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 June 30, 1994 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 July 31, 1994, 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 .............. 3 Condensed Consolidated Statements of Income ........... 4 Condensed Consolidated Balance Sheets ................. 5 Condensed Consolidated Statements of Shareowner's Equity.............................................. 6 Condensed Consolidated Statements of Cash Flows ....... 7 Notes to Condensed Consolidated Financial Statements .. 8 Item 2. Management's Discussion and Analysis of Results of Operations ............................................ 10 PART II. OTHER INFORMATION - --------------------------- Item 6. Exhibits and Reports on Form 8-K ........................ 19 SIGNATURE ........................................................ 20 - --------- 2 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 as of June 30, 1994, and the related condensed consolidated statements of income for the three- and six-month periods ended June 30, 1994 and 1993, and the condensed consolidated statements of shareowner's equity and cash flows for the six-month periods ended June 30, 1994 and 1993. 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 review 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. We have previously audited, in accordance with generally accepted auditing standards, the consolidated balance sheet of Pacific Bell and Subsidiaries as of December 31, 1993, 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 March 3, 1994, 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, 1993, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived. Coopers & Lybrand San Francisco, California August 12, 1994 3 PACIFIC BELL AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited) For the 3 Months Ended For the 6 Months Ended June 30, June 30, ---------------------- ---------------------- (Dollars in millions) 1994 1993 1994 1993 - ----------------------------------------------------------------------------- OPERATING REVENUES: Local service ................. $ 827 $ 858 $1,667 $1,698 Network access Interstate .................. 387 394 784 784 Intrastate .................. 167 164 340 331 Toll service .................. 501 512 994 1,023 Other ......................... 327 344 671 676 Less: Provision for uncollectibles ....... 37 35 76 75 -------- -------- -------- -------- Total Operating Revenues ...... 2,172 2,237 4,380 4,437 -------- -------- -------- -------- OPERATING EXPENSES: Cost of products and services.. 471 479 947 992 Customer operations and selling expense ............. 461 449 884 868 General, administrative, and other expense ............... 231 311 535 600 Depreciation and amortization.. 435 429 869 855 -------- -------- -------- -------- Total Operating Expenses ...... 1,598 1,668 3,235 3,315 -------- -------- -------- -------- Net Operating Revenues ........ 574 569 1,145 1,122 -------- -------- -------- -------- OPERATING TAXES: Income taxes .................. 153 154 302 304 Other taxes ................... 45 47 90 94 -------- -------- -------- -------- Total Operating Taxes ......... 198 201 392 398 -------- -------- -------- -------- OPERATING INCOME .............. 376 368 753 724 -------- -------- -------- -------- Other Income (Expense)......... (3) 6 (1) 4 -------- -------- -------- -------- Income before interest expense and cumulative effect of change in accounting principle..... 373 374 752 728 Interest expense.............. 117 111 220 221 -------- -------- -------- -------- Income before cumulative effect of change in accounting principles....... 256 263 532 507 Cumulative effect of change in accounting principle..... - - - (148) -------- -------- -------- -------- NET INCOME ................... $ 256 $ 263 $ 532 $ 359 ======== ======== ======== ======== The accompanying Notes are an integral part of the Condensed Consolidated Financial Statements. 4 PACIFIC BELL AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS June 30, December 31, (Dollars in millions) 1994 1993 - --------------------------------------------------------------------------- ASSETS (Unaudited) Cash and cash equivalents ..................... $ 42 $ 57 Accounts receivable - (net of allowances for uncollectibles of $143 and $136 in 1994 and 1993, respectively) ......................... 1,496 1,518 Prepaid expenses and other current assets ..... 865 862 ------------ ------------ Total current assets .......................... 2,403 2,437 ------------ ------------ Property, plant, and equipment - at cost....... 25,816 25,660 Less: accumulated depreciation ............. 10,024 9,708 ------------ ------------ Property, plant, and equipment - net .......... 15,792 15,952 ------------ ------------ Deferred charges and other noncurrent assets .. 989 989 ------------ ------------ TOTAL ASSETS .................................. $19,184 $19,378 ============ ============ LIABILITIES AND SHAREOWNER'S EQUITY Accounts payable .............................. 1,150 1,255 Debt maturing within one year ................. 197 542 Other current liabilities ..................... 1,310 1,136 ------------ ------------ Total current liabilities ..................... 2,657 2,933 ------------ ------------ Long-term obligations ......................... 4,758 4,753 ------------ ------------ Deferred income taxes ......................... 2,253 2,280 ------------ ------------ Other noncurrent liabilities and deferred credits ............................ 3,286 3,258 ------------ ------------ Commitments and Contingencies (Note B) Total shareowner's equity ..................... 6,230 6,154 ------------ ------------ TOTAL LIABILITIES AND SHAREOWNER'S EQUITY ..... $19,184 $19,378 ============ ============ The accompanying Notes are an integral part of the Condensed Consolidated Financial Statements. 5 PACIFIC BELL AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF SHAREOWNER'S EQUITY (Unaudited) For the 6 Months Ended June 30, ---------------------- (Dollars in millions) 1994 1993 - ------------------------------------------------------------------------- COMMON STOCK Balance at beginning of period ................. 225 225 --------- --------- Balance at end of period ....................... 225 225 --------- --------- ADDITIONAL PAID-IN CAPITAL Balance at beginning of period ................. 5,168 5,168 --------- --------- Balance at end of period ....................... 5,168 5,168 --------- --------- REINVESTED EARNINGS Balance at beginning of period ................. 761 1,898 Net income ..................................... 532 359 Common dividends declared ...................... (452) (489) Minimum pension liability adjustment............ (4) - --------- --------- Balance at end of period ....................... 837 1,768 --------- --------- TOTAL SHAREOWNER'S EQUITY ...................... $6,230 $7,161 ========= ========= The accompanying Notes are an integral part of the Condensed Consolidated Financial Statements. 6 PACIFIC BELL AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) For the 6 Months Ended June 30, ---------------------- (Dollars in millions) 1994 1993 - --------------------------------------------------------------------------- CASH FROM (USED FOR) OPERATING ACTIVITIES Net Income .......................................... $ 532 $ 359 Adjustments to reconcile net income for items currently not affecting operating cash flows: Cumulative effect of accounting change........... - 148 Depreciation and amortization ................... 869 855 Deferred income taxes ........................... (49) (36) Unamortized investment tax credits .............. (35) (25) Allowance for funds used during construction .... (15) (18) Changes in operating assets and liabilities: Accounts receivable ........................... 39 9 Prepaid expenses and other current assets ..... (4) 12 Deferred charges and other noncurrent assets... 2 50 Accounts payable .............................. (105) (200) Other current liabilities ..................... 173 124 Noncurrent liabilities and deferred credits ... 64 (14) Other adjustments, net .......................... 2 16 ---------- ---------- Cash from operating activities ...................... 1,473 1,280 ---------- ---------- CASH FROM (USED FOR) INVESTING ACTIVITIES Additions to property, plant, and equipment, net .... (700) (842) Other investing activities, net ..................... 1 (1) ---------- ---------- Cash used for investing activities .................. (699) (843) ---------- ---------- CASH FROM (USED FOR) FINANCING ACTIVITIES Proceeds from issuance of long-term debt ............ - 1,700 Retirements of long-term debt ....................... - (1,225) Dividends paid ...................................... (452) (489) Increase (decrease) in short-term borrowings, net ... (345) (305) Principal payments under capital lease obligations .. 8 - Other financing activities, net ..................... - (104) ---------- ---------- Cash used for financing activities .................. (789) (423) ---------- ---------- Increase(decrease) in cash and cash equivalents ..... (15) 14 Cash and cash equivalents at January 1 .............. 57 57 ---------- ---------- Cash and cash equivalents at June 30................. $ 42 $ 71 ========== ========== - --------------------------------------------------------------------------- Cash payments for: Interest ........................................ $ 190 $ 303 Income taxes .................................... $ 238 $ 275 - --------------------------------------------------------------------------- The accompanying Notes are an integral part of the Condensed Consolidated Financial Statements. 7 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 ("Directory") and Pacific Bell Information Services ("PBIS"), hereinafter referred to as the "Company." All significant intercompany balances and transactions have been eliminated. The Condensed Consolidated Financial Statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (the "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 1993 annual report on Form 10-K. 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, independent accountants. Their report is on page 3. B. PRIOR YEAR ACCOUNTING CHANGES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" ("SFAS 106"). Under decisions by the California Public Utilities Commission (the "CPUC"), the Company was granted $100 and $108 million for 1994 and 1993, respectively, for partial recovery of higher costs under SFAS 106. Two ratepayer advocacy groups have each challenged certain aspects of the original decision adopting SFAS 106 for ratemaking, which could affect recovery. The Company is unable to predict the outcome of these pending challenges. 8 PACIFIC BELL AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) B. PRIOR YEAR ACCOUNTING CHANGES (Cont'd) Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 112 ("SFAS 112"), "Employer's Accounting for Postemployment Benefits." SFAS 112 establishes accounting standards for benefits that are provided to former or inactive employees after employment but before retirement. The new Statement requires immediate recognition of the cumulative effect of applying the new rule to prior years. The Company restated first quarter 1993 results to recognize a postemployment benefit liability of $251 million. The net income impact of adopting this accounting standard was $148 million, net of a deferred income tax benefit of $103 million. 9 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OR OPERATIONS - ---------------------------------------------------------------------- RESULTS OF OPERATIONS The following discussions and data compare the six-month period ended June 30, 1994 to the corresponding period in 1993. Results for the first six months of 1994 may not be indicative of results for the full year. (See discussions in "Pending Regulatory Issues" beginning on page 15.) A summary of selected operating data is shown below: For the 6 Months Ended June 30, Change ---------------------- ----------------- Selected Operating Data 1994 1993 Amount Percent - --------------------------------------------------------------------------- Operating ratio (%) 73.9 74.7 (0.8) - Return on shareowner's equity (%) ................... 17.1 10.0** 7.1 - Total employees ................ 52,207 54,912 (2,705) (4.9) Revenues per employee ($ thousands) ................ 83.9 80.8 3.1 3.8 Employees per ten thousand access lines* ................ 33.4 36.3 (2.9) (8.0) - --------------------------------------------------------------------------- * Excludes Directory employees ** Restated due to the Cumulative Effect of Change in Accounting Principle Earnings - -------- For the 6 Months Ended June 30, Change ---------------------- ----------------- ($ Millions) 1994 1993 Amount Percent - --------------------------------------------------------------------------- Net income 532 359 173 48.2 - --------------------------------------------------------------------------- Earnings reflect an improved California economy and the Company's continuing cost reduction programs. 1993 results included the adoption of Statement of Financial Accounting Standards 112 "Employers' Accounting for Postemployment Benefits" effective January 1, 1993. Adoption of the new standard reduced comparative 1993 net income by $148 million. 1994 net income was reduced about $29 million because of a California Public Utilities Commission ("CPUC") refund order. In April 1994, the CPUC let stand its previous order requiring the Company to refund about $35 million in late payment and reconnection charges which resulted from past problems with its payment processing system. The order also imposed penalties totaling $15 million. 10 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (Cont'd) - ------------------------------------------------------------------------------ Operating Revenues - ------------------ For the 6 Months Ended June 30, Change ------------------------ ----------------- Volume Indicators 1994 1993 Amount Percent - --------------------------------------------------------------------------- Customer switched access lines in service at June 30 (thousands) .......... 14,790 14,443 347 2.4 Interexchange Carrier access minutes-of-use (millions) ..... 25,931 23,825 2,106 8.8 Interstate .................... 15,247 13,782 1,465 10.6 Intrastate .................... 10,684 10,043 641 6.4 Toll messages (millions)* ....... 2,195 2,097 98 4.7 - --------------------------------------------------------------------------- * Toll messages for 1993 have been restated to conform to the current presentation. For the 6 Months Ended June 30, Change ------------------------ ----------------- ($ millions) 1994 1993 Dollar Percent - --------------------------------------------------------------------------- Total operating revenues 4,380 4,437 (57) (1.3) - --------------------------------------------------------------------------- Revenues decreased due to rate reductions ordered by the CPUC and the Federal Communications Commission (the "FCC") under incentive-based regulation. In addition, revenues were reduced by accruals totaling $32 million for sharing interstate earnings with customers. The FCC requires sharing earnings above a threshold rate of return. Revenues were also reduced $27 million due to the CPUC's refund order related to customer late payment charges. These and other reductions were partially offset by increases due to customer demand as shown by the key volume indicators above. 11 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (Cont'd) - ------------------------------------------------------------------------------ The primary factors affecting revenue are summarized in the following table. Total Late Misc. Change Price Cap Sharing Payment Rates Customer from ($ millions) Rates Accruals Refund & Other Demand 1993 - --------------------------------------------------------------------------- Local service ...... (27) - - (36) 32 (31) Network access Interstate ....... (8) (32) - (8) 48 0 Intrastate ....... (8) - - (16) 33 9 Toll service ....... (21) - - (13) 5 (29) Other revenues ..... - - (27) - 22 (5) Uncollectibles ..... - - - (1) - (1) -------- -------- -------- -------- -------- -------- Total operating revenues ......... (64) (32) (27) (74) 140 (57) - --------------------------------------------------------------------------- The increases in revenue due to customer demand in the above table are the result of growth in key volume indicators. Local service revenues reflect a 2.4 percent increase from a year ago in customer access lines. Interstate network access revenues reflect a 10.6 percent increase in minutes-of-use, as well as increased access lines. Intrastate network access revenues reflect 6.4 percent growth in minutes-of-use. Competition continues to constrain demand for the Company's toll services. The increase in other revenues due to customer demand reflects the success of the Company's business and residential voice mail products. Voice processing units in service increased 37.2 percent. Directory advertising revenues decreased slightly. 12 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (Cont'd) - ------------------------------------------------------------------------------ Operating Expenses - ------------------ For the 6 Months Ended June 30, Change ------------------------ ----------------- ($ millions) 1994 1993 Dollar Percent - --------------------------------------------------------------------------- Total operating expenses $3,235 $3,315 $(80) (2.4) - --------------------------------------------------------------------------- Total operating expenses for the first half of 1994 decreased when compared with 1993 reflecting the Company's continuing cost reduction efforts. As displayed in the table below, salaries, wages and employee benefits decreased. These decreases were partially offset by increases in contracted services and software licensing fees relating to the Company's efforts to increase the capabilities of the telecommunications network. Total Software Change Salaries Employee Miscel- Contract License From ($ millions) & Wages Benefits laneous Services Fees 1993 - ---------------------------------------------------------------------------- Cost of products & services ........ $(43) $(16) $9 $(11) $16 $(45) Customer operations & selling expense.. (7) 9 5 9 0 16 General, admin. & other expense ..... (5) (40) (25) 5 0 (65) Depreciation & amortization..... - - 14 - - 14 -------- -------- -------- -------- -------- -------- Total operating expenses ......... $(55) $(47) $ 3 $3 $16 $(80) - ----------------------------------------------------------------------------- Salary and wage expense decreased $38 million due to a reduction in the workforce which was partially offset by higher nonsalaried wage rates. Overtime decreased $42 million primarily due to storm repairs in the comparable period last year, and continued cost reduction efforts. Annual management salary increases scheduled to take effect in January were deferred to July 1994. Management estimates this deferral saved about $11 million for the six month period. The decrease in employee benefits expense is primarily due to certain nonrecurring adjustments and a decrease in postretirement benefit costs related to force reduction plans. Contracted services expense increased primarily because of research and development costs supporting the Company's plans to build an integrated telecommunications, information, and entertainment network. However, this increase was largely offset by a $15 million reduction for contract systems programmers which resulted from last year's completion of billing system enhancements. Licensing fees for digital switching software increased as the Company implemented plans to create a fully digital telecommunications network. 13 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (Cont'd) - ------------------------------------------------------------------------------ Operating Taxes - --------------- 1994 1993 Change Percent - --------------------------------------------------------------------------- Operating Taxes $392 $398 $(6) (1.5) - --------------------------------------------------------------------------- Operating taxes decreased slightly in comparison with the first half of 1993. Reductions in certain deferred tax liabilities lowered tax expense by $16 million. Acceleration of investment tax credits due to shorter plant lives decreased tax expense by an additional $10 million over the comparable period. These reductions were largely offset by increases related to the federal tax increase and higher pre-tax income. Interest Expense - ---------------- 1994 1993 Change Percent - --------------------------------------------------------------------------- Interest expense $220 $221 $(1) (0.0) - --------------------------------------------------------------------------- Interest expense remained flat when compared with the first half of 1993. Interest expense on long term debt decreased $21 million. This decrease is composed of a $12 million reduction related to higher borrowing levels last year and a $9 million decrease due to lower interest rates. Long term debt levels were temporarily higher in 1993 due to time-lags between new debt issuances and the retirements of refinanced amounts. These decreases were offset by increases in miscellaneous interest expense related to the CPUC's late payment charges decision and other nonrecurring items. Other Income (Expense) - ---------------------- 1994 1993 Change Percent - --------------------------------------------------------------------------- Other Income (Expense) $(1) $4 $(5) (125.0) - --------------------------------------------------------------------------- A decrease of $11 million in after-tax charges related to the early redemption of long term debt in 1993 reduced comparative expense in this category. The late payment charges penalty increased 1994 other expense by $10 million. Cumulative Effect of Accounting Change - -------------------------------------- Effective January 1, 1993, the Company adopted a new accounting rule for postemployment benefits. A first quarter 1993 noncash charge was recorded representing the cumulative after-tax effect of applying the new rule to prior years. (See also Note B - "Prior Year Accounting Changes" on page 8.) 14 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (Cont'd) - ------------------------------------------------------------------------------ Status of Restructuring Reserve - ------------------------------- 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. The Company expects to reduce force in all of its business units. During the first six months of 1994, 2,750 employees left the Company. However, this number does not equal the net force reduction because employees were also added during the period. A total of $52 million was charged to the reserve in the first half of 1994, primarily to cover severance benefits for about 1,400 employees. The majority of this year's costs will be incurred during the second half of 1994. As of June 30, 1994, a balance of $1,045 million remained in the restructuring reserve. In order to maximize cost savings from restructuring, the Company is reviewing the feasibility of moving certain high priority reengineering projects from later years into 1995. As a result, the timing of force reductions and charges to the reserve may vary from original estimates. The Company may also change the distribution among cost components due to refinement of original estimates. The Company does not believe that these changes would result in a material adjustment to the total amount of the reserve. Capital Expenditures - -------------------- The Company invested about $683 million during the first half of 1994 primarily to modernize and expand the network. The Company expects to invest about $1.8 billion in 1994, and about $16 billion over the next seven years. PENDING REGULATORY ISSUES CPUC Regulatory Framework Review - -------------------------------- In June 1994, the CPUC issued a decision in its review of the New Regulatory Framework ("NRF") ordered in 1989. Among other issues, this review has examined elements of the price cap formula, including the rate of return on investment and the productivity factor. Effective July 1994, the decision reduces the Company's benchmark rate of return from 13.0 percent to 11.5 percent. Earnings from 11.5 percent to 15.0 percent will be shared equally with customers. Earnings above 15.0 percent will be shared 30.0 percent with customers. Also effective July 1994, the decision increases the productivity factor from 4.5 percent to 5.0 percent, a change which each year will reduce annual rates by $32.5 million through 1996. Including a smaller adjustment, these changes in the price cap formula will decrease total revenues from current levels by about $19, $72, and $104 million, respectively, for 1994, 1995, and 1996. The CPUC is scheduled to review the NRF again in 1995. 15 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (Cont'd) - ------------------------------------------------------------------------------ Toll Services Competition - ------------------------- In July 1994, the CPUC issued a revised draft decision in Phase III of its investigation into alternative regulatory frameworks. The draft decision provides that long-distance and other telecommunications companies would be allowed to compete with the Company and other local telephone companies in providing intra-service area toll calls in California. The draft decision also would rebalance the Company's rates bringing them closer to cost. The draft decision would lower rates for intra-service area toll calls about 40 percent and increase residential flat rate service from $8.35 to $11.25 per month. Business basic rates would increase from $8.35 to $9.77 per month. Other rates would also change. Overall, the CPUC intends the draft decision to be revenue neutral; that is, the effect of rate decreases would be offset by the effect of rate increases. The Company believes the draft decision does not reduce toll rates far enough to assure fair competition. In an August 1994 filing with the CPUC, the Company has proposed a reduction in toll rates of about 55 percent to be balanced by further rate increases in basic business access and other services. However, the Company believes there is no need to raise basic residential rates further to balance an additional reduction in toll rates. The CPUC announced it expects to issue a final decision on intra-service area toll competition in September 1994 with implementation scheduled for January 1, 1995. The Company expects the CPUC in the near future to consider whether customers should be allowed to "presubscribe" to one carrier to handle all intra-service area calls. Depreciation Rate Changes - ------------------------- In June 1994, the Company filed an application to change its depreciation rates with the CPUC. The application reflects a preliminary agreement between the Company and the CPUC's Division of Ratepayer Advocates. If adopted, the new rates will increase depreciation expense about $30 million effective January 1, 1995. In July 1994, the FCC authorized new rates which will increase depreciation expense about $9 million annually retroactive to January 1, 1994. Under incentive-based regulation, increases in depreciation expense are not recovered in rates. FCC Annual Access Tariff Filing - ------------------------------- In June 1994, the FCC adopted the Company's annual access tariff filings under price cap regulation. As a result, the Company's interstate network access revenues will be reduced about $30 million annually effective July 1, 1994. The decrease reflects the application of the price cap formula and an $8 million price reduction to help the Company remain competitive with other access providers. 16 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (Cont'd) - ------------------------------------------------------------------------------ Personal Communications Services - -------------------------------- Pacific Telesis Group plans to aggressively pursue licenses for personal communications services ("PCS") at FCC auctions expected late this year or early in 1995. Winning bids in major PCS markets are expected to require large capital expenditures. In December 1993, the FCC awarded "pioneer preferences" to three companies without charge. One company received one of the broad spectrum licenses covering the Los Angeles, San Diego, and Las Vegas market area. In August 1994, the FCC reconsidered its previous decision to award pioneer preferences without charge. Consequently, the FCC amended its rule to require the recipients to pay approximately 90 percent of the value of similar licenses. Interstate Special Access Competition - ------------------------------------- In June 1993, the FCC ordered large local exchange carriers ("LECs"), including the Company, to offer expanded network interconnection for interstate special access services. The Company and other LECs appealed a provision of the decision which permitted competitive access providers and other customers to locate their transmission facilities in the LECs' central offices. In June 1994, the U.S. Court of Appeals for the D.C. Circuit overruled the mandatory physical collocation requirement. The Court also remanded to the FCC the issue of whether the LECs should offer "virtual collocation" instead of physical collocation. With virtual collocation, the interconnection is located outside the LEC's central office. In July 1994, the FCC directed the LECs to provide virtual collocation, but exempted LECs from this requirement at central offices where they offer physical collocation. Interstate special access revenues subject to increased competition represent less than three percent of the Company's total revenues. 17 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (Cont'd) - ------------------------------------------------------------------------------ Telecommunications Legislation - ------------------------------ In June 1994, the U.S. House of Representatives approved two telecommunications bills which would ease certain restrictions imposed by the 1982 Consent Decree and the 1994 Cable Act. The Brooks-Dingell bill would simplify the procedures under which the telephone regional holding companies must request authority to provide long-distance service and manufacture telecommunications equipment. The Markey-Fields bill would open local telephone service to competition and allow competitors to connect to the local network. It would also permit LECs to provide video programming to subscribers in their own service areas, but would prevent them from buying large existing cable systems within these areas. Similar legislation with less favorable provisions has been introduced in the U.S. Senate. In May 1994, the California Assembly passed a bill promoting full competition for intrastate telecommunications services in California. The legislation would direct the CPUC to authorize open competition if federal legislation or court action amends the restriction of the 1982 Consent Decree. If not, the CPUC would be directed to open all intrastate long-distance markets to full competition, subject to protective safeguards. The CPUC would also be directed to issue an order by October 1, 1995 that would require the Company to offer long-distance services and to seek a waiver of the Consent Decree's restriction. The legislation is now in the California Senate. ACCOUNTING UNDER REGULATION The Company currently accounts for the economic effects of regulation under Statement of Financial Accounting Standards No. 71 ("SFAS 71"), "Accounting for the Effects of Certain Types of Regulation." If it becomes no longer reasonable to assume the Company will recover its costs through rates charged to customers, whether resulting from the effects of increased competition or specific regulatory actions, SFAS 71 would no longer apply. The Company monitors the effects of competition and changes in regulation to assess the likelihood it will continue to recover its costs. If the Company were no longer to qualify for the provisions of SFAS 71, the financial effects would be material. 18 PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits. Exhibits identified in parentheses below, 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. The Company will furnish to a security holder upon request a copy of any exhibit at cost. (b) Reports on Form 8-K. -------------------- No reports on Form 8-K have been filed during the quarter for which this report is filed. 19 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 Peter A. Darbee --------------------------------------- Peter A. Darbee Vice President, Chief Financial Officer and Controller August 12, 1994 20 EXHIBIT INDEX Exhibits identified in parentheses below, 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. 21