $579 for investments in debt and equity securities. 44 | 2007 AT&T Annual Report

  • Page 47

    • $316 related to the acquisition of Ingenio, a provider We spent approximately $2,500 on our U-verse services in of Pay Per Call search and directory solutions, 2007 and expect spending to be approximately $2,500 in 2008 and Interwise, a provider of voice, Web and video for capital expenditures on our U-verse services for initial conferencing services. network-related deployment costs. We expect to pass approxi- • $190 to satisfy an obligation to Alaska Native Wireless, mately 30 million living units by the end of 2010. Additional LLC to acquire wireless spectrum and the acquisition customer activation capital expenditures are not included in of an additional ownership interest in Cellular this capital spending forecast. We expect that the business Communications of Puerto Rico. opportunities made available, specifically in the data/broad- • $136 related to the acquisition of wireless and media band area, will allow us to expand our products and services rights, intellectual property and other strategic assets. (see “U-verse Services” discussed in “Expected Growth Areas”). In October 2007, we agreed to purchase spectrum licenses The other segment capital expenditures were less than in the 700 MHz frequency band from Aloha Partners, L.P. 1.5% of total capital expenditures for 2007. Included in the for approximately $2,500. We closed this transaction in other segment are equity investments, which should be February 2008. Additionally, we are an eligible bidder in self-funding as they are not direct AT&T operations; as well the FCC wireless spectrum auctions which began in as corporate, diversified business and Sterling operations, January 2008. which we expect to fund using cash from operations. Net cash provided by investing activities for 2007 was We expect to fund any advertising & publishing segment $2,663 and consisted of net proceeds of $1,594 from capital expenditures using cash from operations. dispositions of non-strategic assets, $1,033 from the sale of marketable and equity securities and $36 related to other Cash Used in or Provided by Financing Activities activities. Proceeds from dispositions included the following: We plan to fund our 2008 financing activities through a • $1,137 from the sale of properties and other non- combination of debt issuances and cash from operations. strategic assets. Our financing activities include funding share repurchases • $301 from the sale of spectrum to Clearwire Corporation, and the repayment of debt. We will continue to examine which includes interest. opportunities to fund our activities by issuing debt at • $156 related to T-Mobile’s exercise of its option to favorable rates and with cash from the disposition of purchase an additional 10 MHz of spectrum in the certain other non-strategic investments. San Diego market, the sale of cost investments and On March 4, 2006, our Board of Directors authorized the the sale of wireless towers. repurchase of up to 400 million shares of AT&T common To provide high-quality communications services to our stock. During 2007, we repurchased 267 million shares at a customers, we must make significant investments in property, cost of $10,390. Share repurchases under this plan totaled plant and equipment. The amount of capital investment is approximately 351 million shares at a cost of $13,068. influenced by demand for services and products, continued On December 10, 2007, our Board of Directors authorized growth and regulatory considerations. Capital expenditures in a new share repurchase plan of 400 million shares, which the wireline segment, which represented approximately 77% replaces our previous share repurchase authorization. of our capital expenditures, increased 68% in 2007, reflecting This new authorization represents approximately 6.6 percent the acquisition of BellSouth. Our capital expenditures are of AT&T’s shares outstanding at December 31, 2007 and primarily for our wireline subsidiaries’ networks, our U-verse expires at the end of 2009. We have repurchased, and intend services, merger-integration projects and support systems for to continue to repurchase, a portion of the shares pursuant our long-distance service. Because of opportunities made to plans that comply with the requirements of Rule 10b5-1(c) available by the continued changing regulatory environment under the Securities Exchange Act of 1934. We will fund and our acquisitions of ATTC and BellSouth, we expect that our additional share repurchases through a combination our capital expenditures for 2008, which include wireless of cash from operations, borrowings dependent upon network expansion and U-verse services, will be in the market conditions, and cash from the disposition of certain midteens as a percentage of consolidated revenue. We expect non-strategic investments. to fund 2008 capital expenditures for our wireline and We paid dividends of $8,743 in 2007, $5,153 in 2006 and wireless segments, including international operations, using $4,256 in 2005, reflecting the issuance of additional shares cash from operations and incremental borrowings depending for the BellSouth and ATTC acquisitions and dividend increases. on interest rate levels and overall market conditions. In December 2007, our Board of Directors approved a During 2007, we spent $3,745 in the wireless segment 12.7% increase in the quarterly dividend from $0.355 to primarily for Universal Mobile Telecommunications System/ $0.40 per share. This increase recognizes our strong growth High-Speed Packet Access (UMTS/HSPA) network expansion, and positive outlook and follows a 6.8% dividend increase GSM/EDGE (Enhanced Data Rates for Global Evolution) approved by AT&T’s Board in December 2006. Dividends network capacity expansion and upgrades, as well as for IT declared by our Board of Directors totaled $1.465 per share and other support systems for our wireless service. The in 2007, $1.35 per share in 2006 and $1.30 per share in 2005. network capacity requirements and expansion of our UMTS/ Our dividend policy considers both the expectations and HSPA wireless networks will continue to require substantial requirements of stockholders, internal requirements of AT&T amounts of capital through 2008. In 2008, our wireless capital and long-term growth opportunities. It is our intent to provide expenditures should be in the lower double-digit range as a the financial flexibility to allow our Board of Directors to percent of our wireless revenues for the integration and consider dividend growth and to recommend an increase in expansion of our networks and the installation of UMTS/HSPA dividends to be paid in future periods. All dividends remain technology in a number of markets. subject to approval by our Board of Directors. 2007 AT&T Annual Report | 45

  • Page 48

    Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) Dollars in millions except per share amounts At December 31, 2007, we had $6,860 of debt maturing no event of default under the credit agreement has occurred. within one year, which included $4,939 of long-term debt The current agreement will expire in July 2011. We also maturities and $1,921 of commercial paper borrowings and have the right to terminate, in whole or in part, amounts other borrowings. All of our commercial paper borrowings are committed by the lenders under this agreement in excess due within 90 days. We continue to examine our mix of of any outstanding advances; however, any such terminated short- and long-term debt in light of interest rate trends. commitments may not be reinstated. Advances under this During 2007, we received net proceeds of $11,367 from agreement may be used for general corporate purposes, the issuance of $11,499 in long-term debt. Debt proceeds including support of commercial paper borrowings and other were used for general corporate purposes and parts of the short-term borrowings. There is no material adverse change proceeds were used for repurchases of our common stock. provision governing the drawdown of advances under this Long-term debt issuances consisted of: credit agreement. This agreement contains a negative pledge • $2,000 of 6.3% global notes due in 2038. covenant, which requires that, if at any time we or a subsid- • $2,000 of 6.5% global notes due in 2037. iary pledge assets or otherwise permits a lien on its proper- • €1.25 billion of 4.375% notes due in 2013 (equivalent ties, advances under this agreement will be ratably secured, to U.S. $1,641 when issued). subject to specified exceptions. We must maintain a debt-to- • $1,500 of floating-rate notes due in 2010. EBITDA (earnings before interest, income taxes, depreciation • $1,200 of 6.375% retail notes due in 2056. and amortization, and other modifications described in the • £600 million of 5.5% notes due in 2027 (equivalent agreement) financial ratio covenant of not more than three- to U.S. $1,158 when issued). to-one as of the last day of each fiscal quarter for the four • $1,000 of 4.95% global notes due in 2013. quarters then ended. We comply with all covenants under the • $500 of 5.625% notes due in 2016. agreement. At December 31, 2007, we had no borrowings • $500 of zero-coupon puttable notes due in 2022. outstanding under this agreement. (See Note 8) In February 2008, we received net proceeds of $3,972 from During 2007, proceeds of $1,986 from the issuance of the issuance of $4,000 in long-term debt. The long-term debt treasury shares were related to the exercise of stock-based issued consisted of the following: compensation. • $2,500 of 5.5% global notes due in 2018. During 2007, we paid $190 to minority interest holders • $750 of 4.95% global notes due in 2013. and $47 to terminate interest rate swaps with notional • $750 of 6.3% global notes due in 2038. amounts totaling $1,800 acquired as a result of our Beginning in May 2009, the $500 zero-coupon puttable acquisition of BellSouth. note may be presented for redemption by the holder at specified dates but not more frequently than annually, Other excluding 2011. If the note is held to maturity in 2022, the Our total capital consists of debt (long-term debt and redemption amount will be $1,030. debt maturing within one year) and stockholders’ equity. We entered into fixed-to-fixed cross-currency swaps on our Our capital structure does not include debt issued by our two foreign-currency-denominated debt instruments to hedge international equity investees. Our debt ratio was 35.7%, our exposure to changes in foreign currency exchange rates. 34.1% and 35.9% at December 31, 2007, 2006 and 2005. These hedges also include interest rate swaps of a fixed The debt ratio is affected by the same factors that affect foreign-denominated rate to a fixed U.S.-denominated interest total capital. Total capital increased $4,146 in 2007 compared rate, which results in a U.S.-denominated rate of 5.31% on to more than $90,000 in 2006. The 2007 total capital our Euro-denominated notes and 5.97% on our British pound increase was due to an increase in debt of $4,319 related sterling-denominated notes. to our financing activities. Our stockholders’ equity balance During 2007, debt repayments totaled $10,183 and was down $173 and included our increase in net income and consisted of: current adjustments for unrealized pension and postretire- • $3,871 related to debt repayments with a weighted- ment gains, which were more than offset by our increased average interest rate of 6.1%, which included the early share repurchase activity and dividend distributions. redemption of debt related to a put exercise on $1,000 The primary factor contributing to the decline in our 2006 of our 4.2% Puttable Reset Securities and called debt of debt ratio was the acquisition of BellSouth, which increased $500 with an interest rate of 7.0%. our stockholders’ equity approximately 105% and our total • $3,411 related to repayments of commercial paper and long-term debt by 96%. The 2006 total capital increase was other short-term bank borrowings. primarily due to the purchase of BellSouth (see Note 2). • $1,735 related to the early redemption of Dobson debt For 2006, our common stock outstanding and capital in acquired with a par value of $1,599 and a weighted- excess of par value increased by $60,850 and our current average interest rate of 9.1%. and long-term debt increased by $29,226. The increase in • $904 related to the early repayment of a Dobson total debt was primarily due to acquired debt from BellSouth long-term credit facility. and AT&T Mobility of $28,321, an increase in commercial • $218 related to the early redemption of a convertible paper and other short-term borrowings of $3,649 and debt note held by Dobson. issuances of $1,500, partially offset by long-term debt • $44 related to scheduled principal payments on other repayments of $4,242 during 2006. Stockholders’ equity debt and repayments of other borrowings. also increased due to our net income and was partially offset We have a five-year $10,000 credit agreement with a by dividend payments and our repurchases of common shares syndicate of investment and commercial banks, which we through our stock repurchase program. have the right to increase up to an additional $2,000, provided 46 | 2007 AT&T Annual Report

  • Page 49

    CONTRACTUAL OBLIGATIONS, COMMITMENTS AND CONTINGENCIES table. Other long-term liabilities were included in the table Current accounting standards require us to disclose our based on the year of required payment or an estimate of the material obligations and commitments to making future year of payment. Such estimate of payment is based on a payments under contracts, such as debt and lease agreements, review of past trends for these items, as well as a forecast and under contingent commitments, such as debt guarantees. of future activities. Certain items were excluded from the We occasionally enter into third-party debt guarantees, but following table as the year of payment is unknown and could they are not, nor are they reasonably likely to become, material. not be reliably estimated since past trends were not deemed We disclose our contractual long-term debt repayment to be an indicator of future payment. obligations in Note 8 and our operating lease payments in Substantially all of our purchase obligations are in our Note 5. Our contractual obligations do not include expected wireline and wireless segments. The table does not include the pension and postretirement payments as we maintain pension fair value of our interest rate swaps. Our capital lease obliga- funds and Voluntary Employee Beneficiary Association trusts tions have been excluded from the table due to the immaterial to fully or partially fund these benefits (see Note 11). In the value at December 31, 2007. Many of our other noncurrent ordinary course of business we routinely enter into commercial liabilities have been excluded from the following table due to commitments for various aspects of our operations, such as the uncertainty of the timing of payments, combined with the plant additions and office supplies. However, we do not believe absence of historical trending to be used as a predictor of such that the commitments will have a material effect on our payments. Additionally, certain other long-term liabilities have financial condition, results of operations or cash flows. been excluded since settlement of such liabilities will not require Our contractual obligations as of December 31, 2007, are the use of cash. However, we have included in the following in the following table. The purchase obligations that follow table obligations which primarily relate to benefit funding and are those for which we have guaranteed funds and will be severance due to the certainty of the timing of these future funded with cash provided by operations or through incre- payments. Our other long-term liabilities are: deferred income mental borrowings. The minimum commitment for certain taxes (see Note 10) of $24,939; postemployment benefit obligations is based on termination penalties that could be obligations (see Note 11) of $24,011; and other noncurrent paid to exit the contract. Since termination penalties would liabilities of $14,648, which included deferred lease revenue not be paid every year, such penalties are excluded from the from our agreement with American Tower of $539 (see Note 5). Contractual Obligations Payments Due By Period Less than 1-3 3-5 More than Total 1 Year Years Years 5 Years Long-term debt obligations1 $ 59,856 $ 4,926 $ 9,731 $12,428 $32,771 Interest payments on long-term debt 54,835 3,582 6,562 5,151 39,540 Commercial paper obligations 1,859 1,859 — — — Other short-term borrowings 62 62 — — — Operating lease obligations 15,147 2,088 3,479 2,622 6,958 Unrecognized tax benefits2 6,579 685 — — 5,894 Purchase obligations3,4 6,366 2,461 2,237 1,197 471 Other long-term obligations5 429 188 228 13 — Total Contractual Obligations $145,133 $15,851 $22,237 $21,411 $85,634 1 The impact of premiums/discounts and derivative instruments included in debt amounts on the balance sheet are excluded from the table. 2 The non-current portion of the unrecognized tax benefits is included in the “More than 5 Years” column as we cannot reasonably estimate the timing or amounts of additional cash payments, if any, at this time. See Note 10 for additional information. 3 We have contractual obligations to utilize network facilities from local exchange carriers with terms greater than one year. Since the contracts have no minimum volume requirements and are based on an interrelationship of volumes and discounted rates, we assessed our minimum commitment based on penalties to exit the contracts, assuming that we had exited the contracts on December 31, 2007. At December 31, 2007, the penalties we would have incurred to exit all of these contracts would have been $703. These termination fees could be $374 in 2008, $132 in the aggregate for 2009 and 2010 and $4 for 2011, assuming that all contracts are exited. These termination fees are excluded from the above table as the fees would not be paid every year and the timing of such payments, if any, is uncertain. 4 We calculated the minimum obligation for certain agreements to purchase goods or services based on termination fees that can be paid to exit the contract. If we elect to exit these contracts, termination fees for all such contracts in the year of termination could be approximately $642 in 2008, $720 in the aggregate for 2009 and 2010, $257 in the aggregate for 2011 and 2012 and $137 in the aggregate, thereafter. Certain termination fees are excluded from the above table as the fees would not be paid every year and the timing of such payments, if any, is uncertain. 5 Other long-term obligations include commitments with local exchange carriers for dedicated leased lines. MARKET RISK business risks. We seek to manage the potential negative effects We are exposed to market risks primarily from changes in from market volatility and market risk. The majority of our interest rates and foreign currency exchange rates. In managing financial instruments are medium- and long-term fixed rate notes exposure to these fluctuations, we may engage in various and debentures. Fluctuations in market interest rates can lead to hedging transactions that have been authorized according to significant fluctuations in the fair value of these notes and documented policies and procedures. On a limited basis, we use debentures. It is our policy to manage our debt structure and certain derivative financial instruments, including foreign currency foreign exchange exposure in order to manage capital costs, exchange contracts and combined interest rate foreign currency control financial risks and maintain financial flexibility over the contracts, to manage these risks. We do not use derivatives for long term. Where appropriate, we will take actions to limit the trading purposes, to generate income or to engage in speculative negative effect of interest and foreign exchange rates, liquidity activity. Our capital costs are directly linked to financial and and counterparty risks on stockholder value. 2007 AT&T Annual Report | 47

  • Page 50

    Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) Dollars in millions except per share amounts We enter into foreign currency contracts to minimize our projected gains or losses in fair value that we expect to incur. exposure to risk of adverse changes in currency exchange Future impacts would be based on actual developments in rates. We are subject to foreign exchange risk for foreign global financial markets. We do not foresee any significant currency-denominated transactions, such as debt issued, changes in the strategies used to manage interest rate risk, recognized payables and receivables and forecasted transac- foreign currency rate risk or equity price risk in the near future. tions. At December 31, 2007, our foreign currency exposures Interest Rate Sensitivity The principal amounts by were principally Euros, British pound sterling, Danish krone expected maturity, average interest rate and fair value of our and Japanese yen. liabilities that are exposed to interest rate risk are described in Notes 8 and 9. Following are our interest rate derivatives, QUANTITATIVE INFORMATION ABOUT MARKET RISK subject to interest rate risk as of December 31, 2007. The In order to determine the changes in fair value of our various interest rates illustrated in the interest rate swaps section financial instruments, we use certain financial modeling of the table below refer to the average expected rates we techniques. We apply rate-sensitivity changes directly to our would receive and the average expected rates we would interest rate swap transactions and forward rate sensitivity to pay based on the contracts. The notional amount is the our foreign currency-forward contracts. principal amount of the debt subject to the interest rate The changes in fair value, as discussed below, assume the swap contracts. The net fair value asset (liability) represents occurrence of certain market conditions, which could have an the amount we would receive or pay if we had exited the adverse financial impact on AT&T and do not represent contracts as of December 31, 2007. Maturity After Fair Value 2008 2009 2010 2011 2012 2012 Total 12/31/07 Interest Rate Derivatives Interest Rate Swaps: Receive Fixed/Pay Variable Notional Amount — — — $1,250 $2,000 — $3,250 $88 Variable Rate Payable1 4.6% 4.4% 5.1% 5.4% 5.3% — Weighted-Average Fixed Rate Receivable 6.0% 6.0% 6.0% 6.0% 5.9% — 1 Interest payable based on current and implied forward rates for Three or Six Month LIBOR plus a spread ranging between approximately 64 and 170 basis points. We had fair value interest rate swaps with a notional value of the U.S. dollar against foreign currencies from the of $3,250 at December 31, 2007, and $5,050 at prevailing foreign currency exchange rates, the fair value of December 31, 2006, with a net carrying and fair value asset the foreign exchange forward contracts (net liability) would of $88 and liability of $80, respectively. The net fair value have decreased approximately $29. Because our foreign liability at December 31, 2006, was comprised of a liability exchange contracts are entered into for hedging purposes, of $86 and an asset of $6. Included in the fair value interest we believe that these losses would be largely offset by rate swap notional amount for 2006 were interest rate swaps gains on the underlying transactions. with a notional value of $1,800, which were acquired as a The risk of loss in fair values of all other financial instru- result of our acquisition of BellSouth on December 29, 2006. ments resulting from a hypothetical 10% change in market These swaps were unwound in January 2007. prices was not significant as of December 31, 2007. Foreign Exchange Forward Contracts The fair value of foreign exchange contracts is subject to changes in foreign QUALITATIVE INFORMATION ABOUT MARKET RISK currency exchange rates. For the purpose of assessing specific Foreign Exchange Risk From time to time, we make risks, we use a sensitivity analysis to determine the effects investments in businesses in foreign countries, are paid that market risk exposures may have on the fair value of our dividends and receive proceeds from sales or borrow funds financial instruments and results of operations. To perform in foreign currency. Before making an investment, or in the sensitivity analysis, we assess the risk of loss in fair anticipation of a foreign currency receipt, we often will enter values from the effect of a hypothetical 10% change in the into forward foreign exchange contracts. The contracts are value of foreign currencies (negative change in the value used to provide currency at a fixed rate. Our policy is to of the U.S. dollar), assuming no change in interest rates. measure the risk of adverse currency fluctuations by See Note 9 to the consolidated financial statements for calculating the potential dollar losses resulting from additional information relating to notional amounts and changes in exchange rates that have a reasonable fair values of financial instruments. probability of occurring. We cover the exposure that For foreign exchange forward contracts outstanding at results from changes that exceed acceptable amounts. December 31, 2007, assuming a hypothetical 10% depreciation We do not speculate in foreign exchange markets. 48 | 2007 AT&T Annual Report

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