AT&T (T)

In the Telecommunications Act of 1996 (Telecom Act), Congress established a national policy framework intended to bring the benefits of competition and investment in advanced telecommunications facilities and services to all Americans by opening all telecommunications markets to competition and reducing or eliminating burdensome regulation. Since the Telecom Act was passed, the Federal Communications Commission (FCC) and some state regulatory commissions have maintained many of the extensive regulatory requirements applicable to our traditional wireline subsidiaries. We are actively pursuing additional legislative and regulatory measures to reduce or eliminate regulatory requirements that inhibit our ability to provide the full range of services demanded by our customers. For example, we are supporting regulatory and legislative efforts at both the state and federal levels that would offer a streamlined process for new video service providers to compete with traditional cable television providers. In March 2007, the FCC released an order adopting rules that prohibit municipalities from making unnecessary and unreasonable demands on competitive video service providers, and which require prompt action by such localities on cable franchise applications by new entrants. In addition, states representing a majority of our local service access lines have adopted legislation or a regulatory process that enables new video entrants to acquire a statewide franchise to offer video services. We also are supporting efforts to update regulatory treatment for retail services. Passage of legislation is uncertain and depends on many factors.

Our wireless operations are likewise subject to substantial governmental regulation. Wireless communications providers must be licensed by the FCC to provide communications services at specified spectrum frequencies within specified geographic areas and must comply with the rules and policies governing the use of the spectrum as adopted by the FCC. While wireless communications providers’ prices and service offerings are generally not subject to state regulation, an increasing number of states are attempting to regulate or legislate various aspects of wireless services, such as in the area of consumer protection.

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AT&T INC.

MARCH 31, 2007

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued

Dollars in millions except per share amounts

We are a Fortune 500 company with annual revenues of over $20 billion. Our core businesses are wireline and wireless communications and our largest customer segment is the retail consumer. We have interests in wireless communications through our ownership of 40 percent of Cingular Wireless, the nation’s largest wireless company based on number of customers and revenue. We also operate one of the largest directory advertising businesses in the United States. The majority of our revenues are generated based on monthly recurring services.

We operate much of our wireline business in one of the country’s strongest regional economies, where the population is increasing, real income growth is outpacing the national average and a diverse mix of businesses require advanced information and communication technology solutions. The Southeast is a positive net migration region, with net migration averaging almost 500,000 annually. The region’s real income growth is expected to exceed the national average over the next five years.

INDUSTRY DYNAMICS

Demand in the traditional voice business has been negatively impacted by the proliferation of wireless services led by one-rate pricing plans that include a large bucket of minutes and free roaming and long-distance, the popularity of e-mail and instant messaging, and technological advances such as broadband. After a period of significant growth in the 1990s, access lines, a key driver of our business, have declined steadily since 2001.

While the last mile connectivity to the customer remains essential, the communications industry is transitioning from a network-centric circuit-based infrastructure to an applications-centric Internet Protocol (IP) infrastructure, which could create uncertainty around traditional business models. Further, industry consolidation, such as the recent combinations of SBC and AT&T, Verizon and MCI, and Sprint and Nextel, and the pending merger of BellSouth and AT&T, are creating large enterprises with global reach and economies of scale.

Based on comparisons to penetration rates in other parts of the world, there is still significant growth potential in the wireless market in the United States. There are currently four national wireless companies engaging in aggressive competition in a growing market. The intense competition has driven down pricing, increased costs due to customer churn and increased wireless usage as companies attempt to differentiate their service plans. Meanwhile, significant capital is being invested in networks to meet increasing demand and to upgrade capabilities in anticipation of the development of new data applications.

REGULATION AND COMPETITION

Our core businesses are subject to regulation, and all of our businesses are subject to vigorous competition.

Changes to federal law in the early 1990s generally preempted states from regulating the market entry or rates of a wireless carrier, while allowing states to regulate other terms and conditions of wireless service. Wireless carriers are also subject to regulation by the Federal Communications Commission (FCC), which allocates the spectrum used by wireless carriers, and adopts and enforces other policies relating to wireless services.

Our wireline business is subject to dual state and federal regulation. The FCC has historically engaged in heavy regulation of our interstate services. In recent years, it has granted increasing pricing flexibility for our interstate telecommunications services because of the additional competition to which those services are subject, though nearly all of the services remain subject to tariffing requirements. Separately, in response to the Telecommunications Act of 1996, the FCC initially required us to share our network extensively with local service competitors, and prescribed a pricing policy (TELRIC) that has not permitted fair cost recovery. These sharing (unbundling) rules were invalidated by the courts on three separate occasions, but not before the invalid policies had been generally implemented in our contracts with competitors. In February 2005, the FCC issued rules that cut back significantly on some of the anticompetitive sharing requirements. The new rules essentially eliminated the unbundled network platform, or UNE-P, a combination of unbundled elements that replicate local service at unfairly low prices.

During 2005 and early 2006, we transitioned most former UNE-P customers to a similar platform service at commercially negotiated terms and prices. Our completion of the FCC-ordered phase out is being litigated before certain state commissions.

(Dollars in Millions, Except Per Share Amounts and as Otherwise Indicated)

The FCC provided additional relief when it released new broadband rules effective in November 2005 that responded to a U.S. Supreme Court decision. The new rules are designed to provide our high speed Internet access services with regulation equivalent to that of our competition, particularly cable modem providers. The new rules were fully phased in during the third quarter of 2006.

The states in our region continue to exert economic regulation over much of the revenue generated by our traditional narrowband wireline telecommunications services, though that regulation has been lessening. During the past two years, state legislatures and state regulatory commissions have taken action that moved regulation toward equivalence with our telecommunications competitors by prohibiting state regulation of broadband services, rebalancing rates, and reducing regulation of service bundles and services under contract.

Despite these successes, our wireline business remains more regulated than competing businesses that use cable, wireless or non-facilities based technologies. While we welcome the reforms, the transition of our wireline business regulation from the comprehensive, utility-like regulation of previous years to standard business regulation is not complete, and adjusting to each individual change requires significant management attention. We will accordingly continue to encourage regulatory reform in every appropriate forum.

Competition in the yellow pages industry continues to intensify. Major markets are seeing multiple competitors, with many different media competing for advertising revenue. We continue to respond to the increasing competition and the dynamic media environment with investments in product enhancements, multiple delivery options, local promotions, customer value plans, increased advertising and sales execution.

MERGERS, ACQUISITIONS AND DISPOSITIONS

On March 4, 2006, we agreed to merge with a subsidiary of AT&T. In the merger, shareholders of BellSouth will receive 1.325 shares of AT&T common stock for each share of BellSouth common stock. The transaction has been approved by the Board of Directors and shareholders of each company, as well as the US Department of Justice (DOJ) and all necessary state and foreign regulatory authorities. The FCC has scheduled a meeting to vote on the merger on November 3, 2006. We currently expect the transaction to close in the fall of 2006. We expect the combined company to be a more effective and efficient provider in the wireless, broadband, video, voice and data markets. The merger will also put control of Cingular Wireless in one company.

We have completed the exit of our international operations and increased our investment in the wireless market through Cingular Wireless’ acquisition of AT&T Wireless. The addition of AT&T Wireless filled in Cingular Wireless’ national coverage footprint, added depth to its licensed spectrum position, and added size and scale to compete more effectively. Cingular Wireless’ improvements in customer service and network coverage combined with new advertising campaigns are driving customer loyalty and growth. Customer churn has reduced appreciably, integration efforts are well underway and cost synergies are contributing to margin expansion. This acquisition substantially increases BellSouth’s participation in the wireless industry, bringing wireless to over 40 percent of our proportional revenues including Cingular Wireless. As Cingular completes its integration of AT&T Wireless and executes its strategy, we expect its contribution to BellSouth’s earnings to increase.

HIGHLIGHTS AND OUTLOOK

Consolidated revenues, which do not include our share of Cingular, increased 2.9 percent in the third quarter of 2006 and 1.9 percent year-to-date compared to the same periods of 2005, attributable to growth in both the Communications Group and Advertising & Publishing Group. The year-over-year growth in consolidated revenues was positively impacted by $51 in one-time credits issued during the third quarter of 2005 to customers affected by Hurricane Katrina. Revenue growth was driven by digital subscriber lines (DSL), long distance, wholesale wireless transport and emerging data services, as well as by electronic media and print services. This growth was partially offset by revenue declines from retail residence and wholesale voice access line losses. We added 176,000 net DSL customers and 118,000 long distance customers during the third quarter of 2006. We served more than 3.4 million total DSL customers and approximately 7.6 million long distance customers at September 30, 2006. At September 30, 2006 we had more than 5.1 million residential packages, an increase of 5.7 percent compared to the same period in 2005. Nearly 44 percent of packages included multiple products.

Total access lines were down 301,000 from June 30, 2006 driven by technology substitution and competition from cable telephony providers. Total retail access lines were down 127,000, which included 135,000 of line losses in consumer and positive retail small business line growth of 20,000 offset by a 13,000 decline in retail large business. The wholesale line base, of which the majority is UNE-P, declined 174,000 compared to June 30, 2006.

Our cost structure is heavily weighted towards labor and fixed asset related costs. We have adjusted our workforce due to shifts in market share of access lines. Since the beginning of 2001, we have reduced our domestic workforce by nearly 21,000 employees, or 26 percent. These workforce reductions along with reduced overtime and project spending contributed to improved year-over-year wireline operating margins. Sustaining our margins will require continued

(Dollars in Millions, Except Per Share Amounts and as Otherwise Indicated)

market penetration of new services and improvements in productivity to manage our costs as competition and technology substitution intensifies.

Operating cash flow from continuing operations of $5,268 for the first nine months of 2006 was $666 lower than the same period in 2005 primarily due to a $566 federal income tax payment in the third quarter of 2006. Capital expenditures were $2,761 for the first nine months of 2006 and $2,465 for the first nine months of 2005. The increase in capital expenditures compared to the prior period relates primarily to expenditures of approximately $265 for Hurricane Katrina restoration efforts in 2006 compared to $22 in the third quarter of 2005, and increased spending for broadband investments in infrastructure and systems.

Cingular Wireless

Cingular Wireless added approximately 1.4 million net customers in the third quarter of 2006, bringing its nationwide customer base to 58.7 million customers. Customer churn of 1.8 percent in the third quarter of 2006 decreased 50 basis points compared to the same period in the prior year. Year-over-year revenue growth exceeded 9 percent driven by subscriber growth and higher data average revenue per user (ARPU). Operating margin has been improving due to revenue growth and ARPU stabilization coupled with operational and merger-related synergies.

In the Telecommunications Act of 1996 (Telecom Act), Congress established a pro-competitive, deregulatory national policy framework to bring the benefits of competition and investment in advanced telecommunications facilities and services to all Americans by opening all telecommunications markets to competition and reducing or eliminating burdensome regulation. Since the Telecom Act was passed, the FCC and some state regulatory commissions have maintained many of the extensive regulatory requirements applicable to our traditional wireline subsidiaries. We are actively pursuing additional legislative and regulatory measures to reduce or eliminate regulatory requirements that inhibit our ability to provide the full range of services increasingly demanded by our customers. For example, we are supporting legislative efforts at both the state and federal levels, as well as proposed rules at the FCC, that would offer a streamlined process for new video service providers to compete with traditional cable television providers. Several states have passed legislation that enables new video entrants to acquire a state-wide franchise to offer video services. In addition, we are supporting efforts to update regulatory treatment for retail services. Several bills are also pending before Congress that would both reform the Telecom Act and promote additional video competition. Passage

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AT&T INC.

SEPTEMBER 30, 2006

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Continued

Dollars in millions except per share amounts

of legislation is uncertain and depends on many factors, but we believe that the increasing pace of technological change and competition in our industry will encourage lawmakers to remove artificial barriers to competition.