Some merger buzz, a few upside surprises and pessimists covering their short bets puts AT&T (T) - Get Report atop a furious telecom rally.

Despite continued sales declines in its key business services division and heavy competition in long distance from the Baby Bells,

AT&T beat Wall Street's earnings and revenue expectations Wednesday, sending short-sellers running to cover.

Though informal merger talks between

BellSouth

(BLS)

and AT&T had

collapsed weeks ago, due largely to Ma Bell's inability to win corporate customers from its flailing rivals

MCI

and

Sprint

(FON)

, a report Wednesday in

The Wall Street Journal

helped fan the flames of potential industry linkups.

Officially, BellSouth and AT&T have denied there were talks. Investors ignored the denials, however, sending AT&T shares up more than $2.50, or 18%, to $16.31 Wednesday. Meanwhile, Sprint rose 62 cents, or 6%, to $11.30. Local phone giants

Verizon

(VZ) - Get Report

and

SBC

(SBC)

shared in the fun, jumping 7% and 4%, while scandal-plagued

Qwest

(Q)

added 11%.

"You had a confluence of a few positives and a ton of shorts caught with their pants down," says a Wall Street money manager with no AT&T positions.

Still, a somber discussion of the company's first-quarter performance on an earnings call Wednesday suggests that the heights of the market's enthusiasm may not last long.

In its all-important business services division, AT&T saw another year-over-year decline. Revenue for the unit was $6.4 billion, down 1.4% from the same period a year ago. Operating margins fell to 9% from 13% over that same time frame.

The nation's No. 1 long-distance company said it expects heavy price competition and margin declines in its core phone business as the Baby Bells push further into long-distance services.

AT&T also joined peer Sprint this week in slashing capital spending. AT&T said Wednesday that it plans to cut its budget by 12% to $3 billion this year, leaving its budget 23% below last year's $3.9 billion level.

BellSouth, which

beat estimates by a dime Wednesday, rose $2, or 9% to, $23.70.