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UPDATE 3-AT&T disappoints on cash flow target, subscriber growth

(Adds executive and analyst comment, share price update)

NEW YORK, Jan 28 (Reuters) - AT&T Inc's fourth quarter wireless subscriber growth and its free cash flow target lagged well behind analyst estimates, sending its shares down 2 percent in late trade on Tuesday.

Chief Executive Randall Stephenson also told investors on the company's conference call that a U.S. spying scandal was hurting its business irrespective of any effect it could have on prospects for overseas acquisitions.

With a price war brewing and market share losses to smaller rival T-Mobile US and market leader Verizon Wireless at home, some investors want AT&T to expand overseas with an acquisition of Vodafone Group Plc even after it ruled out such deal for now.

AT&T added fuel to investor worries with a free cash flow target of $11 billion for 2014 and 2015 down from $13.6 billion in 2013. This implies that a "nerve-wracking" 86 percent of its cash flow will be needed for paying dividends, according to MoffettNathanson analyst Craig Moffett.

"That doesn't leave much room for a price war," Moffett said in a research note. "AT&T may or may not return to Vodafone in the second half, but they need to do ... something."

Analysts had hoped for 2014 free cash flow closer to $14 billion. AT&T, which is beefing up its network in an effort to compete better, also set a 2014 capital budget in the $21 billion range, which was $1 billion more than analysts expected.

On top of financial concerns, investors are worried about whether competition will become more intense as T-Mobile U.S. has spent several quarters directly marketing to AT&T customers, while AT&T recently offered to pay T-Mobile customers to switch.

For the fourth quarter, AT&T had subscriber net additions of 566,000, behind the average Wall Street expectation for 636,000 according to eight analysts contacted by Reuters.

It also trailed market leader Verizon Wireless which had 1.6 million subscriber additions, and T-Mobile U.S. which had 869,000.

While AT&T executives spoke of intense competition on the quarterly conference call they said their customer defection rate, known in the industry as churn, was their best ever for the fourth quarter, and showed that they were holding their own.

Jefferies analyst Michael McCormack was disappointed with the free cash flow and capital budget targets, although he noted that AT&T's churn of 1.11 percent was much better than his expectation for 1.19 percent.

"I think the market was expecting a much worse result in terms of wireless profitability and market share losses," he said.

The company reported stronger than expected wireless profitability with a service margin of 37.4 percent, compared with 29.1 percent in the year-ago quarter and analyst expectations closer to 34 percent.

NSA ISSUES

While the bulk of AT&T's business is domestic, CEO Stephenson noted for the first time on Tuesday that his company was being hurt by revelations from former NSA contractor Edward Snowden of a widespread U.S. surveillance program that used records of communications on networks including that of AT&T.

U.S. equipment maker Cisco Systems Inc recently blamed the scandal for a loss of business in China.

Stephenson said he had discussed the matter with European policy makers at the World Economic Forum in Switzerland last week as the NSA scandal fallout was "not inconsequential" to AT&T.

He explained that AT&T had issued a statement on Monday ruling out a Vodafone bid at least for now because of a request from UK regulators over the weekend due to press reports about his meetings with European officials.

Although he did not quantify the financial impact of the NSA issue, Stephenson said: "We are having customers ask us a lot of questions."

Some investors worry that the NSA affair could hurt AT&T's ability to gain European regulatory approval for a purchase of Vodafone if it pursued such a deal.

"We've had some business impacts from the NSA," Stephenson told investors during the company's quarterly earnings call. "Its affecting our ongoing business today irrespective of anything that might relate to M&A."

EARNINGS, REVENUE SLIGHTLY AHEAD

AT&T reported fourth-quarter earnings of $6.9 billion, or $1.31 per share, compared with a loss of $3.86 billion, or 68 cents per share in the year-ago quarter when it had a massive actuarial charge.

The latest quarter included a pension related gain.

Excluding unusual items AT&T earnings per share was 53 cents in the quarter compared with Wall Street expectations for 50 cents, according to Thomson Reuters I/B/E/S.

Revenue rose to $33.16 billion from $32.58 billion slightly ahead of Wall Street expectations for $33.06 billion according to Thomson Reuters I/B/E/S.

For 2014, AT&T forecast continued revenue growth in the 2 to 3 percent range.

AT&T shares fell to $33.00 in late trade after closing at $33.70 in the regular New York Stock Exchange session.

(Reporting by Sinead Carew; Editing by David Gregorio and Stephen Coates)

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