3rd UPDATE: AT&T Profit Up 26%;Contract Subscriber Growth Slows

AT&T Inc. (T) reported a 26% increase in second-quarter earnings due to an investment gain, lower costs and fewer defections, but the rate of growth in new contract customers slowed despite the benefits of the new Apple Inc. (AAPL) iPhone.

National wireless carriers have increasingly found it difficult to maintain momentum in signing up customers to long-term contracts, with many consumers opting to move to prepaid alternatives. AT&T's so-called postpaid net subscriber growth, which saw a dramatic decline from a year ago in the first quarter, continued to lag in the second quarter, underscoring the shrinking opportunity of the wireless industry's most lucrative source of income.

AT&T said it added 496,000 postpaid subscribers, or a little more than a third of the number of customers it signed up a year ago.

"Our expectation this year is that net adds will be less than it has been in the last couple of years," Chief Financial Officer Rick Lindner said in an interview. "That doesn't mean there isn't significant opportunity for growth."

Lindner added he expects third-quarter postpaid customer growth to bounce back in the third quarter, particularly as more new customers get their hands on the recently released iPhone 4.

The iPhone continued to be the single-largest driver of AT&T's growth. The carrier activated 3.2 million iPhones in the period, although fewer of those activations coming from new customers than in the past. Still, there remains supply issues, and Lindner said the devices sell out as soon as they arrive.

The company turned to the burgeoning prepaid market and the business of providing cellular services to nontraditional devices such as electronic readers and dog collars for growth. In total, it added 1.6 million wireless connections in the period.

AT&T reported a profit of $4.02 billion, or 68 cents a share, up from $3.2 billion, or 54 cents, a year earlier. The most-recent quarter included a 7-cent investment gain from a stock deal involving Telmex Internacional S.A.B. de C.V. (TII). Revenue rose 0.6% to $30.81 billion.

Analysts polled by Thomson Reuters had most recently forecast earnings of 57 cents on $30.9 billion in revenue. A company spokesperson said analysts' comparisons wouldn't factor in that the company excluded the revenue from its Sterling Commerce business-to-business holding, which it is divesting, from the results.

AT&T was able to post impressive margin growth through its stronger mix of high-quality subscribers and lower defections. The slowdown in new customers also meant lower acquisition costs.

But the margin improvement comes even as the iPhone 4 weighed heavily on AT&T's profitability. The telecommunications giant has to pay a lofty subsidy for each iPhone, increasing the costs for adding customers. Having launched with a week left in the quarter, customers with the new device contributed little to revenue.

During the quarter, AT&T changed its data service plans and placed limits on how much a customer could browse the Internet, stream music or videos and send and receive email on their smartphones. In exchange, it cut the price of each plan in an effort to attract new customers.

"Customer response has been good and it's been pretty much in line with expectations," Lindner said.

While growth may have slowed, customers stuck to AT&T. Its rate of turnover fell to 1.29% from 1.48% a year ago, with postpaid defections falling to 1.01%.

Prepaid results were also helped by sales of cellular-connected iPads, which access data services through a prepaid model. Lindner said AT&T activated 400,000 to 500,000 iPad 3Gs in the quarter.

On the wireline side, the company continued to lose customers. In the crucial high-speed Internet business, the company added 255,000 U-Verse Internet customers, but lost 92,000 total broadband customers, implying a loss of 347,000 traditional DSL customers.

Lindner blamed the decline on seasonal weakness, partially because college students cancel their Internet lines and head back home for the summer. But he admitted that its cable competitors have gotten aggressive, and said the company would have a targeted response.

AT&T's postpaid subscriber additions and DSL losses likely portend similar performance by Verizon Communications Inc. (VZ), which is slated to report its results Friday.

AT&T also added 209,000 U-Verse TV subscribers to reach 2.5 million total customers of its Internet-based TV service.

The company generated $5.4 billion in revenue from residential customers, flat with year-earlier results. Lindner said he sees a "clear line of sight" to a return to revenue growth in the area.

The company said it is seeing further signs of stabilization in the business markets, but revenue of $9.6 billion still marked a 4.7% decline from a year ago. The company is heavily dependent on businesses hiring new workers and has suffered from high unemployment.

AT&T changed its tone for its expectations for the year. Rather than stable-to-improved per-share earnings, it now expects strong earnings growth, along with improved margins and free cash flow above 2008 levels.

AT&T shares rose 3.09% to $28.42 in recent trading.

-By Roger Cheng, Dow Jones Newswires; 212-416-2153; roger.cheng@dowjones.com

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