-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Myu1tiSdfKpdLkR96A+mp2OTxYBSuXw0+/zRQREmOqS7m49FyDrd8qFyHK3rSPrp uIrNZL1W+NkqNgey4PtLag== 0000075641-96-000016.txt : 19961115 0000075641-96-000016.hdr.sgml : 19961115 ACCESSION NUMBER: 0000075641-96-000016 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 19960930 FILED AS OF DATE: 19961113 SROS: NYSE SROS: PSE FILER: COMPANY DATA: COMPANY CONFORMED NAME: PACIFIC BELL CENTRAL INDEX KEY: 0000075641 STANDARD INDUSTRIAL CLASSIFICATION: TELEPHONE COMMUNICATIONS (NO RADIO TELEPHONE) [4813] IRS NUMBER: 940745535 STATE OF INCORPORATION: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-01414 FILM NUMBER: 96661873 BUSINESS ADDRESS: STREET 1: 140 NEW MONTGOMERY ST CITY: SAN FRANCISCO STATE: CA ZIP: 94105 BUSINESS PHONE: 4155429000 FORMER COMPANY: FORMER CONFORMED NAME: PACIFIC TELEPHONE & TELEGRAPH CO DATE OF NAME CHANGE: 19840115 10-Q 1 PACIFIC BELL'S 1996 3RD QTR FORM 10-Q FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 1996 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number 1-1414 PACIFIC BELL I.R.S. Employer No. 94-0745535 A California Corporation 140 New Montgomery Street, San Francisco, California 94105 Telephone - Area Code (415) 542-9000 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes X No . --- --- At October 31, 1996, 224,504,982 common shares were outstanding. THE REGISTRANT, A WHOLLY OWNED SUBSIDIARY OF PACIFIC TELESIS GROUP, MEETS THE CONDITIONS SET FORTH IN GENERAL INSTRUCTION H(1)(a) AND (b) OF FORM 10-Q AND IS THEREFORE FILING THIS FORM WITH REDUCED DISCLOSURE FORMAT PURSUANT TO GENERAL INSTRUCTION H(2). PACIFIC BELL AND SUBSIDIARIES TABLE OF CONTENTS Page PART I. FINANCIAL INFORMATION Number - ------------------------------ ------ Item 1. Financial Statements Review Report of Independent Accountants .............. 1 Condensed Consolidated Statements of Income ........... 2 Condensed Consolidated Balance Sheets ................. 3 Condensed Consolidated Statements of Cash Flows ....... 4 Notes to Condensed Consolidated Financial Statements .. 6 Item 2. Management's Discussion and Analysis of Results of Operations ............................................ 10 PART II. OTHER INFORMATION - --------------------------- Item 6. Exhibits............................................. 24 SIGNATURE......................................................... 25 - --------- PART I. FINANCIAL INFORMATION Item 1. Financial Statements REVIEW REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareowner of Pacific Bell: We have reviewed the accompanying condensed consolidated balance sheet of Pacific Bell and Subsidiaries (the "Company") as of September 30, 1996 and the related condensed consolidated statements of income for the three- and nine- month periods ended September 30, 1996 and 1995, and the condensed consolidated statements of cash flows for the nine-month periods ended September 30, 1996 and 1995. These financial statements are the responsibility of the Company's management. We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to the accompanying condensed consolidated financial statements for them to be in conformity with generally accepted accounting principles. The Company discontinued application of Statement of Financial Accounting Standards No. 71 effective third quarter 1995. We have previously audited, in accordance with generally accepted auditing standards, the consolidated balance sheet of Pacific Bell and Subsidiaries as of December 31, 1995, and the related consolidated statements of income, shareowner's equity, and cash flows for the year then ended (not presented herein); and in our report dated February 22, 1996, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 1995, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived. /s/Coopers & Lybrand L.L.P. San Francisco, California November 13, 1996 1 PACIFIC BELL AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited) For the 3 Months Ended For the 9 Months Ended September 30, September 30, ---------------------- ---------------------- (Dollars in millions) 1996 1995 1996 1995 - -------------------------------------------------------------------------- OPERATING REVENUES Local service............ $ 1,006 $ 944 $ 2,962 $ 2,803 Network access: Interstate ............ 448 413 1,338 1,257 Intrastate ............ 176 179 539 522 Toll service ............ 325 306 953 910 Other service revenues .. 422 386 1,220 1,134 ------ ------ ------ ------ TOTAL OPERATING REVENUES 2,377 2,228 7,012 6,626 ------ ------ ------ ------ OPERATING EXPENSES Cost of products and services .............. 450 399 1,287 1,323 Customer operations and selling expenses ...... 491 476 1,425 1,351 General, administrative, and other expenses .... 349 340 1,036 959 Property and other taxes. 46 45 132 141 Depreciation and amortization .......... 462 461 1,370 1,381 ------ ------ ------ ------ TOTAL OPERATING EXPENSES. 1,798 1,721 5,250 5,155 ------ ------ ------ ------ OPERATING INCOME......... 579 507 1,762 1,471 Interest expense......... 95 110 277 327 Other income (expense)-net.......... 3 17 4 45 ------ ------ ------ ------ INCOME BEFORE INCOME TAXES AND EXTRAORDINARY ITEM. 487 414 1,489 1,189 Income taxes............. 198 156 606 442 ------ ------ ------ ------ INCOME BEFORE EXTRAORDINARY ITEM .................. 289 258 883 747 Extraordinary item, net of tax............. - (3,360) - (3,360) ------ ------ ------ ------ NET INCOME (LOSS)........ $ 289 $(3,102) $ 883 $(2,613) =========================================================================== The accompanying Notes are an integral part of the Condensed Consolidated Financial Statements. 2 PACIFIC BELL AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS September 30, December 31, (Dollars in millions) 1996 1995 - --------------------------------------------------------------------------- ASSETS: (Unaudited) Cash and cash equivalents........................ $ 78 $ 68 Accounts receivable - (net of allowances for uncollectibles of $156 and $131 in 1996 and 1995, respectively)........................ 1,563 1,475 Prepaid expenses and other current assets........ 847 802 ------- ------- Total current assets............................. 2,488 2,345 ------- ------- Property, plant, and equipment - at cost......... 27,808 26,688 Less: accumulated depreciation................ (16,501) (15,608) ------- ------- Property, plant, and equipment - net............. 11,307 11,080 ------- ------- Other noncurrent assets.......................... 465 474 ------- ------- TOTAL ASSETS..................................... $14,260 $13,899 ======= ======= LIABILITIES AND SHAREOWNER'S EQUITY: Accounts payable and accrued liabilities......... $ 1,953 $ 2,109 Debt maturing within one year.................... 608 781 Other current liabilities........................ 475 552 ------- ------- Total current liabilities........................ 3,036 3,442 ------- ------- Long-term obligations............................ 5,295 4,608 ------- ------- Deferred income taxes............................ 443 321 ------- ------- Other noncurrent liabilities and deferred credits 2,124 2,417 ------- ------- Commitments and contingencies (Note B) Common stock ($1.00 stated value, 300,000,000 shares authorized, 224,504,982 shares issued and outstanding)............................... 225 225 Additional paid-in capital....................... 5,586 5,387 Accumulated deficit.............................. (2,449) (2,501) ------- ------- Total shareowner's equity........................ 3,362 3,111 ------- ------- TOTAL LIABILITIES AND SHAREOWNER'S EQUITY........ $14,260 $13,899 ========================================================================== The accompanying Notes are an integral part of the Condensed Consolidated Financial Statements. 3 PACIFIC BELL AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) For the 9 Months Ended September 30, ---------------------- (Dollars in millions) 1996 1995 - --------------------------------------------------------------------------- CASH FROM (USED FOR) OPERATING ACTIVITIES: Net income (loss)................................... $ 883 $(2,613) Adjustments to reconcile net income (loss) to cash from operating activities: Extraordinary item................................. - 3,360 Depreciation and amortization...................... 1,370 1,381 Change in deferred income taxes.................... 133 53 Unamortized investment tax credits................. (35) (37) Changes in operating assets and liabilities: Accounts receivable.............................. (107) 49 Prepaid expenses and other current assets........ (37) (22) Other noncurrent assets.......................... 15 135 Accounts payable and accrued liabilities......... (139) (115) Other current liabilities........................ (77) 24 Noncurrent liabilities and deferred credits...... (258) (343) Other adjustments, net........................... 6 8 ------- ------- Cash from operating activities...................... 1,754 1,880 ------- ------- CASH USED FOR INVESTING ACTIVITIES: Additions to property, plant, and equipment.......... (1,597) (1,285) Other investing activities, net...................... (32) (1) ------- ------- Cash used for investing activities................... (1,629) (1,286) ------- ------- CASH FROM (USED FOR) FINANCING ACTIVITIES: Equity infusion from parent.......................... 198 57 Proceeds from issuance of long-term debt............. 495 - Dividends paid....................................... (830) (763) Increase (decrease) in short-term borrowings, net.... (186) 120 Proceeds from sale and leaseback transactions........ 211 - Other financing activities, net...................... (3) (4) ------- ------- Cash used for financing activities................... (115) (590) ------- ------- (Continued on next page) 4 PACIFIC BELL AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Continued) For the 9 Months Ended September 30, ---------------------- (Dollars in millions) 1996 1995 - --------------------------------------------------------------------------- Increase in cash and cash equivalents............... 10 4 Cash and cash equivalents at January 1.............. 68 62 ------- ------- Cash and cash equivalents at September 30........... $ 78 $ 66 ======= ======= Cash payments for: Interest.......................................... $ 305 $ 317 Income taxes...................................... $ 253 $ 396 ============================================================================ The accompanying Notes are an integral part of the Condensed Consolidated Financial Statements. 5 PACIFIC BELL AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) A. BASIS OF PRESENTATION The Condensed Consolidated Financial Statements include the accounts of Pacific Bell, and its wholly-owned subsidiaries, Pacific Bell Directory, Pacific Bell Information Services, Pacific Bell Mobile Services, Pacific Bell Internet Services, Pacific Bell Network Integration and others, hereinafter referred to as the "Company". All significant intercompany balances and transactions have been eliminated. The Condensed Consolidated Financial Statements reflect reclassifications made to conform with the current year presentation. These reclassifications did not affect net income or shareowner's equity. The Condensed Consolidated Financial Statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission ("SEC") applicable to interim financial information. Certain information and footnote disclosures included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted in these interim statements pursuant to such SEC rules and regulations. Management recommends that these interim financial statements be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company's 1995 annual report on Form 10-K. Effective third quarter 1995, for external financial reporting purposes, the Company discontinued the application of Statement of Financial Accounting Standards No. ("SFAS") 71, "Accounting for the Effects of Certain Types of Regulation," an accounting standard for entities subject to traditional regulation. As a result, during third quarter 1995 the Company recorded a non-cash, extraordinary, after-tax charge of $3.4 billion. In management's opinion, the Condensed Consolidated Financial Statements include all adjustments (consisting of only normal recurring adjustments) necessary to present fairly the financial position and results of operations for each interim period shown. The Condensed Consolidated Financial Statements have been reviewed by Coopers & Lybrand L.L.P., independent accountants. Their report is on page 1. Change In Estimates In March 1996, management amended the salaried pension plan, which changed from a final pay plan to a cash balance plan. As a result of the approval of this plan amendment, in second quarter 1996 the Company updated its actuarial assumptions to reflect changes in market interest rates and recent experience, including a change in its assumption concerning future ad hoc increases in pension benefits. These changes in estimates increased net income by approximately $75 million for the first nine months of 1996 in comparison to the same period in 1995. 6 PACIFIC BELL AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) B. COMMITMENTS AND CONTINGENCIES Merger Agreement On April 1, 1996, SBC Communications Inc. ("SBC") and Pacific Telesis, the Company's parent, jointly announced a definitive agreement whereby Pacific Telesis will become a wholly-owned subsidiary of SBC. Under terms of the merger agreement, each share of Pacific Telesis common stock will be exchanged for 0.733 shares of SBC common stock, subject to adjustment. The transaction is intended to be accounted for as a pooling of interests and to be a tax-free reorganization. On July 31, 1996, the shareowners of Pacific Telesis and SBC approved the transaction, which previously had been approved by the respective Board of Directors of each company. On November 5, 1996, the U.S. Department of Justice announced it had concluded that the merger does not violate the antitrust laws and accordingly that it was closing its investigation into the merger. The merger is subject to certain other conditions and regulatory approvals. The California Public Utilities Commission ("CPUC") has established a schedule for review of the transaction with final comments from interested parties due in January 1997. On September 30, 1996, the Office of Ratepayer Advocates ("ORA"), the consumer interest branch of the CPUC, filed testimony in the merger proceeding recommending a $2.1 billion refund to customers payable over five years. Management does not agree with the ORA's recommendation and believes no customer rebate should be required in connection with the merger. The CPUC is expected to make a final decision on the merger by the end of March 1997. In Nevada, SBC and Pacific Telesis entered into a stipulation with the staff of the Public Service Commission of Nevada ("PSCN") and the Office of the Consumer Advocate to refund to customers the greater of $4 million or 2.0 percent of the amount, if any, ordered by the CPUC to be refunded to Pacific Bell customers. The refund is conditioned on approval of the stipulation by the PSCN and closing of the merger. The PSCN has scheduled hearings for November 25, 1996, and approval is expected in December 1996. If all necessary approvals are granted, the transaction is expected to close in the first quarter of 1997. 7 PACIFIC BELL AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) B. COMMITMENTS AND CONTINGENCIES (Cont'd) Purchase Commitments In December 1994, the Company contracted for the purchase of up to $2 billion of Advanced Communications Network facilities, which will incorporate emerging technologies. The Company is committed to purchase these facilities in 1998 if they meet certain quality and performance criteria. Management now expects the actual amount of these facilities purchased in 1998 will be less than $700 million. As of September 30, 1996, the Company had purchase commitments of about $212 million remaining in connection with its previously announced program for deploying an all-digital switching platform with ISDN and SS-7 capabilities. Revenues Subject to Refund In 1992, the CPUC issued a decision adopting, with modification, SFAS 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," for regulatory accounting purposes. Annual price cap decisions by the CPUC granted the Company approximately $100 million in each of the years 1993-1996 for partial recovery of higher costs under SFAS 106. However, the CPUC in October 1994 reopened the proceeding to determine the criteria for exogenous cost treatment and whether the Company should continue to recover these costs. The CPUC's order held that related revenues collected after October 12, 1994 are subject to refund plus interest. It is possible that the CPUC could decide this issue in the near term, and that the decision could have a material adverse effect on the Company. Related revenues subject to refund totaled about $197 million at September 30, 1996. Management believes postretirement benefits costs are appropriately recoverable in the Company's price cap filings. 8 PACIFIC BELL AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) B. COMMITMENTS AND CONTINGENCIES (Cont'd) Property Tax Investigation In 1992, a settlement agreement was reached between the State Board of Equalization, all California counties, the State Attorney General, and 28 utilities, including the Company, on a specific methodology for valuing utility property for property tax purposes for a period of eight years. The CPUC opened an investigation to determine if any resulting property tax savings should be returned to customers. Intervenors have asserted that as much as $20 million of annual property tax savings should be treated as an exogenous cost reduction in the Company's annual price cap filings. These intervenors have also asserted that past property tax savings totaling as much as approximately $66 million as of September 30, 1996, plus interest should be returned to customers. Management believes that, under the CPUC's regulatory framework, any property tax savings should be treated only as a component of the calculation of shareable earnings not as an exogenous cost. In an Interim Opinion issued in June 1995, the CPUC decided to defer a final decision on this matter pending resolution of the criteria for exogenous cost treatment under its regulatory framework. The criteria are being considered in a separate proceeding initiated for rehearing of the CPUC's postretirement benefits other than pensions decision discussed above. It is possible that the CPUC could decide this issue in the near term, and that the decision could have a material adverse effect on the Company. C. DEBT ISSUANCES The Company issued $500 million of debentures, $250 million in February 1996 at 5.875 percent due February 15, 2006, and $250 million in August 1996 at 6.875 percent due August 15, 2006. Neither issue may be redeemed prior to maturity. The proceeds from the sale of the debentures were used to reduce short-term debt incurred to retire the Company's debentures totaling approximately $500 million called in December 1995. The Company has remaining CPUC authority, which will expire December 31, 1996, to issue up to $750 million of long- and intermediate-term debt. The Company plans to make an application to renew this authority. The proceeds may be used only to redeem maturing debt and to refinance other debt issues. The Company has remaining authority from the SEC to issue up to $150 million of long- and intermediate-term debt through a shelf registration filed in April 1993. 9 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS In addition to historical information contained herein, this quarterly report on Form 10-Q contains certain forward-looking statements that involve potential risks and uncertainties. Pacific Bell's (the "Company") future results could differ materially from those discussed herein. Factors that could cause or contribute to such differences include, but are not limited to, those discussed herein and those discussed in "Management's Discussion and Analysis of Results of Operations" included in the Company's December 31, 1995 Form 10-K. Readers are cautioned not to place undue reliance on these forward-looking statements which speak only as of the date hereof. The Company undertakes no obligation to revise or update these forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. RESULTS OF OPERATIONS The following discussions and data compare the results of operations of the Company for the nine-month period ended September 30, 1996 to the corresponding period in 1995. Results for the first nine months of 1996 may not be indicative of results for the full year. A summary of selected operating data is shown below: For the 9 Months Ended September 30, ----------------------- % Operating Statistics 1996 1995 Change - ---------------------------------------------------------------------------- Return on shareowner's equity (%)............... 36.4 -57.5 - Capital expenditures ($mil)..................... 1,596 1,201 32.9 Total employees at September 30................. 46,193 48,359 -4.5 Telephone network employees at September 30*.... 43,444 45,793 -5.1 Telephone network employees per ten thousand access lines*................................. 27.1 29.8 -9.1 ============================================================================ * Excludes Pacific Bell Directory and Pacific Bell Mobile Services employees. 10 Earnings - -------- The Company's earnings continue to reflect revenue growth from increased customer demand for local telephone products associated with marketing efforts and California's growing economy, offset by expenses to prepare to enter new businesses and to comply with local competition mandates. The Company reported net income of $883 million for the first nine months of 1996, an 18.2 percent increase over the $747 million before extraordinary item reported for the same period last year. The extraordinary item was a one-time, non- cash, after-tax charge of $3.4 billion recorded in third quarter 1995. The extraordinary charge resulted from the discontinued application by the Company of special accounting rules for entities subject to traditional regulation and its change to the general accounting rules used by competitive enterprises. (See "Extraordinary Item" on page 17.) For the first nine months in 1995, pressure on earnings before extraordinary item resulted from incremental labor expense associated with the severe storms in early 1995. These earnings decreases in 1995 were partially offset by the Company's ongoing cost-reduction efforts. The California Public Utilities Commission ("CPUC") authorized facilities- based local services competition effective January 1996, and resale competition effective March 1996. Certain issues remain open in the local competition proceedings. (See "CPUC Local Services Competition" on page 22.) As of September 30, 1996, such competition had not yet had a significant effect on the Company's earnings. In August 1996, the Federal Communications Commission ("FCC") released a decision establishing guidelines to implement the 1996 Telecommunications Act, which sets additional rules for opening local telecommunications markets to full competition. (See "FCC Interconnection Order" on page 21.) Management is concerned that final terms set by regulators could deprive the Company of the opportunity to earn a fair return on investment. 11 Volumes - ------- For the 9 Months Ended September 30, ------------------------- % Volume Indicators 1996 1995 Change - ----------------------------------------------------------------------------- Switched access lines in service at September 30 (thousands)..................... 16,018 15,348* 4.4 Residence.................................... 9,979 9,621* 3.7 Business..................................... 5,829 5,521* 5.6 Other........................................ 210 206* 1.9 ISDN access lines (Included in above access lines).............................. 90 43 109.3 Interexchange carrier access minutes-of-use (millions)...................... 47,307 43,210 9.5 Interstate................................... 25,961 23,715 9.5 Intrastate................................... 21,346 19,495 9.5 Toll messages (millions)......................... 3,870 3,596 7.6 Toll minutes-of-use (millions)................... 11,521 10,825 6.4 Voice mailbox equivalents at Sept. 30(thousands). 1,649 1,360 21.3 Custom calling services at Sept. 30(thousands)... 7,758 7,037 10.3 ============================================================================ * Restated The total number of access lines in service grew to 16.018 million, an increase of 4.4 percent for the twelve months ended September 30, 1996. This is an improvement over the 2.7 percent increase for the same period last year. The residential access line growth rate increased to 3.7 percent for the twelve months ended September 30, 1996, from 1.7 percent last year. Changes in technology, telecommuting, Internet access and the Company's marketing efforts continue to fuel increased demand for additional telephone lines in the home. Second access lines in residences grew 14.1 percent from 1.732 million lines to 1.976 million lines for the twelve months ended September 30, 1996. The growth rate in business access lines was 5.6 percent for the twelve months ended September 30, 1996, up from 4.4 percent for the same period last year. The number of ISDN lines in service for the Company grew to 90 thousand, an increase of 109.3 percent for the twelve months ended September 30, 1996, as customers increased telecommuting and demanded faster data transmission and Internet access. Accelerated demand for the Company's high-speed data transmission continued through the third quarter due to the Company's intensified marketing efforts. Access minutes-of-use represent the volume of traffic carried by interexchange carriers over the Company's local network. Total access minutes-of-use for the nine months ended September 30, 1996 increased by 9.5 percent over the same period last year. The increase in access minutes-of-use was primarily attributable to the continued economic growth in California. 12 Toll messages and minutes-of-use are comprised of Message Telecommunications Service and Optional Calling Plans ("local toll") as well as WATS and terminating 800 services. For the nine months ended September 30, 1996, toll minutes-of-use increased by 6.4 percent driven by the continued economic growth in California. High demand for the Company's voice mail products continued in 1996. Voice mailbox equivalents in service increased 21.3 percent for the twelve months ended September 30, 1996 to 1.649 million. Similarly, demand for custom calling services, such as call waiting, grew 10.3 percent for the twelve months ended September 30, 1996 due to California's growing economy and the Company's focused customer retention efforts. Operating Revenues - ------------------ For the 9 Months Ended September 30, ------------------------ ($ millions) 1996 1995 Change - ----------------------------------------------------------------------------- Total operating revenues ....................... $7,012 $6,626 $386 5.8% - ----------------------------------------------------------------------------- Revenues for the first nine months of 1996 increased from the same period last year primarily due to increased customer demand for the Company's telephone services driven by marketing efforts and California's growing economy. Revenues for the nine-months ended September 30, 1996 were offset by a $55 million rate reduction due to FCC price cap orders. Revenues for the six months ended June 30, 1996, decreased $60 million due to the FCC price cap filing for the twelve months ending June 30, 1996. For the 1996 annual access tariffs filings effective July 1, 1996, revenues increased approximately $5 million for the three-month period ending September 30, 1996. (See "FCC Annual Access Tariff Filing and Regulatory Framework Review" on page 22.) The CPUC price cap order effective January 1, 1996, had a minimal effect on the Company's revenues due to an order in December 1995 suspending use of the "inflation minus productivity" component of the price cap formula for 1996 through 1998. This action freezes the price caps on most of the Company's regulated services through 1998 except for adjustments due to exogenous costs or price changes approved through the CPUC's application process. (See "CPUC Regulatory Framework Review" on page 23.) 13 Factors affecting revenue changes are summarized in the following table. Total Price Change Cap Customer From Orders Misc. Demand 1995 - ----------------------------------------------------------------------------- Local service........................ $ - $15 $144 $159 Network access: Interstate......................... -55 54 82 81 Intrastate......................... - -19 36 17 Toll service......................... - -24 67 43 Other service revenues............... - 10 76 86 ----- ----- ----- ---- Total operating revenues............. $-55 $36 $405 $386 ============================================================================= The $144 million increase in customer demand for local service revenues is the result of the 4.4 percent growth in access lines and the 10.3 percent growth in custom calling services. These increases were generated by the continuing growth in the California economy and the Company's focused customer retention efforts. In addition, the Company introduced a new feature, "Call Return," on a "pay-per-use" basis in April 1996 that generated revenues of approximately $30 million for 1996. The $82 million increase in interstate network access revenues due to customer demand reflects increased interexchange carrier access minutes-of-use, as well as increased access lines. The $36 million customer demand-related increase in intrastate network access revenues also resulted from growth in access minutes-of-use. The $67 million increase in toll service revenues due to customer demand was driven primarily by increased local toll usage resulting from general economic growth. The customer demand-related increase in local toll service revenues was partially offset by competitive losses in WATS and 800 services. Interexchange carriers currently have the competitive advantage of being able to offer WATS and 800 service both within and between service areas. The $76 million increase in other service revenues due to customer demand reflects the continuing success of the Company's voice mail products and directory operations. In addition, primarily in the second and third quarters of 1996, customer demand-related revenues increased in the Company's network integration services. 14 Operating Expenses - ------------------ For the 9 Months Ended September 30, ------------------------ ($ millions) 1996 1995 Change - ----------------------------------------------------------------------------- Total operating expenses....................... $5,250 $5,155 $95 1.8% - ----------------------------------------------------------------------------- Total operating expenses for the nine-month period ended September 30, 1996 increased when compared with 1995 reflecting costs for increased demand for products and services, new business initiatives and costs incurred to prepare for local competition. Increased expenses were partially offset by cost reductions from the Company's ongoing efficiency efforts and savings due to changes in employee benefit plans and benefit plan assumptions. Primary factors affecting expense changes are summarized below. Total Change Salaries Employee Subsi- From ($ millions) & Wages* Benefits* Misc.* diaries 1995 - ----------------------------------------------------------------------------- Cost of products and services.. $6 $-94 $55 $-3 $-36 Customer operations and selling expenses......... 6 -49 29 88 74 General, administrative and other expenses........... 5 -12 112 -28 77 Property and other taxes....... - - -9 - -9 Depreciation and amortization.. - - -15 4 -11 ---- ---- ---- ---- ---- Total operating expenses....... $17 $-155 $172 $61 $95 ============================================================================= * Excludes Pacific Bell subsidiaries. Excluding its subsidiaries, the Company's salary and wage expense for the nine-month period ended September 30, 1996 increased $17 million compared to the same period in 1995, primarily due to wage increases associated with new labor agreements effective August 1995 and overtime in the second and third quarters of 1996 due to increased business volumes. These increases were mostly offset by force reduction programs. Decreased overtime in first quarter 1996 due to milder weather when compared to 1995 also partially offset the increases. 15 Excluding its subsidiaries, the Company's employee benefits expense for the nine-month period ended September 30, 1996 decreased $155 million compared to the same period in 1995 primarily due to changes in employee benefit plans and a related remeasurement of benefit plan expense. The changes in employee benefit plans and benefit plan assumptions will continue to produce savings through year end and are expected to produce savings in future periods. (See "Change In Estimates" under Note A on page 6.) Excluding its subsidiaries, the Company's miscellaneous cost of products and services, and general, administrative and other expenses increased for the nine-month period ended September 30, 1996 compared to 1995 primarily due to costs incurred to prepare for local competition and contract services associated with increased demand for products and services. Excluding its subsidiaries, the Company's miscellaneous property and other taxes decreased for the nine-month period ended September 30, 1996 compared to 1995 primarily due to nonrecurring audit adjustments accrued in 1995. Depreciation expense at the Company, excluding its subsidiaries, decreased $15 million for the nine-month period ended September 30, 1996 compared to 1995 primarily due to the elimination of the amortization of certain regulatory assets associated with the discontinued application of Statement of Financial Accounting Standards No. ("SFAS") 71, "Accounting for the Effects of Certain Types of Regulation." (See "Extraordinary Item" on page 17.) The effect of this decrease was partially offset by higher telecommunications plant balances. The Company's subsidiaries' customer operations and selling expenses increased $88 million for the nine-month period ended September 30, 1996 compared to 1995 due to new business initiatives, such as Personal Communications Services ("PCS"), Internet access and network integration. The Company's subsidiaries' general, administrative and other expenses decreased $28 million for the nine-month period ended September 30, 1996 compared to 1995 primarily due to reduced software expenses. Interest Expense - ---------------- For the 9 Months Ended September 30, ------------------------ ($ millions) 1996 1995 Change - ----------------------------------------------------------------------------- Interest expense................................ $277 $327 $-50 -15.3% - ----------------------------------------------------------------------------- Interest expense decreased for the nine-month period ended September 30, 1996 compared to 1995. This decrease was due to lower interest rates and a change in classification of interest capitalized during construction from an item of other income to a reduction in interest expense due to the discontinued application of SFAS 71. 16 Other Income (Expense) - Net - ---------------------------- For the 9 Months Ended September 30, ----------------------- ($ millions) 1996 1995 Change - ------------------------------------------------------------------------------ Other income (expense) - net .................. $4 $ 45 $-41 -91.1% - ------------------------------------------------------------------------------ Other income (expense)-net decreased for the nine-month period ended September 30, 1996 compared to 1995 primarily due to a change in classification of interest capitalized during construction from an item of other income to a reduction of interest expense and due to interest income received on a tax refund in first quarter 1995. Income Taxes - ------------ For the 9 Months Ended September 30, ------------------------ ($ millions) 1996 1995 Change - ------------------------------------------------------------------------------ Income taxes...................................... $606 $442 $164 37.1% - ------------------------------------------------------------------------------ Income tax expense increased for the nine-month period ended September 30, 1996 compared to 1995 primarily due to higher pre-tax income and tax adjustments. Extraordinary Item - ------------------ Effective third quarter 1995, for external financial reporting purposes, the Company discontinued the application of SFAS 71, an accounting standard for entities subject to traditional regulation. As a result, during third quarter 1995 the Company recorded a non-cash, extraordinary, after-tax charge of $3.4 billion. 17 Status of Reserves - ------------------ As previously reported, the Company established a restructuring reserve at the end of 1993 to provide for the incremental cost of force reductions and other related costs to restructure its internal business processes through 1997. After new hires, net force reduction for the Company, excluding its subsidiaries, was approximately 1,225 employees for the first nine months of 1996. A total of $141 million in cash outlays was charged to the reserve in the first nine months of 1996. In 1995, the Company charged $219 million to the restructuring reserve for the cost through 1997 of enhanced retirement benefits negotiated in the 1995 union contracts. Based on its experience, the Company this year revised its estimate of these retirement costs. Consequently, $64 million of these 1995 noncash charges were reversed in second quarter 1996. There was no effect on net income from either the 1995 charge or the 1996 change in estimate. As of September 30, 1996 $142 million remained in the restructuring reserve. Capital Expenditures - -------------------- The Company invested $1,596 million through September 30, 1996, primarily in the Company's core telecommunications network and the Pacific Bell Mobile Services PCS network. 18 CREDIT RATINGS In March 1996, Moody's Investors Services, Inc. ("Moody's"), placed the senior long-term debt ratings of the Company under review for possible downgrade. In August 1996, Moody's downgraded the Company's debentures and notes to A1 from Aa3 and the shelf registration of debt securities to (P)A1 from (P)Aa3. The downgrades were prompted by Moody's concerns about the ability of the Company to continue to generate the same level of highly predictable cash flows in an increasingly uncertain competitive and regulatory environment. In April 1996, reflecting the announcement of the merger agreement with SBC Communications Inc. ("SBC"), Standard & Poor's Corporation reaffirmed its rating of Double-A-Minus ("AA-") on the Company's debentures and its credit rating outlook as negative. (See "Merger Agreement" under Note B on page 7.) Also reflecting the merger agreement announcement, Duff and Phelps, Inc. reaffirmed its ratings of Duff 1+ and Double-A-Minus ("AA-") on the Company's commercial paper and debentures, respectively. The following are commercial paper and bond ratings for the Company as of September 30, 1996: Moody's Investors Standard & Duff and Services, Inc. Poor's Corp. Phelps, Inc. ----------------- ------------ ------------ Commercial Paper............ Prime-1 A-1+ Duff 1+ Long- and Intermediate- Term Debt................ A1 AA- AA- The above ratings reflect the views of the rating agencies and are subject to change. The ratings should be evaluated independently and are not recommendations to buy, sell, or hold the securities of the Company. 19 MERGER AGREEMENT On April 1, 1996, SBC and Pacific Telesis, the Company's parent, jointly announced a definitive agreement whereby Pacific Telesis will become a wholly- owned subsidiary of SBC. Under terms of the merger agreement, each share of Pacific Telesis common stock will be exchanged for 0.733 shares of SBC common stock, subject to adjustment. The transaction is intended to be accounted for as a pooling of interests and to be a tax-free reorganization. On July 31, 1996, the shareowners of Pacific Telesis and SBC approved the transaction, which previously had been approved by the respective Board of Directors of each company. On November 5, 1996, the U.S. Department of Justice announced it had concluded that the merger does not violate the antitrust laws and accordingly that it was closing its investigation into the merger. The merger is subject to certain other conditions and regulatory approvals. The California Public Utilities Commission ("CPUC") has established a schedule for review of the transaction with final comments from interested parties due in January 1997. On September 30, 1996, the Office of Ratepayer Advocates ("ORA"), the consumer interest branch of the CPUC, filed testimony in the merger proceeding recommending a $2.1 billion refund to customers payable over five years. Management does not agree with the ORA's recommendation and believes no customer rebate should be required in connection with the merger. The CPUC is expected to make a final decision on the merger by the end of March 1997. In Nevada, SBC and Pacific Telesis entered into a stipulation with the staff of the Public Service Commission of Nevada ("PSCN") and the Office of the Consumer Advocate to refund to customers the greater of $4 million or 2.0 percent of the amount, if any, ordered by the CPUC to be refunded to Pacific Bell customers. The refund is conditioned on approval of the stipulation by the PSCN and closing of the merger. The PSCN has scheduled hearings for November 25, 1996, and approval is expected in December 1996. If all necessary approvals are granted, the transaction is expected to close in the first quarter of 1997. PENDING REGULATORY ISSUES FCC Recommendation on Universal Service - --------------------------------------- On November 7, 1996, the Joint Federal-State Board on Universal Service (the "Board") issued a recommendation on how to implement sections of the 1996 Telecommunications Act regarding universal service. Generally the plan creates a system that identifies cost subsidies in rural and high-cost areas. However, the Board deferred a recommendation on how large the subsidy should be. The Board also recommended creation of a $2.25 billion fund for providing discounted services to schools and libraries. The FCC has until May 8, 1997 to issue a final decision on this matter. 20 FCC Interconnection Order - ------------------------- In August 1996, the FCC released a decision (the "Interconnection Order") establishing guidelines to implement the 1996 Telecommunications Act, which sets rules for opening local telecommunications markets to full competition. The Interconnection Order lays out how long-distance companies and other new competitors may connect to local networks and sets guidelines and prices for network components. Management believes that the Interconnection Order undermines the intent of the 1996 Telecommunications Act by, among other things, denying states a role in managing and setting prices for local markets. Management is also concerned that the order requires local telephone companies to offer wholesale network services at unrealistically low prices. The Company, along with other local telephone companies, the National Association of Regulatory Utility Commissioners and state PUCs including the CPUC, appealed the Interconnection Order to a federal court. On October 15, 1996, the U.S. Court of Appeals for the Eighth Circuit (the "Court of Appeals") issued a partial stay of the Interconnection Order that stays the operation and effect of the pricing provisions and the "pick and choose" rule, but allows the non-pricing elements of the order to go into effect. The U.S. Supreme Court issued a memorandum decision on November 12, 1996 refusing to overturn the stay imposed by the Court of Appeals. The Interconnection Order also addressed the issue of wireless interconnection, or the arrangements under which local exchange carriers ("LECs") are compensated for interconnecting with and terminating traffic for commercial mobile radio service ("CMRS") providers (including cellular, PCS and paging). The Interconnection Order ruled that CMRS providers are entitled to reciprocal compensation arrangements for transport and termination of local telecommunications traffic. On November 1, 1996 the Court of Appeals lifted a part of the stay described above with respect to the non-price aspects of the FCC's reciprocal compensation rules for CMRS providers. As a result of this order, the Company is currently renegotiating its CMRS contracts. 21 FCC Annual Access Tariff Filing and Regulatory Framework Review - --------------------------------------------------------------- The Company filed its 1996 annual access tariffs with the FCC, which will increase annual revenues by approximately $27 million, for the twelve months beginning July 1, 1996. The revenue increases are under review by the FCC. The FCC adopted new interim price cap rules in 1995 that govern the prices that the larger LECs, including the Company, charge interexchange carriers for access to local telephone networks. The interim rules require the LECs to adjust their maximum prices for changes in inflation, productivity and certain costs beyond the control of the LEC. Under the interim plan, LECs may choose from three productivity factors: 4.0, 4.7 or 5.3 percent. Election of the 5.3 percent productivity factor permits the LEC to retain all of its earnings whereas the other lower productivity factors require earnings to be shared with customers. As in 1995, the Company again chose the 5.3 percent productivity factor that will enable it to retain all of its earnings effective July 1, 1996. The higher productivity factor was chosen because management believes that it will be more than offset by elimination of the sharing mechanism. An FCC ruling on permanent price cap rules has been delayed until 1997 due to the implementation of the 1996 Telecommunications Act. Management continues to believe that the FCC should adopt pure price cap regulation and eliminate the productivity factor, sharing and earnings cap. CPUC Local Services Competition - ------------------------------- The CPUC authorized facilities-based local services competition effective January 1996 and resale competition effective March 1996. Several issues still need to be resolved in order to implement competition in all California telecommunications markets. Issues to be finalized include final rates for resale and number portability, LEC provisioning and pricing of essential network functions to competitors and presubscription. The CPUC expects to issue final rules on presubscription in early 1997 and final rates and rules for all other issues in late 1997. Management believes that all markets should be open to all competitors under the same rules at the same time, and that a truly open competitive market, in which the Company can compete without restrictions, offers long-term opportunity to build the business. 22 CPUC Decision on Universal Service - ---------------------------------- The CPUC issued its final decision on universal service on October 25, 1996, establishing an annual California universal service fund of approximately $352 million. Customers of all telecommunications providers will contribute to the preservation of affordable telephone service via a 2.87 percent surcharge on all bills for telecommunications services provided in California. The new program will go into effect February 1, 1997. Applications for rehearing are due on December 4, 1996. Management is evaluating whether to seek rehearing. Management is concerned that the decision underestimates the true cost of providing universal telephone service. While $305 million of the total $352 million is expected to be paid to the Company, this is far short of what the Company estimates the true cost of providing universal service to be. The Company developed a Cost Proxy Model to calculate the cost of service in California. That model estimated the average cost of providing service to be $27 per line per month. The CPUC uses the model for the new program, but has determined that the average cost is only $20.30 per line per month. In order to ensure revenue neutrality, the Company must offset its rates dollar for dollar for any funds it receives from the newly created universal service fund. This offset will initially be accomplished by means of an across-the-board surcredit on all of the Company's products and services except for residential basic exchange services. The final decision also establishes a discount program for schools, libraries, certain community-based organizations and municipal- and county-owned hospitals and clinics. Carriers providing services at a discounted price will be reimbursed from a newly created California Teleconnect Fund. This discount program will be funded by a separate surcharge of 0.41 percent on the bills of customers of all telecommunications carriers in California. CPUC Regulatory Framework Review - -------------------------------- As previously reported, in December 1995, the CPUC issued an order in its review of the regulatory framework in California. The order suspended use of the "inflation minus productivity" component of the price cap formula for 1996 through 1998. This action freezes the price caps on most of the Company's regulated services for the years 1996 through 1998 except for adjustments due to exogenous costs or price changes approved through the CPUC's application process. In October 1996, the Company filed an application with the CPUC to adjust its rates due to exogenous cost changes, proposing an annual revenue reduction of approximately $65 million effective January 1, 1997. The CPUC is expected to issue a decision before the end of 1996. 23 PART II. OTHER INFORMATION Item 6. Exhibits (a) Exhibits. Exhibits identified as on file with the SEC are incorporated herein by reference as exhibits hereto. Exhibit Number Description - ------- ----------- 4 No instrument which defines the rights of holders of long- and intermediate-term debt of Pacific Bell is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, Pacific Bell hereby agrees to furnish a copy of any such instrument to the SEC upon request. 15 Letter re unaudited interim financial information. 27 Article 5 FDS for 3rd Quarter 1996 Form 10-Q. The Company will furnish to a security holder upon request a copy of any exhibit at cost. 24 FORM 10-Q SIGNATURE --------- Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Pacific Bell By: /s/Peter A. Darbee --------------------------------------- Peter A. Darbee Vice President, Chief Financial Officer and Controller Date: November 13, 1996 25 EXHIBIT INDEX Exhibits identified as on file with the SEC are incorporated herein by reference as exhibits hereto. All other exhibits are provided as part of the electronic transmission. Exhibit Number Description - ------- ----------- 4 No instrument which defines the rights of holders of long- and intermediate-term debt of Pacific Bell is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, Pacific Bell hereby agrees to furnish a copy of any such instrument to the SEC upon request. 15 Letter re unaudited interim financial information. 27 Article 5 FDS for 3rd Quarter 1996 Form 10-Q. 26 EX-15 2 LTR RE: UNAUDITED INTERIM FIN. INFO. EXHIBIT 15 ---------- COOPERS & LYBRAND L.L.P. November 13, 1996 Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549 Ladies and Gentlemen: Re: Pacific Bell Registration Statement on Form S-3 ---------------------------------------------------- We are aware that our report dated November 13, 1996 on our review of the interim financial information of Pacific Bell and Subsidiaries for the nine- month period ended September 30, 1996 included in this Form 10-Q is incorporated by reference in the Company's registration statement as follows: Form S-3: Pacific Bell $1.575 Billion Debt Securities ------------------------------------------------------ Pursuant to Rule 436(c) under the Securities Act of 1933, this report should not be considered a part of the registration statement prepared or certified by us within the meaning of Sections 7 and 11 of that Act. Very truly yours, /s/ Coopers & Lybrand L.L.P. EX-27 3 ARTICLE 5 FDS FOR 3RD QUARTER 1996 FORM 10-Q
5 1,000,000 DEC-31-1996 JAN-01-1996 SEP-30-1996 9-MOS 78 0 1,719 156 0 2,488 27,808 16,501 14,260 3,036 5,295 225 0 0 3,137 14,260 0 7,012 0 5,250 0 0 277 1,489 606 0 0 0 0 883 0.00 0.00
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