FORM 10-K
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
(Mark One)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For fiscal year ended December 31, 1997
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ______to____
Commission File Number: 1-1414
PACIFIC BELL
Incorporated under the laws of the State of California
I.R.S. Employer Identification Number 94-0745535
140 New Montgomery Street, San Francisco, California 94105-3705
Telephone Number 415-542-9000
Securities registered pursuant to Section 12(b) of the Act: (See attached
Schedule A)
Securities registered pursuant to Section 12(g) of the Act: None.
THE REGISTRANT, AN INDIRECTLY HELD WHOLLY-OWNED SUBSIDIARY OF SBC
COMMUNICATIONS, INC., MEETS THE CONDITIONS SET FORTH IN GENERAL INSTRUCTION
I(1)(a) AND (b) OF FORM 10-K AND IS THEREFORE FILING THIS FORM WITH REDUCED
DISCLOSURE FORMAT PURSUANT TO GENERAL INSTRUCTION I(2).
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
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [Not Applicable]
SCHEDULE A
Securities Registered Pursuant To Section 12(b) Of The Act:
Name of each exchange
Title of each Class on which registered
------------- ---------------
7.250% Note Due 07/01/02 New York Stock Exchange
6.250% Note Due 03/01/05 New York Stock Exchange
7.125% Debenture due 03/15/26 New York Stock Exchange
7.500% Debenture due 02/01/33 New York Stock Exchange
6.875% Debenture due 08/15/23 New York Stock Exchange
6.625% Debenture due 10/15/34 New York Stock Exchange
TABLE OF CONTENTS
Item Page
- ---- ----
PART I
1. Business.......................................................
2. Properties.....................................................
3. Legal Proceedings..............................................
4. Submission of Matters to a Vote of Security Holders............
PART II
5. Market for Registrant's Common Equity and Related
Stockholder Matters..........................................
6. Selected Financial and Operating Data..........................
7. Management's Discussion and Analysis of Results of Operations
(Abbreviated pursuant to General Instruction I(2)).............
7A. Quantitative and Qualitative Disclosures about Market Risk.....
8. Financial Statements and Supplementary Data....................
9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.....................................
PART III
10. Directors and Executive Officers of the Registrant.............
11. Executive Compensation.........................................
12. Security Ownership of Certain Beneficial Owners and
Management...................................................
13. Certain Relationships and Related Transactions.................
PART IV
14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
__________
*Omitted pursuant to General Instruction I(2).
PART I
ITEM 1. BUSINESS
GENERAL
Pacific Bell (PacBell, which includes its subsidiaries) is a telecommunications
company whose subsidiaries and affiliates operate predominantly in the
communications services industry. PacBell is a wholly-owned subsidiary of
Pacific Telesis Group (PAC), a wholly-owned subsidiary of SBC Communications
Inc. (SBC). PacBell's subsidiaries provide landline and wireless
telecommunications services and equipment, directory advertising and publishing.
Pacific Bell's telephone operations (Telephone Operations), provide
telecommunications services over approximately 17 million access lines in
California. The Telephone Operations operate within California providing local
exchange services and are subject to regulation by the California Public
Utilities Commission (CPUC) and by the Federal Communications Commission (FCC).
PacBell was incorporated under the laws of the State of California in 1906 and
has its principal executive offices at 140 New Montgomery, San Francisco,
California 94105-3705 (telephone number 415-542-9000).
PAC was one of the original seven regional holding companies (RHCs) formed to
hold AT&T Corp.'s (AT&T) local telephone companies. AT&T divested PAC, and its
subsidiary, PacBell, by means of a spin-off of stock to its shareowners on
January 1, 1984 (divestiture). As a result, PAC became a publicly traded
company. The divestiture was made pursuant to a consent decree, referred to as
the Modification of Final Judgment (MFJ), issued by the United States District
Court for the District of Columbia (District Court). With the mergers of SBC and
PAC, and Bell Atlantic Corporation and NYNEX Corporation, there are now five
RHCs.
COMPLETION OF MERGER OF SBC AND PAC
On April 1, 1997, SBC and PAC completed the merger of an SBC subsidiary with
PAC, in a transaction in which each outstanding share of PAC common stock was
exchanged for 1.4629 shares of SBC common stock (equivalent to approximately
626 million shares; both the exchange ratio and shares issued have been restated
to reflect SBC's two-for-one stock split, effected in the form of a stock
dividend, declared January 30, 1998 with a record date of February 20, 1998 and
distribution date of March 19, 1998). With the merger, PAC became a wholly-owned
subsidiary of SBC. The transaction was accounted for by SBC as a pooling of
interests and a tax-free reorganization.
Post-merger initiatives
Several strategic decisions resulted from the merger integration process. The
decisions resulted from an extensive review of operations throughout the merged
company and included significant integration of operations and consolidation of
some administrative and support functions.
Reorganization
SBC is centralizing several key functions that will support the Telephone
Operations and two other SBC subsidiaries, Southwestern Bell Telephone Company
(SWBell) and Nevada Bell, including network planning, strategic marketing and
procurement. It is also consolidating a number of corporate-wide support
activities, including research and development, information technology,
financial transaction processing and real estate management. PacBell, Nevada
Bell and SWBell will continue as separate legal entities. These initiatives will
result in the creation of some jobs and the elimination and realignment of
others, with many of the affected employees changing job responsibilities and in
some cases assuming positions in other locations.
PacBell recognized charges during 1997 in connection with these initiatives. The
charges were comprised mainly of postemployment benefits, primarily related to
severance, and costs associated with closing down duplicate operations,
primarily contract cancellations. Other charges arising out of the merger
relating to relocation, retraining and other effects of consolidating certain
operations are being recognized in the periods those charges are incurred.
Additional information on these charges is contained in Note 3 of the Financial
Statements.
FEDERAL LEGISLATION AND THE MFJ
On February 8, 1996, the Federal Government enacted the Telecommunications Act
of 1996 (the Telecom Act), a major, wide-ranging amendment to the Communications
Act of 1934.
By its specific terms, the Telecom Act supersedes the jurisdiction of the
District Court with regard to activities occurring after the date of enactment.
The FCC is given authority for all post-enactment conduct, with the District
Court retaining jurisdiction of pre-enactment conduct for a five-year period. As
a result of these provisions, on April 11, 1996 the District Court issued its
Opinion and Order terminating the MFJ and dismissing all pending motions as
moot, thereby effectively ending 13 years of RHCs regulation under the MFJ.
In July 1997, SBC brought suit in the U.S. District Court for the Northern
District of Texas (U.S. District Court), seeking a declaration that a portion of
the Telecom Act is unconstitutional on the grounds that it improperly
discriminates against SBC's telephone subsidiaries including PacBell, by name by
imposing restrictions that prohibit SBC from offering interLATA (Local Access
Transport Area) long-distance and other services in California that other Local
Exchange Carriers (LECs) are free to provide. The suit challenged only that
portion of the Telecom Act that excluded SBC from competing in certain lines of
business. On December 31, 1997 the U.S. District Court issued a ruling declaring
unconstitutional, among other things, the prohibitions on SBC providing
interLATA long-distance. The FCC and competitor intervenors sought and received
a stay of the decision by the U.S. District Court, and SBC anticipates further
opposition to this ruling from the Justice Department and interexchange carriers
(IXCs), but is unable to predict the outcome of subsequent appeals. Additional
information relating to the Telecom Act is contained in Item 7, Management's
Discussion and Analysis of Results of Operations of this report under the
heading "Competitive Environment" beginning on page 17.
BUSINESS OPERATIONS
The Telephone Operations provide telecommunication services by serving
approximately 17 million access lines in the nation's most populous state,
California as well as two of the country's five largest metropolitan areas.
PacBell's broad operations offer customers an expansive range of services and
products, varying by market, including: local exchange services, wireless
communications, long-distance, Internet services, telecommunications equipment,
enhanced services, and directory advertising and publishing. Services and
products are provided by the Telephone Operations and through several
wholly-owned subsidiaries, which include: Pacific Bell Mobile Services (PBMS),
Pacific Bell Directory (PBDirectory), Pacific Bell Information Services (PBIS)
and Pacific Bell Internet Services (PBI). These services and products (which are
described more fully below) include landline and wireless telecommunications
services, sales of advertising for and publication of yellow pages and white
pages directories, sales of customer premises, private business exchange (PBX)
and wireless equipment, enhanced services and Internet services. Personal
Communication Services (PCS) are provided by PBMS in California and Nevada.
Landline telecommunications services are provided to California by the Telephone
Operations.
PacBell's revenues are categorized for financial reporting purposes as local
service (substantially all of which was provided by the Telephone Operations and
PBMS), network access (provided by the Telephone Operations), long-distance
service (substantially all of which was provided by the Telephone Operations and
PBMS), directory advertising (principally provided by PBDirectory) and other
(including equipment sales at PBMS, nonregulated products and services provided
by the Telephone Operations, billing and collection services for IXCs provided
by the Telephone Operations and Internet services provided by PBI). With the
passage of the Telecom Act, PBMS offers wireless long-distance services between
Local Access Transport Areas (interLATA) and within Local Access Transport Areas
(intraLATA). The Telephone Operations provide intraLATA long-distance service.
The following table sets forth for PacBell the percentage of total operating
revenues by any class of service which accounted for 10% or more of total
operating revenues in any of the last three fiscal years.
- ------------------------------------------------------------------------------
Percentage of Total
Operating Revenues
- ------------------------------------------------------------------------------
1997 1996 1995
- ------------------------------------------------------------------------------
Local service 44% 42% 42%
Network access 25% 27% 27%
Long-distance service 12% 13% 14%
Directory advertising 11% 11% 11%
- ------------------------------------------------------------------------------
Communication Services
Communication services include local, long-distance and network access services.
Local services involve the transport of landline and wireless telecommunications
traffic between telephones and other customer premises equipment (CPE) located
within the same local service calling area. Local services include: basic local
exchange service, certain extended area service, dedicated private line services
for voice and special services, directory assistance and various vertical
services, including custom calling services, call control options and Caller ID
services. Until the passage of the Telecom Act, the Telephone Operations'
long-distance services involved the transport of intraLATA telecommunications
traffic, except for certain wireless service areas that cover more than one
LATA, for which PacBell had obtained MFJ waivers. In addition to these services,
beginning in 1996, PBMS provided both interLATA and intraLATA wireless
long-distance services to its PCS customers. Long-distance services also include
other services such as Wide Area Telecommunications Service (WATS or 800
services) and other special services. Network access services connect a
subscriber's telephone or other equipment to the transmission facilities of
other carriers that provide long-distance (principally interLATA) and other
communications services. Network access services are either switched, which use
a switched communications path between the carrier and the customer, or special,
which use a direct nonswitched path.
Landline Network Services
During the latter half of 1996 and over the course of 1997, the Telephone
Operations have been offering certain services on a "wholesale" basis as well as
providing elements of the Telephone Operations' networks on an "unbundled" basis
to competitors. These services are being offered as specified by the Telecom Act
and state actions and agreements. Such federal and state regulation have
resulted in the Telephone Operations facing increased competition in significant
portions of its business. At December 31, 1997 the Telephone Operations provided
wholesale services to more than 200 thousand access lines. Management cannot
quantify the impact to the Telephone Operations' business in 1998 from local
exchange competition, because uncertainty exists as to the breadth and scope of
competitors' offering of local exchange services to all portions of the market,
and as certain regulations, tariffs and negotiations governing such competition
are not yet finalized.
The Telephone Operations provided approximately 86% of PacBell's operating
revenues in 1997. The Telephone Operations provide telecommunications services
to approximately 10.5 million residential and 6.7 million business access lines
in California. During 1997 total access lines grew by 4.7%.
The Telephone Operations continue to expand their offering of vertical services
throughout their operating areas. These services include, among other things,
Caller ID, a feature which displays the telephone number of the person calling;
Call Return, a feature that redials the number of the last incoming call; and
Call Blocker, a feature which allows customers to automatically reject calls
from a designated list of telephone numbers.
PBIS provides voice messaging services under several registered trademark
products, which include residential voice messaging services (The Message
Center), business messaging services (Pacific Bell Voice Mail), and business
call management services (Pacific Bell Call Management). PBI provides Internet
services in selected metropolitan areas in California.
Wireless
In 1993, the FCC adopted an order allocating radio spectrum and outlining the
development of licenses for new PCS deployment. PCS utilizes wireless
telecommunications digital technology at a higher frequency radio spectrum than
cellular using lower powered transmission equipment. Like cellular, it is
designed to permit access to a variety of communications services regardless of
subscriber location. In an FCC auction, which concluded in March 1995, PCS
licenses were awarded in 51 major markets. PAC affiliates acquired PCS licenses
in the Major Trading Areas (MTAs) of Los Angeles-San Diego, California and San
Francisco-San Jose, California. The California licenses cover substantially all
of California and Nevada.
PBMS was formed to offer PCS services across California and Nevada. The PBMS
network incorporates the Global System for Mobile Communications (GSM) standard,
which is widely used internationally, and its phones feature a built-in pager
and answering machine. PBMS began trials in August 1996 and began offering
services in January 1997, and by mid-1997 provided widespread offerings of PCS
services to all of the major markets in California and Nevada. At the end of
1997, PBMS provided wireless services to approximately 340,000 customers over
its PCS networks.
Directory Advertising
PBDirectory, the publisher of Pacific Bell SMART Yellow Pages, publishes 35
million books, representing approximately 112 directories in California and
Nevada. PacBell recognizes all directory advertising revenues and expenses in
the month the related directory is published. PBDirectory's publishing schedule
is spread throughout the year for its directories. PBDirectory's directories are
printed by World Color Press.
Customer Premises Equipment and Other Equipment Sales
Equipment offerings range from single-line and cordless telephones to
sophisticated digital PBX systems. PBX is a private telephone switching system,
usually located on a customer's premises, which provides intra-premise telephone
services as well as access to the public switched network.
Video Services
As part of the change in strategic direction of the post-merger initiatives, SBC
announced during 1997 that it is scaling back its limited direct investment in a
number of video services. Additional information on these matters is contained
in Note 3 of the Financial Statements. As part of this curtailment, PacBell
halted construction on the Advanced Communications Network (ACN) in California.
As part of an agreement with the ACN vendor, PacBell paid the liabilities of the
ACN trust that owned and financed ACN construction and incurred costs to shut
down all construction previously conducted under the trust and receive certain
consideration from the vendor.
GOVERNMENT REGULATION
The Telephone Operations are subject to regulation by the CPUC which has the
power to regulate, in varying degrees, intrastate rates and services, including
local, long-distance and network access (both intraLATA and interLATA access
within the state) services. The Telephone Operations are also subject to the
jurisdiction of the FCC with respect to interstate rates and services, including
interstate access charges. Access charges are designed to compensate the
Telephone Operations for the use of their facilities for the origination or
termination of long-distance and other communications by other carriers. There
are currently no access charges for the Internet.
Additional information relating to federal and state regulation of the Telephone
Operations is contained in Item 7, Management's Discussion and Analysis of
Results of Operations of this report under the heading "Regulatory Environment"
on page 15.
IMPORTANCE, DURATION AND EFFECT OF LICENSES
Under the auction process of an FCC order outlining the development of PCS,
licenses with durations of ten years were awarded in 51 major markets. The
licenses for Los Angeles-San Diego, California and San Francisco-San Jose,
California expire in 2005. These licenses, upon application and a showing of
compliance with FCC use and conduct standards, may be renewed.
MAJOR CUSTOMER
No customer accounted for more than 10% of PacBell's consolidated revenues in
1997 or 1996. Approximately 10% of PacBell's consolidated revenues were from
services provided to AT&T for 1995.
COMPETITION
Communication Services
Information relating to competition in the communications industry is contained
in Item 7, Management's Discussion and Analysis of Results of Operations of this
report under the heading "Competitive Environment" beginning on page 17.
Directory Advertising and Publishing
PBDirectory faces competition from over 50 publishers of printed directories in
its operating areas. Direct and indirect competition also exist from other
advertising media, including newspapers, radio, television, and direct mail
providers, as well as from directories offered over the Internet.
Customer Premises Equipment and Other Equipment Sales
PacBell faces significant competition from numerous companies in marketing its
telecommunications equipment.
RESEARCH AND DEVELOPMENT
Certain company-sponsored basic and applied research was conducted at Bell
Communications Research, Inc. (Bellcore). The Telephone Operations owned a
one-seventh interest in Bellcore and another affiliate of SBC owned a
one-seventh interest, with the remainder owned by the other four remaining RHCs.
In November 1997, the sale of Bellcore was completed. The RHCs have retained the
activities of Bellcore that coordinate the Federal Government's
telecommunications requirements for national security and emergency
preparedness.
Applied research is also conducted at SBC Technology Resources, Inc. and Telesis
Technology Laboratories, subsidiaries of SBC. They provide research, technology
planning and evaluation services to PacBell and its subsidiaries.
EMPLOYEES
As of December 31, 1997, PacBell employed approximately 50,030 persons.
Approximately 70% of the employees are represented by the Communications Workers
of America (CWA). Contracts covering an estimated 33,340 employees between the
CWA and the Telephone Operations end in August 1998. New contracts are scheduled
to be negotiated in 1998. In 1995, PBDirectory negotiated two new three-year
contracts with the International Brotherhood of Electrical Workers (IBEW),
covering approximately 1,300 employees in northern and southern California.
PBDirectory also is scheduled to negotiate new contracts with the IBEW in 1998.
ITEM 2. PROPERTIES
The properties of PacBell do not lend themselves to description by character and
location of principal units. At December 31, 1997, 96% of the property, plant
and equipment of PacBell was related to the Telephone Operations. Network access
lines represented 41% of the Telephone Operations' investment in telephone
plant; central office equipment represented 38%; land and buildings represented
10%; other miscellaneous property, comprised principally of furniture and office
equipment and vehicles and other work equipment, represented 5%; and information
origination/termination equipment represented 6%.
ITEM 3. LEGAL PROCEEDINGS
There are no legal proceedings to report.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Omitted pursuant to General Instruction I(2).
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Not applicable.
ITEM 6. SELECTED FINANCIAL AND OPERATING DATA
-----------------------------------------------------------------------------
At December 31, or for the year ended
1997 1996
------------------------------------------------------------------------------
Return on Weighted Average Total 4.42% 16.92%
Capital (1)
Debt Ratio (debt, including current
maturities, as a percentage of 65.82% 59.00%
total capital) (2)
Network access lines in service (000) 17,369 16,585
Access minutes of use (000,000) 69,100 63,338
Long-distance messages billed (000,000) 5,638 5,158
Number of employees 50,030 45,589
------------------------------------------------------------------------------
Operating data may be periodically revised to reflect the most current
information available.
(1) Calculated using income before changes in accounting principles. These
impacts are included in shareowner's equity.
(2) Shareowners equity used in these calculations includes changes in
accounting principles.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
Dollars in millions
This discussion should be read in conjunction with the financial statements and
the accompanying notes.
RESULTS OF OPERATIONS
Summary
Financial results, including percentage changes from the prior year, are
summarized as follows:
- --------------------------------------------------------------------------------
Percent Change
1997 1996 1997 vs.1996
- --------------------------------------------------------------------------------
Operating revenues $ 9,938 $ 9,446 5.2%
Operating expenses $ 9,429 $ 7,142 32.0%
Income before cumulative effect of $ 8 $ 1,170 -99.3%
accounting changes
Cumulative effect of accounting changes $ 342 $ 85 -
Net income $ 350 $ 1,255 -
- --------------------------------------------------------------------------------
PacBell recognized the cumulative effect of accounting changes in 1997 relating
to conforming accounting methodologies between PacBell and SBC for, among other
items, pensions and postretirement benefits. PacBell recognized the cumulative
effect of a change in accounting in 1996 relating to the recognition of
directory publishing revenues and related expenses.
PacBell's income before cumulative effect of accounting changes includes
after-tax charges of approximately $1.2 billion reflecting strategic initiatives
resulting from SBC's comprehensive review of operations of the merged company,
the impact of several regulatory rulings during the second quarter of 1997,
costs incurred for customer number portability since the merger and charges for
ongoing merger integration costs. Excluding these items, PacBell reported income
before cumulative effect of accounting changes of $1,171 for 1997. Net income
for 1997 was favorably affected by the $18 after-tax gain on the sale of
PacBell's interest in Bellcore and a first quarter 1997 $87 after-tax settlement
gain associated with lump-sum pension payments that exceeded the projected
service and interest costs for 1996 retirements. Excluding these additional
items, PacBell reported an adjusted income before cumulative effect of
accounting changes of $1,066 for 1997, 8.9% lower than the 1996 income before
cumulative effect of accounting changes of $1,170. The primary factors
contributing to this decrease were increased expenses, including expenses for
the introduction of PCS operations in California and Nevada, partially offset by
growth in demand for wireline and non-regulated services and products.
Items affecting the comparison of the operating results between 1997 and 1996
are discussed in the following sections.
Management's Discussion and Analysis, continued
Dollars in millions
Operating Revenues
PacBell's operating revenues for 1997 reflect reductions of $114 related
primarily to the impact of several regulatory rulings during the second quarter
of 1997. Excluding these reductions, PacBell's operating revenues increased
$606, or 6.4%, in 1997. Components of total operating revenues, including
percentage changes from the prior year, are as follows:
- -------------------------------------------------------------------------------
Percent Change
1997 1996 1997 vs.1996
- -------------------------------------------------------------------------------
Local service $ 4,386 $ 3,956 10.9%
Network access
Interstate 1,714 1,805 -5.0%
Intrastate 790 718 10.0%
Long-distance service 1,182 1,274 -7.2%
Directory advertising 1,125 1,051 7.0%
Other 741 642 15.4%
================================================================
$ 9,938 $ 9,446 5.2%
===============================================================================
Local service revenues increased in 1997 due primarily to increases in
demand, including increases in residential and business access lines and
vertical services revenues. Total access lines increased by 4.7% in 1997,
with approximately 32% of access line growth due to the sales of additional
access lines to existing residential customers. Vertical services revenues,
which include custom calling options, Caller ID and other enhanced
services, increased by approximately 15%. Local service revenues also
reflect the implementation of the California High Cost Fund (CHCFB) that
went into effect February 1, 1997. The CPUC has stated that the CHCFB is
intended to directly subsidize the provision of service to high cost areas
and allow PacBell to set competitive rates for other services. The
rebalancing provisions of the CHCFB resulted in a shift from long-distance
revenues of $84 and intrastate network access revenues of $26 to local
service revenues in 1997. This shift is subject to final CPUC approval,
expected in the second or third quarter of 1998. For further information on
the operations of the CHCFB, see the discussion under the heading
"Regulatory Environment". Additionally, Federal payphone deregulation
increased local service revenues and decreased long-distance service
revenues and interstate network access revenues; the overall impact was a
slight increase in total operating revenues. Rate reductions in 1997 due to
CPUC price cap orders partially offset increases in local service revenues.
Wireless revenues also contributed to the increase in local service
revenues due to introduction of PCS in 1997.
Network Access Interstate network access revenues decreased in 1997 due to
$134 in charges. These charges include billing claim settlements related to
the Percentage Interstate Usage (PIU) factor and several federal regulatory
issues including end-user charges, 800 data base charges, recovery of
certain employee-related expenses and the retroactive effect of the
productivity factor adjustment mandated in the July 1, 1997 Federal price
cap filing. While the change in PIU factor, which is used to allocate
network access revenues between interstate and intrastate jurisdictions,
also had the effect of increasing intrastate network access revenues, it
resulted in a slight decline in total network access revenues. Excluding
these impacts, interstate network access revenues increased in 1997 due
largely to increases in demand for access services by IXCs. Growth in
revenues from end-user charges attributable to an increasing access line
base also contributed to the increase. Partially offsetting these increases
were the effects of rate reductions of approximately $22 related to the
FCC's productivity factor adjustment and revenue sharing adjustments made
in 1996.
Intrastate network access revenues in 1997 reflect an increase due to the
PIU settlements and a decrease due to the effects of the CHCFB described
above. Excluding these impacts, intrastate network access revenues
increased in 1997 as increases in demand, including usage by alternative
intraLATA toll carriers, were partially offset by state regulatory rate
orders.
Long-Distance Service revenues decreased in 1997 due to the effect of the
CHCFB discussed above, federal payphone deregulation discussed above and
rate reductions due to CPUC price cap orders partially offset by increases
in demand resulting from California's growing economy.
Directory Advertising revenues increased in 1997 due mainly to increased
demand at PBDirectory and the publication of books in 1997 that were not
published in 1996.
Other operating revenues increased in 1997 due primarily to revenues from
new business initiatives, primarily Internet services and equipment sales
at PBMS. Revenues also increased due to demand for nonregulated products
and services including voice messaging services.
Operating Expenses
PacBell's operating expenses for 1997 reflect approximately $1.7 billion of
charges related to strategic initiatives resulting from a comprehensive review
of operations of the merged company, the impact of several regulatory rulings
during the second quarter of 1997 (see Note 3 to the Financial Statements),
costs incurred for customer number portability since the merger and charges for
ongoing merger integration costs. Excluding these charges, PacBell's operating
expenses increased $587, or 8.2%, in 1997. Components of total operating
expenses including percentage changes from the prior year, are as follows:
- -------------------------------------------------------------------------------
Percent Change
1997 1996 1997 vs. 1996
- --------------------------------------------------------------------------------
Cost of services and products $ 4,218 $ 3,713 13.6%
Selling, general and administrative 3,190 1,603 99.0%
Depreciation and amortization 2,021 1,826 10.7%
- ----------------------------------------------------------------
$ 9,429 $ 7,142 32.0%
===============================================================================
Cost of Services and Products reflects charges of $190 in 1997 relating to
SBC's strategic initiatives, operational reviews, costs incurred for
customer number portability since the merger and ongoing merger integration
costs; excluding these charges, expenses increased $315, or 8.5% in 1997. A
significant part of this increase was caused by the introduction of PCS
operations during 1997. Other major factors contributing to the increase
included increases in interconnection costs and employee compensation,
including increases related to force additions and contract labor. These
increases were partially offset by decreased employee benefit expenses due
to conforming of accounting methodologies between PacBell and SBC for
pensions and postretirement benefits.
Selling, General and Administrative expense in 1997 reflects $1,352 of
charges relating to SBC's strategic initiatives, operational reviews and
ongoing merger integration costs. As discussed in Note 3 to the Financial
Statements, the most significant of these charges included the shutdown of
ACN, regulatory costs related to the approval of the merger with SBC by
California regulators and reorganization initiatives. Excluding these
charges, expenses increased $235, or 14.7%, in 1997. Significantly
increasing expenses was caused by the introduction of PCS operations during
1997. Other major factors contributing to the increase were due primarily
to other business ventures, primarily voice messaging and Internet
services, and increases in employee compensation and uncollectibles. These
increases were partially offset by a first quarter 1997 $146 settlement
gain associated with lump-sum pension payments that exceeded the projected
service and interest costs for 1996 retirements and reduced expenses
resulting from conforming of accounting methodologies for pensions and
postretirement benefits (see Note 3 to the Financial Statements).
Depreciation and Amortization in 1997 reflects charges totaling $158 to
record impairment of plant and intangibles. As discussed in Note 3 to the
Financial Statements, the most significant of these impairments related to
certain analog switching equipment and cable within commercial buildings.
Excluding these charges, depreciation and amortization increased $37, or
2.0% in 1997 due primarily to overall higher plant levels. Reduced
depreciation beginning with the second quarter of 1997 on analog switching
equipment partially offset this increase.
Interest Expense increased $98 or 27.0% in 1997 due primarily to increased
average debt levels during the year. Also contributing to the increase was
interest associated with the second quarter 1997 one-time charges,
primarily interest on merger-approval costs.
Other Income (Expense) - Net increased income by $2 in 1997. Results
reflect $36 in charges related to SBC's strategic initiatives, primarily
writeoffs of nonoperating plant. These charges were offset by the
recognition of investment returns on funds held in trust for deferred
compensation and the gain recognized from the sale of PacBell's interest in
Bellcore.
Income Taxes expense decreased $729, or 94.1% in 1997. Income taxes for
1997 reflect the tax effect of charges for strategic initiatives resulting
from SBC's comprehensive review of operations of the merged company, the
impact of several regulatory rulings during the second quarter of 1997,
costs incurred for customer number portability since the merger and charges
for ongoing merger integration costs. Excluding these items, income taxes
for 1997 were lower due to reduced income before income tax.
Income taxes paid, net of refunds reflect the impact of reduced tax
payments due to merger-related and integration costs incurred and the
application of the SBC tax sharing agreement.
Cumulative Effect of Accounting Changes, as discussed in Note 3 to the
Financial Statements, were recorded in the second quarter of 1997,
retroactive to January 1, 1997. The changes were to conform accounting
methodologies between PacBell and SBC, primarily the adoption of SBC's
methodology of amortizing gains and losses on assets held within the
pension and postretirement plans. The cumulative after-tax effect of this
one-time gain is $342, net of deferred taxes of $238.
As discussed in Note 1 to the Financial Statements, PBDirectory changed its
method of recognizing directory publishing revenues and related expenses
effective January 1, 1996. The cumulative after-tax effect of applying the
new method to prior years was recognized as of January 1, 1996 as a
one-time non-cash gain of $85. Management believes this change to the issue
basis method is preferable because it is the method generally followed in
the publishing industry, including Southwestern Bell Yellow Pages, a
wholly-owned subsidiary of SBC, and better reflects the operating activity
of the business. This accounting change is not expected to have a
significant effect on net income of future periods.
Operating Environment and Trends of the Business
Regulatory Environment
The telecommunications industry is in transition from a tightly regulated
industry overseen by multiple regulatory bodies, to a more incentive-based,
market driven industry monitored by state and federal agencies. The Telephone
Operations remain subject to regulation by the CPUC for intrastate services and
by the FCC for interstate services. The Telephone Operations under price cap
regulation may establish and modify prices for some services as long as they do
not exceed the price caps and may change prices for some services without
regulatory approval.
Federal Regulation
During 1997, the FCC issued an Access Reform Order restructuring access charges
paid for IXCs access to the Telephone Operations' networks. The order raises the
flat monthly end user charge for primary business lines, and additional
residence and business lines, and lowers the price caps on per minute access
charges for interstate long distance carriers. The Access Reform Order, which
took effect in January 1998 and other price cap changes which took effect in
1997, are supposed to shift sources of revenue from carriers to end users
without changing the total amount of revenue received by the LECs.
The FCC's price cap plan for the LECs provides for changes to be made annually
to the price caps for inflation, productivity and changes in other costs. In
1997 the Telephone Operations were ordered to begin using a 6.5% productivity
offset, with no sharing. Prior to 1997, there were three productivity offsets,
two of which provided for a sharing of profits above a specified earnings level
with the Telephone Operations' customers and a higher productivity offset which
did not include sharing. The Telephone Operations have elected the higher 5.3%
productivity offset without sharing.
With the passage of the Telecom Act, the FCC has been conducting further
proceedings in conjunction with access reform to address a number of pricing and
productivity issues, and is performing a broader review of price cap regulation
in the context of the increasingly more competitive telecommunications
environment. The Chairman of the FCC has indicated that the FCC intends to act
on these proceedings in 1998. The Telecom Act and FCC actions taken to implement
provisions of the Telecom Act are discussed further under the heading
"Competitive Environment."
Pursuant to the Telecom Act, the local coin rate in the payphone industry was
deregulated by the FCC in October 1997, and LECs were required to remove any
direct or indirect subsidy of payphone service from their regulated
telecommunications operations. Removal of the subsidy caused the Telephone
Operations to raise the local coin rates throughout its operating territory in
1997.
State Regulation
The CPUC's form of price caps requires the Telephone Operations to submit an
annual price cap filing to determine prices for categories of services for each
new year. The productivity factor used in calculating price caps has been set
equal to the inflation factor for the period 1996-1998. The price cap plan
includes a sharing mechanism that requires the Telephone Operations to share its
earnings with customers above certain earnings levels but no sharing has
occurred under the sharing mechanism. The CPUC includes PBDirectory earnings in
the sharing mechanism calculation for the Telephone Operations. In December
1997, the CPUC adopted a decision on the Telephone Operations' 1997 price cap
filing resulting in a revenue reduction in 1998 of approximately $86 effective
January 1, 1998. The reduction reflects items accrued in the 1997 results of
operations, including, among other things, the rate reduction ordered in the
CPUC decision approving the SBC/PAC merger and the gain on the sale of the
Telephone Operations' interest in Bellcore. Because of the accruals, the order
will not materially affect the Telephone Operations' results of operations in
1998.
In an April 1997 ruling, the CPUC reaffirmed that postretirement benefit costs
were appropriately recoverable in the Telephone Operations' price cap filings as
exogenous costs. In its December 1997 decision, the CPUC continued to allow
recovery in 1998 consistent with the amount requested by the Telephone
Operations in an October 1997 filing. Concurrent with the approval of recovery
for 1998, the CPUC ordered a further proceeding to address procedures and
amounts for future recovery.
In May 1997, the FCC adopted new separations rules that shifted recovery of a
substantial amount of billing and collection costs to the interstate
jurisdiction. The Telephone Operations filed for a waiver of the requirement and
were denied the waiver in December 1997. As a result, the Telephone Operations
could be required to refund an annualized amount of approximately $21 to
customers since July 1997, with refunds commencing in 1999.
In 1996, the CPUC issued an order on universal service and established the CHCFB
to subsidize telephone service in California's high cost areas. The estimated
$352 cost of the program is expected to be collected from customers of all
telecommunications providers who will contribute to the fund through a 2.87%
surcharge on all bills for telecommunications services provided in California.
The surcharge became effective February 1, 1997 and PacBell collected the
surcharge from its customers during 1997; the surcharge will continue in 1998.
To maintain revenue neutrality, the Telephone Operations will reduce its
revenues dollar for dollar for amounts it will receive from the fund. This
reduction will occur through an across the board surcredit on all products and
services (except for residential basic exchange services and contracts) or
through permanent price reductions for those services that previously subsidized
universal service. The Telephone Operations filed to reduce permanently certain
toll and access rates. Hearings were held in October 1997, and a decision is
expected in the second or third quarter of 1998.
The Telephone Operations expect to receive approximately $305 annually from the
CHCFB fund based on CPUC estimates of the cost of providing universal service.
The Telephone Operations believe the new program underestimates the cost of
providing universal service and that the average cost of providing service is up
to 33% higher per line, per month than the CPUC estimate. As a result, subsidies
for universal service will remain in the prices for the Telephone Operations'
competitive services, which may place it at a competitive disadvantage.
In a 1988 CPUC decision, the Telephone Operations received a rate increase as a
result of expensing items that were previously capitalized. The decision
required an annual incremental rate reduction of $23, but did not address a
termination date for the rate reduction. The Telephone Operations filed an
application in 1995 to terminate the rate reductions. With CPUC approval, the
Telephone Operations halted rate reductions for 1996, 1997 and 1998, pending the
outcome of the hearings. An adverse decision may restore all or some portion of
the revenue reductions. The deferred rate reductions are subject to refund plus
interest. Revenues subject to refund as of December 31, 1997 were approximately
$69 plus interest. The revenues subject to refund are expected to continue to
increase at the rate of $23 per year plus interest until the matter is resolved.
In 1992, the Telephone Operations entered into a settlement with tax authorities
and others which fixed a specific methodology for valuing utility property for
tax purposes for a period of eight years. As a result, the CPUC opened an
investigation to determine if any resulting property tax savings should be
returned by the Telephone Operations to its customers. Intervenors have asserted
that as much as $20 of annual property tax savings should be treated as an
exogenous cost reduction in the Telephone Operations' annual price cap filings
and that as much as $90 in past property tax savings as of December 31, 1997,
plus interest, should be returned to customers. The Telephone Operations believe
that, under the CPUC's regulatory framework, any property tax savings qualify
only as a component of shareable earnings and not as an exogenous cost. In an
interim opinion issued in June 1995, the CPUC ruled in favor of intervenors, but
decided to defer a final decision on the matter pending resolution in a separate
proceeding of the criteria for exogenous cost treatment under its regulatory
framework. To date, the CPUC has taken no further action on the issue.
More than 120 applications for certification to provide competitive local
service have been approved by the CPUC, with over 25 more applications pending
approval. As a result, the Telephone Operations expect competition to continue
to develop for local service, but the financial impacts of this competition
cannot be reasonably estimated at this time.
Competitive Environment
Competition continues to increase for telecommunication and information
services. Recent changes in legislation and regulation have increased the
opportunities for alternative service providers offering telecommunications
services. Technological advances have expanded the types and uses of services
and products available. As a result, PacBell faces increasing competition in
significant portions of its business.
On February 8, 1996, the Telecom Act was enacted into law. The Telecom Act is
intended to address various aspects of competition within, and regulation of,
the telecommunications industry. The Telecom Act provides that all
post-enactment conduct or activities which were subject to the MFJ, are now
subject to the provisions of the Telecom Act. In April 1996, the District Court
issued its Opinion and Order terminating the MFJ and dismissing all pending
motions related to the MFJ as moot. This ruling effectively ended 13 years of
RHC regulation under the MFJ. Among other things, the Telecom Act also defines
conditions the Telephone Operations must comply with before being permitted to
offer interLATA long-distance service and establishes certain terms and
conditions intended to promote competition for the Telephone Operations' local
exchange services.
Under the Telecom Act, PacBell may immediately offer interLATA long-distance
outside California and over its wireless network both inside and outside
California. Before being permitted to offer landline interLATA long-distance
service in California, PacBell must apply for and obtain state-specific approval
from the FCC. The FCC's approval, which involves consultation with the United
States Department of Justice and appropriate state commission, requires
favorable determinations that the Telephone Operations have entered into
interconnection agreement(s) that satisfy a 14-point "competitive checklist"
with predominantly facilities-based carrier(s) that serve residential and
business customers or, alternatively, that the Telephone Operations have a
statement of terms and conditions effective in California under which it offers
the "competitive checklist" items. The FCC must also make favorable public
interest and structural separation determinations in connection with such
applications.
In July 1997, SBC brought suit in the U.S. District Court, seeking a declaration
that parts of the Telecom Act are unconstitutional on the grounds that they
improperly discriminate against PacBell by imposing restrictions that prohibit
PacBell, among others, by name from offering interLATA long-distance and other
services that other LECs are free to provide. The suit challenged only those
portions of the Telecom Act that exclude PacBell from competing in certain lines
of business. On December 31, 1997 the U.S. District Court issued a ruling
declaring unconstitutional, among other things, the prohibitions on SBC
providing interLATA long-distance in California. If upheld, this ruling is
expected to speed competition in the interLATA long-distance markets in
California. The FCC and competitor intervenors have sought and received a stay
of the decision by the U.S. District Court.
In August 1996, the FCC issued rules by which competitors could connect with the
LECs' networks, including those of the Telephone Operations. Among other things,
the rules addressed unbundling of network elements, pricing for interconnection
and unbundled elements, and resale of retail telecommunications services. The
FCC rules were appealed by numerous parties, including SBC.
In July 1997, the United States Court of Appeals for the Eighth Circuit in St.
Louis (8th Circuit) held that the FCC did not have authority to promulgate rules
related to the pricing of local intrastate telecommunications and that its rules
in that regard were invalid. The 8th Circuit also overturned the FCC's rules
which allowed competitors to "pick and choose" among the terms and conditions of
approved interconnection agreements. In October 1997, the 8th Circuit issued a
subsequent decision clarifying that the Telecom Act does not require the
incumbent LECs to deliver network elements to competitors in anything other than
completely unbundled form.
In September 1997, a number of parties including SBC, filed petitions to enforce
the July 1997 ruling of the 8th Circuit that the right to set local exchange
prices, including the pricing methodology used, is reserved exclusively to the
states. The petitions responded to the FCC's rejection of Ameritech
Corporation's interLATA long-distance application in Michigan in which the FCC
stated it intended to apply its own pricing standards to RHC interLATA
applications. The petitioners asserted the FCC was violating state authority. On
January 22, 1998 the 8th Circuit ordered the FCC to abide by the July 1997
ruling and reiterated that the FCC cannot use interLATA long-distance
applications made by SBC and other RHC wireline subsidiaries wishing to provide
interLATA long-distance to attempt to re-impose the pricing standards ruled
invalid in July 1997 by the 8th Circuit. On January 26, 1998, the U.S. Supreme
Court agreed to hear all appeals of the July 1997 8th Circuit decision.
The effects of the FCC rules are dependent on many factors including, but not
limited to: the ultimate resolution of the pending appeals; the number and
nature of competitors requesting interconnection, unbundling or resale; and the
results of the state regulatory commissions' review and handling of related
matters within their jurisdictions. Accordingly, PacBell is not able to assess
the impact of the FCC rules at this time.
Landline Local Service
Recent state legislative and regulatory developments also allow increased
competition for local exchange services. Companies wishing to provide
competitive local service have filed numerous applications with the CPUC, and
the CPUC has been approving these applications since late 1995. Under the
Telecom Act, companies seeking to interconnect to the Telephone Operations'
networks and exchange local calls must enter into interconnection agreements
with the Telephone Operations. These agreements are then subject to approval by
the CPUC. The Telephone Operations have reached approximately 40 interconnection
and resale agreements with competitive local service providers, and most have
been approved by the CPUC. AT&T and other competitors are reselling the
Telephone Operations local exchange services, and as of December 31, 1997, there
were more than 200 thousand Telephone Operations' access lines supporting
services by resale competitors throughout California. Many competitors have
placed facilities in service, and have begun advertising campaigns and offering
services.
The CPUC authorized facilities-based local services competition effective
January 1996 and resale competition effective March 1996. While the CPUC has
established local competition rules and interim prices, several issues still
remain to be resolved, including final rates for resale and LEC provisioning and
pricing of certain network elements to competitors. In order to provide services
to resellers, the Telephone Operations use established operating support systems
and has implemented electronic ordering systems and a customer care/billing
center. Costs to implement local competition, especially number portability, are
substantial. The CPUC has set a schedule to review the Telephone Operations'
recovery of its local competition implementation costs incurred since January 1,
1996.
The CPUC has issued orders regarding the implementation of competition in 1997.
Some of the key ones include permitting the resale of Centrex services to
businesses only, prohibiting aggregation of customers to obtain toll discounts,
enforcing optional calling plans retail tariff restrictions on resale,
prohibiting sharing of certain Centrex features to route intraLATA calls,
adopting no discount on private line resale, ordering resale of voice mail to
competitors, and allowing collection of intrastate access charges on unbundled
network elements. The CPUC order on resale of voice mail service was stayed and
is being reviewed.
As a result of the Telecom Act and conforming interconnection agreements, the
Telephone Operations expect increased competitive pressure in 1998 and beyond
from multiple providers in various markets including facilities-based
Competitive Local Exchange Carriers, IXCs and resellers. At this time management
is unable to assess the effect of competition on the industry as a whole, or
financially on PacBell, but expects both losses of market share in local service
and gains resulting from new business initiatives, vertical services and new
service areas.
Wireless Local Service
In 1993, the FCC adopted an order allocating radio spectrum and licenses for
PCS. PCS utilizes wireless telecommunications digital technology at a higher
frequency radio spectrum than cellular. Like cellular, it is designed to permit
access to a variety of communications services regardless of subscriber
location. In an FCC auction, which concluded in March 1995, PCS licenses were
awarded in 51 major markets. PAC or affiliates acquired PCS licenses in the MTAs
of Los Angeles-San Diego, California and San Francisco-Oakland-San Jose,
California. The California licenses cover substantially all of California and
Nevada. PBMS is currently operational in all of its major California-Nevada
markets.
In November 1996, PBMS conducted an extensive PCS trial in San Diego,
California. Service was formally launched in San Diego, California in January
1997, in Las Vegas, Nevada in February 1997, in Sacramento, California in March
1997, in San Francisco in May 1997, in Los Angeles in July 1997 and in
Bakersfield, California in October 1997. The network incorporates the GSM
standard which is widely used in Europe. PBMS is selling PCS as an off-the-shelf
product in retail stores across California and Nevada. Significant competition
exists, particularly from the two established cellular companies in each market.
PacBell also has state approved interconnection agreements to receive reciprocal
compensation from IXCs and other LECs accessing its wireless networks in
California and Nevada.
Companies granted licenses in MTAs where PBMS also provides service include
subsidiaries and affiliates of AT&T, Sprint Corporation and other RHCs.
Significant competition from PCS providers exists in PBMS major markets.
Competition has been based upon both price and product marketing.
Long-distance
Competition continues to intensify in the Telephone Operations' intraLATA
long-distance markets. It is estimated that providers other than PacBell now
serve more than half of the business intraLATA long-distance customers in
California.
Since the Telecom Act, PBMS has entered the wireless long-distance markets, and
offers wireless long-distance service in all of its wireless service areas.
Other
In the future, it is likely that additional competitors will emerge in the
telecommunications industry. Cable television companies and electric utilities
have expressed an interest in, or already are, providing telecommunications
services. As a result of recent and prospective mergers and acquisitions within
the industry, PacBell may face competition from entities offering both cable TV
and telephone services in California. IXCs have been certified to provide local
service, and a number of other major carriers have publicly announced their
intent to provide local service in certain markets, some of which are in
California. Public communications services such as public payphone services will
also face increased competition as a result of federal deregulation of the
payphone industry.
PacBell is aggressively representing its interests regarding competition before
federal and state regulatory bodies, courts, Congress and the California state
legislature. PacBell will continue to evaluate the increasingly competitive
nature of its business, and develop appropriate competitive, legislative and
regulatory strategies.
OTHER BUSINESS MATTERS
Restructuring Reserve In December 1993, PacBell established a reserve to record
the incremental cost of force reductions associated with restructuring PacBell's
business processes, of $977 in expenses, which impacted net income by $576. This
restructuring was expected to allow PacBell to eliminate approximately
10,000 employee positions through 1997, net of approximately 4,000 new positions
expected to be created. For the three-year period 1994 through 1996 net force
reductions totaled 9,168.
This table sets forth the status and activity of this reserve during the three
year period:
- ----------------------------------------------------------------------
1996 1995 1994
- ----------------------------------------------------------------------
Balance - beginning of year $ 219 $ 819 $ 1,097
Charges: cash outlays (190) (381) (216)
Non-cash 64 (219) (62)
- ----------------------------------------------------------------------
Balance - end of year $ 93 $ 219 $ 819
======================================================================
The remaining 1996 reserve of $93 was used during 1997. As a result of the new
initiatives from the merger with SBC, net force changes during 1997 are not
meaningful to the restructuring reserve.
Commitments PacBell has purchase commitments of approximately $190 remaining in
connection with its previously announced program for deploying an all-digital
switching platform with ISDN and SS-7 capabilities.
Local Number Portability/interconnection Over the next few years, the Local
Number Portability/Interconnection Over the next few years, the Telephone
Operations expect to incur significant capital and software expenditures for
customer number portability, which allows customers to switch to local
competitors and keep the same phone number, and interconnection. PacBell expects
capital costs and expenses associated with customer number portability to total
up to $600 on a pre-tax basis over the next four years. Full recovery of
customer number portability costs is required under the Telecom Act; however,
the FCC has not yet determined when or how those significant costs will be
recovered. PacBell has filed a tariff for recovery of these costs. No action has
been taken by the FCC on this tariff, pending the issuance of its order on
customer number portability. PacBell is unable to predict the likelihood of the
FCC permitting the tariffs to become effective. Capital costs and expenses
associated with interconnection will vary based on the number of competitors
seeking interconnection, the particular markets entered and the number of
customers served by those competitors. Accordingly, PacBell is currently unable
to reasonably estimate the future costs that will be incurred associated with
interconnection.
Year 2000 Costs PacBell currently operates numerous date-sensitive computer
applications and systems throughout its business. As the century change
approaches, it will be essential for PacBell to ensure that these systems
properly recognize the year 2000 and continue to process critical operational
and financial information. PacBell has established processes for evaluating and
managing the risks and costs associated with preparing its systems and
applications for the year 2000 change. Total expenses for this project have been
estimated to be less than $100 over the next three years. PacBell expects to
substantially complete modifications and incur most of these costs during 1998
to allow for thorough testing before the year 2000.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Quantitative Information about Market Risk
- --------------------------------------------------------------------------------
Foreign Exchange Risk Sensitivity Analysis
- --------------------------------------------------------------------------------
US Dollar Value Net Underlying Net Exposed Foreign Exchange
December 31, of Net Foreign Foreign Long/Short Loss from a 10%
1997 Exchange Currency Currency Depreciation of
(millions of $) Contracts Transaction Position the US dollar
Exposures
- --------------------------------------------------------------------------------
Japanese Yen 142 142 - -
- --------------------------------------------------------------------------------
The preceding table describes the effects of a change in the value of the
Japanese yen as it relates to leases entered into by PBMS. Since the identified
exposure is fully covered with forward contracts, changes in the value of the US
dollar which affect the value of the underlying foreign currency commitment are
fully offset by changes in the value of the foreign currency contract. Were the
underlying currency transaction exposure to change, the resulting mismatch would
expose the company to currency risk of the foreign exchange contract. For this
reason, all contracts are related to firm commitments and matched by maturity
and currency.
Qualitative Information about Market Risk
PacBell follows SBC's policy on foreign exchange risk. From time to time SBC is
required to make investments, receive dividends, or borrow funds in foreign
currency. To maintain the dollar cost of the investment or limit the dollar cost
of the funding, SBC will enter into forward foreign exchange contracts. The
contracts are used to provide currency at a fixed rate. SBC's policy is to
measure the risk of adverse currency fluctuations by calculating the potential
dollar losses resulting from changes in exchange rates that have a reasonable
probability of occurring. Changes that exceed acceptable loss limits require
that SBC cover the exposure. SBC does not speculate in foreign exchange markets,
and does not hedge all foreign exchange exposures due to uncertainty in foreign
cash flows.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Independent Auditors
The Board of Directors
Pacific Bell
We have audited the accompanying consolidated balance sheet of Pacific Bell (a
wholly-owned subsidiary of Pacific Telesis Group, a wholly-owned subsidiary of
SBC Communications Inc.) as of December 31, 1997, and the related consolidated
statements of income, shareowner's equity and cash flows for the year then
ended. Our audit also included the financial statement schedules listed in the
Index at Item 14(a). These financial statements and schedules are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements and schedules based on our
audit.
We conducted our audit in accordance with generally accepted auditing standards.
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
In our opinion the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Pacific
Bell at December 31, 1997, and the consolidated results of its operations and
its cash flows for the year then ended, in conformity with generally accepted
accounting principles. Also, in our opinion, the related financial statement
schedules, when considered in relation to the basic financial statements taken
as a whole, present fairly in all material respects the information set forth
therein.
As discussed in Note 3 to the consolidated financial statements, in 1997 the
Company changed its method of accounting for pensions and postretirement
benefits.
ERNST & YOUNG LLP
San Antonio, Texas
February 20, 1998
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Shareowner of Pacific Bell:
We have audited the accompanying consolidated balance sheet of Pacific Bell (a
wholly owned subsidiary of the Pacific Telesis Group, which became a wholly
owned subsidiary of SBC Communications Inc. effective April 1, 1997) and
Subsidiaries (the "Company"), as of December 31, 1996, the related consolidated
statements of income, shareowners' equity and cash flows for each of the two
years in the period ended December 31, 1996, and the financial statement
schedule as of and for the two years ended December 31, 1996. These consolidated
financial statements and the financial statement schedule are the responsibility
of management. Our responsibility is to express an opinion on these financial
statements and the financial statement schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform an audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Pacific
Bell and Subsidiaries as of December 31, 1996, and the consolidated results of
their operations and their cash flows for each of the two years in the period
ended December 31, 1996 in conformity with generally accepted accounting
principles. In addition, in our opinion, the financial statement schedule
referred to above, when considered in relation to the basic financial statements
taken as a whole, presents fairly, in all material respects, the information
required to be included therein as of and for the two years ended December 31,
1996.
As discussed in Note 1 to the Consolidated Financial Statements, the Company's
Pacific Bell Directory subsidiary changed its method of recognizing directory
publishing revenues and related expenses effective January 1, 1996. As discussed
in Note 2 to the Consolidated Financial Statements, the Company discontinued its
application of Statement of Financial Accounting Standards No. 71, "Accounting
for the Effects of Certain Types of Regulation" in 1995.
COOPERS & LYBRAND L.L.P.
San Francisco, California
February 27, 1997
PACIFIC BELL AND SUBSIDIARIES
- -------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF INCOME
Dollars in millions
- -------------------------------------------------------------------------------
1997 1996 1995
- -------------------------------------------------------------------------------
Operating Revenues
Local service $ 4,386 $ 3,956 $ 3,742
Network access:
Interstate 1,714 1,805 1,682
Intrastate 790 718 707
Long-distance service 1,182 1,274 1,210
Directory advertising 1,125 1,051 1,012
Other 741 642 509
- -------------------------------------------------------------------------------
Total operating revenues 9,938 9,446 8,862
- -------------------------------------------------------------------------------
Operating Expenses
Cost of services and products 4,218 3,713 3,596
Selling, general and administrative 3,190 1,603 1,512
Depreciation and amortization 2,021 1,826 1,831
- -------------------------------------------------------------------------------
Total operating expenses 9,429 7,142 6,939
- -------------------------------------------------------------------------------
Operating Income 509 2,304 1,923
- -------------------------------------------------------------------------------
Other Income (Expense)
Interest expense (461) (363) (410)
Other income - net 6 4 25
- -------------------------------------------------------------------------------
Total other income (expense) (455) (359) (385)
- -------------------------------------------------------------------------------
Income Before Income Taxes, Extraordinary Loss
and Cumulative Effect of Accounting Changes 54 1,945 1,538
- -------------------------------------------------------------------------------
Income Taxes 46 775 569
- -------------------------------------------------------------------------------
Income Before Extraordinary Loss and
Cumulative Effect of Accounting Changes 8 1,170 969
- -------------------------------------------------------------------------------
Extraordinary Loss from Discontinuance of
Regulatory Accounting, net of tax - - (3,360)
- -------------------------------------------------------------------------------
Cumulative Effect of Accounting Changes, net of tax 342 85 -
- -------------------------------------------------------------------------------
Net Income (Loss) $ 350 $ 1,255 $ (2,391)
- -------------------------------------------------------------------------------
The accompanying notes are an integral part of the financial statements.
PACIFIC BELL AND SUBSIDIARIES
- -------------------------------------------------------------------------------
CONSOLIDATED BALANCE SHEETS
Dollars in millions except per share data
- -------------------------------------------------------------------------------
1997 1996
- -------------------------------------------------------------------------------
Assets
Current Assets
Cash and cash equivalents $ 43 $ 58
Accounts receivable - net of allowances for
uncollectibles of $237 and $161 2,199 2,133
Prepaid expenses 54 37
Deferred charges 22 45
Deferred income taxes 329 119
Other current assets 56 37
- -------------------------------------------------------------------------------
Total current assets 2,703 2,429
- -------------------------------------------------------------------------------
Property, Plant and Equipment - at cost 29,681 28,372
Less: Accumulated depreciation and amortization 17,606 16,699
- -------------------------------------------------------------------------------
Property, Plant and Equipment - Net 12,075 11,673
- -------------------------------------------------------------------------------
Other Assets 725 547
- -------------------------------------------------------------------------------
Total Assets $ 15,503 $ 14,649
- -------------------------------------------------------------------------------
Liabilities and Shareowner's Equity
Current Liabilities
Debt maturing within one year $ 716 $ 287
Accrued taxes 340 95
Accounts payable and accrued liabilities 2,955 2,451
- -------------------------------------------------------------------------------
Total current liabilities 4,011 2,833
- -------------------------------------------------------------------------------
Long-Term Debt 5,588 5,364
- -------------------------------------------------------------------------------
Deferred Credits and Other Noncurrent Liabilities
Deferred income taxes 952 476
Postemployment benefit obligation 917 671
Unamortized investment tax credits 188 236
Other noncurrent liabilities 574 1,142
- -------------------------------------------------------------------------------
Total deferred credits and other noncurrent 2,631 2,525
liabilities
- -------------------------------------------------------------------------------
Shareowner's Equity
Common shares ($1 par value, 300,000,000 authorized:
issued 224,504,982 at December 31, 1997 and 1996) 225 225
Capital in excess of par value 5,096 6,100
Retained earnings (deficit) (2,048) (2,398)
- -------------------------------------------------------------------------------
Total shareowner's equity 3,273 3,927
- -------------------------------------------------------------------------------
Total Liabilities and Shareowner's Equity $ 15,503 $ 14,649
- -------------------------------------------------------------------------------
The accompanying notes are an integral part of the financial statements.
PACIFIC BELL AND SUBSIDIARIES
- -------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF CASH FLOWS
Dollars in millions, increase (decrease) in cash and cash equivalents
- -------------------------------------------------------------------------------
1997 1996 1995
- -------------------------------------------------------------------------------
Operating Activities
Net income (loss) $ 350 $ 1,255 $ (2,391)
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization 2,021 1,826 1,831
Provision for uncollectible accounts 245 167 166
Amortization of investment tax credits (48) (47) (52)
Deferred income taxes 158 250 93
Extraordinary loss, net of tax - - 3,360
Cumulative effect of accounting change, net of tax (342) (85) -
Changes in operating assets and liabilities:
Accounts receivable (312) (719) (125)
Other current assets (13) 294 (2)
Accounts payable and accrued liabilities 749 (114) (121)
Other - net (209) (305) (98)
- -------------------------------------------------------------------------------
Total adjustments 2,249 1,267 5,052
- -------------------------------------------------------------------------------
Net Cash Provided by Operating Activities 2,599 2,522 2,661
- -------------------------------------------------------------------------------
Investing Activities
Construction and capital expenditures (2,312) (2,334) (1,964)
Dispositions 65 - -
Other (14) (29) 19
- -------------------------------------------------------------------------------
Net Cash Used in Investing Activities (2,261) (2,363) (1,945)
- -------------------------------------------------------------------------------
Financing Activities
Net change in short-term borrowings with original
maturities of three months or less 406 (504) 526
Issuance of other short-term borrowings 610 - -
Repayment of other short-term borrowings (610) - -
Issuance of long-term debt 253 770 6
Repayment of long-term debt (8) (4) (501)
Equity received from parent 156 713 218
Dividends paid (1,160) (1,151) (943)
Other - 7 (16)
- --------------------------------------------------------------------------------
Net Cash Used in Financing Activities (353) (169) (710)
- --------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents (15) (10) 6
- -------------------------------------------------------------------------------
Cash and cash equivalents beginning of year 58 68 62
- -------------------------------------------------------------------------------
Cash and Cash Equivalents End of Period $ 43 $ 58 $ 68
- -------------------------------------------------------------------------------
The accompanying notes are an integral part of the financial statements.
PACIFIC BELL AND SUBSIDIARIES
- ---------------------------------------------------------------------------
STATEMENTS OF SHAREOWNER'S EQUITY
Dollars in millions
- ---------------------------------------------------------------------------
Retained
Common Paid-in Earnings
Stock Surplus (Deficit)
- ---------------------------------------------------------------------------
Balance, December 31, 1994 $ 225 $ 5,169 $ 830
Net income (loss) - - (2,391)
Dividend to shareowner - - (943)
Equity from parent - 218 -
Other - - 3
- ---------------------------------------------------------------------------
Balance, December 31, 1995 225 5,387 (2,501)
- ---------------------------------------------------------------------------
Net income - - 1,255
Dividend to shareowner - - (1,151)
Equity from parent - 713 -
Other - - (1)
- ---------------------------------------------------------------------------
Balance, December 31, 1996 225 6,100 (2,398)
- ---------------------------------------------------------------------------
Net income - - 350
Dividend to shareowner - (1,160) -
Equity from parent - 156 -
- ---------------------------------------------------------------------------
Balance, December 31, 1997 $ 225 $ 5,096 $ (2,048)
- ---------------------------------------------------------------------------
The accompanying notes are an integral part of the financial statements.
Notes to Financial Statements, continued
Dollars in millions
NOTES TO FINANCIAL STATEMENTS
Dollars in millions
1. Summary of Significant Accounting Policies
Basis of Presentation - The consolidated financial statements include the
accounts of Pacific Bell (PacBell, which includes its subsidiaries). PacBell
is a wholly-owned subsidiary of Pacific Telesis Group (PAC), a wholly-owned
subsidiary of SBC Communications Inc. (SBC). PacBell operates predominantly
in the telecommunications services industry in California and Nevada,
providing landline services in California and wireless services and
equipment in California and Nevada, and directory advertising services.
PacBell provides telephone operations (Telephone Operations) and has several
subsidiaries including Pacific Bell Directory (PBDirectory), Pacific Bell
Information Services (PBIS), Pacific Bell Mobile Services (PBMS), Pacific
Bell Internet Services (PBI), Pacific Bell Network Integration (PBNI), and
others.
All significant intercompany transactions are eliminated in the
consolidation process.
Certain amounts in prior period financial statements have been reclassified
to conform to the current year's presentation.
The preparation of financial statements in conformity with generally
accepted accounting principles (GAAP) requires management to make estimates
and assumptions that affect the amounts reported in the financial statements
and accompanying notes. Actual results could differ from those estimates.
Income Taxes - PacBell is included in SBC's consolidated federal income tax
return. Federal income taxes are provided for in accordance with the
provisions of the Tax Allocation Agreement (SBC Tax Agreement) between
PacBell and SBC. In general, PacBell's income tax provision under the SBC
Tax Agreement reflects the financial consequences of income, deductions and
credits which can be utilized on a separate return basis or in consolidation
with SBC and which are assured of realization.
Deferred income taxes are provided for temporary differences between the
carrying amounts of assets and liabilities for financial reporting purposes
and the amounts used for tax purposes.
Investment tax credits earned prior to their repeal by the Tax Reform Act of
1986 are amortized as reductions in income tax expense over the lives of the
assets which gave rise to the credits.
Cash Equivalents - Cash equivalents include all highly liquid investments
with original maturities of three months or less.
Deferred Charges - Directory advertising costs are deferred until the
directory is published and advertising revenues related to these costs are
recognized.
Directory Accounting Change - Prior to January 1, 1996, PBDirectory
recognized revenues and expenses related to publishing directories in
California using the "amortization" method, under which revenues and
expenses were recognized over the lives of the directories, generally one
year. Effective January 1, 1996, PBDirectory changed to the "issue basis"
method of accounting which recognizes the revenues and expenses at the time
the related directory is published. The change in methodology was made
because the issue basis method is generally followed in the publishing
industry, including Southwestern Bell Yellow Pages, a wholly-owned
subsidiary of SBC, and better reflects the operating activity of the
business.
The cumulative after-tax effect of applying the change in method to prior
years is recognized as of January 1, 1996 as a one-time, non-cash gain of
$85. The gain is net of deferred taxes of $58. Had the current method been
applied during 1995, income before extraordinary loss and accounting change
would not have been materially affected.
Property, Plant and Equipment - Property, plant and equipment is stated at
cost. The cost of additions and substantial betterments of property, plant
and equipment is capitalized. The cost of maintenance and repairs of
property, plant and equipment is charged to operating expenses. Property,
plant and equipment is depreciated using straight-line methods over their
estimated economic lives, generally ranging from 3 to 50 years. Prior to the
discontinuance of regulatory accounting in the third quarter of 1995,
PacBell computed depreciation using certain straight-line methods and rates
as prescribed by regulators. In accordance with composite group depreciation
methodology, when a portion of PacBell's depreciable property, plant and
equipment is retired in the ordinary course of business, the gross book
value is charged to accumulated depreciation; no gain or loss is recognized
on the disposition of this plant.
Software Costs - The costs of computer software purchased or developed for
internal use are expensed as incurred. However, initial operating system
software costs are capitalized and amortized over the lives of the
associated hardware.
Advertising Costs - Costs for advertising products and services or corporate
image are expensed as incurred.
Derivative Financial Instruments - PacBell does not invest in any
derivatives for trading purposes. From time to time PacBell invests in
immaterial amounts of foreign currency forward exchange contracts in order
to manage exposure to changes in foreign currency rates. Amounts related to
derivative contracts are recorded using the hedge accounting approach.
PacBell currently does not recognize the fair values of these derivative
financial investments or their changes in fair value in its financial
statements. At December 31, 1997, PacBell's forward exchange contracts
related to leases entered into by PBMS.
2. Discontinuance of Regulatory Accounting
In the third quarter of 1995, PacBell discontinued its application of
Statement of Financial Accounting Standards No. 71, "Accounting for the
Effects of Certain Types of Regulation," (FAS 71). FAS 71 requires
depreciation of telephone plant using lives set by regulators which are
generally longer than those established by unregulated companies, and
deferral of certain costs and obligations based on regulatory actions
(regulatory assets and liabilities). As a result of competition, management
determined that PacBell no longer met the criteria for application of
FAS 71.
Upon discontinuance of FAS 71, PacBell recorded a non-cash, extraordinary
charge to net income of $3,360 (after a net deferred tax benefit of $2,421).
This charge is comprised of an after-tax charge of $2,842 to reduce the net
carrying value of telephone plant, and an after-tax charge of $518 for the
elimination of net regulatory assets. The components of the charge are as
follows:
--------------------------------------------------------------------------
Pre-tax After-tax
--------------------------------------------------------------------------
Increase telephone plant accumulated depreciation $ 4,819 $ 2,842
Elimination of net regulatory assets 962 518
--------------------------------------------------------------------------
Total $ 5,781 $ 3,360
==========================================================================
The increase in accumulated depreciation of $4,819 reflected the effects of
adopting depreciable lives for PacBell's plant categories which more closely
reflect the economic and technological lives of the plant. The adjustment
was supported by a discounted cash flow analysis that estimated amounts of
telephone plant that may not be recoverable from future discounted cash
flows. These analyses included consideration of the effects of anticipated
competition and technological changes on plant lives and revenues.
Following is a comparison of new lives to those prescribed by regulators for
selected plant categories:
-------------------------------------------------------------------------
Average Lives (in Years)
-------------------------------------------------------------------------
Regulator- Estimated
Prescribed Economic
-------------------------------------------------------------------------
Digital switch 17 10
Digital circuit 10-12 8
Copper cable 19-26 14
Fiber cable 28-30 20
Conduit 59 50
-------------------------------------------------------------------------
The discontinuance of FAS 71 for external financial reporting purposes also
required the elimination of net regulatory assets of $962. Regulatory assets
and liabilities are related primarily to accounting policies used by
regulators in the ratemaking process which are different from those used by
non-regulated companies. The differences arose predominantly in the
accounting for income taxes, deferred compensated absences, pension costs
and debt redemption costs. These items were required to be eliminated with
the discontinuance of accounting under FAS 71. PacBell accounting and
reporting for regulatory purposes are not affected by the discontinuance of
FAS 71 for external financial reporting purposes.
With the discontinuance of FAS 71, PacBell began accounting for interest on
funds borrowed to finance construction as an increase in property, plant and
equipment and a reduction of interest expense. Under the provisions of FAS
71, PacBell capitalized both interest and equity costs allowed by regulators
during periods of construction as other income and as an addition to the
cost of plant constructed. Additionally, PacBell began accounting for
pension costs under Statement of Financial Accounting Standards No. 87,
"Employers' Accounting for Pensions," (FAS 87) and Statement of Financial
Accounting Standards No. 88, "Employers' Accounting for Settlements and
Curtailments of Defined Benefit Pension Plans and for Termination Benefits"
(FAS 88).
3. Merger of SBC and PAC
On April 1, 1997, SBC and PAC completed the merger of an SBC subsidiary with
PAC, in a transaction in which each outstanding share of PAC common stock
was exchanged for 1.4629 shares of SBC common stock (equivalent to
approximately 626 million shares; both the exchange ratio and shares issued
have been restated to reflect SBC's two-for-one stock split, effected in the
form of a stock dividend, declared January 30, 1998 with a record date of
February 20, 1998 and distribution date of March 19, 1998). With the merger,
PAC became a wholly-owned subsidiary of SBC. The transaction was accounted
for by SBC as a pooling of interests and a tax-free reorganization.
Conforming accounting changes and merger transaction costs PacBell's results
include merger transaction costs and the effects of changes to conform
accounting methodologies between SBC and PacBell for, among other items,
pensions and postretirement benefits. These changes were recorded by PacBell
in the second quarter of 1997, retroactive to January 1, 1997, as a
cumulative effect of accounting changes of $342 net of deferred taxes of
$238, and increased income before income taxes and cumulative effect of
accounting changes and net income for 1997 by $77 and $45. Had these changes
been adopted January 1, 1996 and 1995 they would have increased income
before income taxes and cumulative effect of accounting changes by $142 and
$79 and net income by $84 and $47. The changes in accounting for pension and
postretirement benefits were to adopt SBC's methodology of amortizing gains
and losses on assets held within those benefit plans. Among other costs
relating to the close of the merger, PacBell recorded the present value of
amounts to be returned to California ratepayers as a condition of the merger
of $276 ($173 net of tax).
Post-merger initiatives
During the second quarter of 1997, PacBell recorded after-tax charges of
$943 related to SBC's June 19, 1997 announcement of several strategic
decisions resulting from the merger integration process that began with the
April 1 closing of the SBC/PAC merger, which included $107 ($65 after tax)
of charges related to several regulatory rulings during the second quarter
of 1997 and $276 ($173 after tax) for merger approval costs. The decisions
resulted from an extensive review of operations throughout the merged
company and include significant integration of operations and consolidation
of some administrative and support functions. Following is a discussion of
the most significant of these charges.
Reorganization - SBC is centralizing several key functions that will support
the Telephone Operations and two other SBC subsidiaries, Nevada Bell and
Southwestern Bell Telephone Company (SWBell), including network planning,
strategic marketing and procurement. It is also consolidating a number of
corporate-wide support activities, including research and development,
information technology, financial transaction processing and real estate
management. PacBell, Nevada Bell and SWBell will continue as separate legal
entities. These initiatives will result in the creation of some jobs and the
elimination and realignment of others, with many of the affected employees
changing job responsibilities and in some cases assuming positions in other
locations.
PacBell recognized a charge of approximately $154 ($97 net of tax) during
the second quarter of 1997 in connection with these initiatives. This charge
was comprised mainly of postemployment benefits, primarily related to
severance, and costs associated with closing down duplicate operations,
primarily contract cancellations. Other charges arising out of the merger
related to relocation, retraining and other effects of consolidating certain
operations are being recognized in the periods those charges are incurred.
During the second half of 1997, PacBell incurred $252 ($149 net of tax) of
merger-related charges.
Impairments/asset valuation - As a result of SBC's merger integration plans,
strategic review of domestic operations and organizational alignments,
PacBell reviewed the carrying values of related long-lived assets. This
review included estimating remaining useful lives and cash flows and
identifying assets to be abandoned. Where this review indicated impairment,
discounted cash flows related to those assets were analyzed to determine the
amount of the impairment. As a result of these reviews, PacBell wrote off
some assets and recognized impairments to the value of other assets with a
combined charge of $416 ($262 after tax) recorded in the second quarter of
1997. These impairments and write-offs related to certain analog switching
equipment, selected wireless equipment, duplicate or obsolete equipment,
cable within commercial buildings and certain nonoperating plant and other
assets.
Video curtailment/purchase commitments - SBC also announced that it is
scaling back its limited direct investment in video services. As part of
this curtailment, PacBell halted construction on the Advanced Communications
Network (ACN). As part of an agreement with the ACN vendor, PacBell paid the
liabilities of the ACN trust that owned and financed ACN construction,
incurred costs to shut down all construction previously conducted under the
trust and received certain consideration from the vendor. In the second
quarter of 1997, PacBell recognized its net expense of $553 ($346 after tax)
associated with these activities.
4. Property, Plant and Equipment
Property, plant and equipment, which is stated at cost, is summarized as
follows at December 31:
--------------------------------------------------------------------------
1997 1996
--------------------------------------------------------------------------
Property, plant and equipment
In service $ 28,886 $ 27,075
Under construction 795 1,297
--------------------------------------------------------------------------
29,681 28,372
Accumulated depreciation and amortization (17,606) (16,699)
--------------------------------------------------------------------------
Property, plant and equipment-net $ 12,075 $ 11,673
==========================================================================
PacBell's depreciation expense as a percentage of average depreciable plant
was 7.3% for 1997, 6.9% for 1996 and 7.1% for 1995.
5. Leases
Certain facilities and equipment used in operations are under operating or
capital leases. Rental expenses under operating leases for 1997, 1996 and
1995 were $158, $138 and $84. At December 31, 1997, the aggregate minimum
rental commitments under noncancelable leases were as follows:
---------------------------------------------------------------------------
Operating Capital
Year Leases Leases
----------------------------------------------------------------------------
1998 $ 37 $ 38
1999 34 40
2000 31 42
2001 27 45
2002 19 46
Thereafter 37 123
=============================================================
Total Minimum Lease Payments $ 185 334
=============================================================
Amount representing interest (47)
---------------------------------------------------------------------------
Present value of minimum lease payments $ 287
===========================================================================
6. Debt
Long-term debt, including interest rates and maturities, is summarized as
follows at December 31:
----------------------------------------------------------------------------
1997 1996
----------------------------------------------------------------------------
Debentures
4.62%-5.88% 1999-2006 $ 475 $ 475
6.00%-6.88% 2002-2034 1,194 1,194
7.12%-7.75% 2008-2043 2,250 2,150
8.50% 2031 225 225
--------------------------------------------------------------------------
4,144 4,044
Unamortized discount--net of premium (89) (89)
----------------------------------------------------------------------------
Total debentures 4,055 3,955
----------------------------------------------------------------------------
Notes
6.25%-8.70% 2001-2009 1,300 1,150
Unamortized discount (18) (18)
----------------------------------------------------------------------------
Total notes 1,282 1,132
----------------------------------------------------------------------------
Capitalized leases 287 291
----------------------------------------------------------------------------
Total long-term debt, including current maturities 5,624 5,378
Current maturities (36) (14)
----------------------------------------------------------------------------
Total long-term debt $ 5,588 $ 5,364
============================================================================
In February 1998, PacBell called $175 of debentures and notes. Estimated net
income impact from unamortized discounts and call premiums is approximately
$(2). During 1995, PacBell refinanced long-term debentures. Costs of $18
associated with refinancing are included in other income (expense) - net,
with related income tax benefits of $7 included in income taxes, in
PacBell's Consolidated Statements of Income.
At December 31, 1997, the aggregate principal amounts of long-term debt
scheduled for repayment for the years 1998 through 2002 were $36, $138,
$166, $241 and $468. As of December 31, 1997, PacBell was in compliance with
all covenants and conditions of instruments governing its debt.
Debt maturing within one year consists of the following at December 31:
----------------------------------------------------------------------------
1997 1996
----------------------------------------------------------------------------
Commercial paper $ - $ 200
Intercompany loans 680 73
Current maturities of long-term debt 36 14
============================================================================
Total $ 716 $ 287
============================================================================
The weighted average interest rate on debt maturing with one year, excluding
current maturities of long-term debt, at December 31, 1997 and 1996 was 6.0%
and 6.64%.
7. Financial Instruments
The carrying amounts and estimated fair values of PacBell's long-term debt,
including current maturities, are summarized as follows at December 31:
----------------------------------------------------------------------------
1997 1996
----------------------------------------------------------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
----------------------------------------------------------------------------
Debentures $4,055 $4,337 $3,955 $3,917
Notes 1,282 1,342 1,132 1,171
----------------------------------------------------------------------------
The fair values of PacBell's long-term debt were estimated based on quoted
market prices, where available, or on the net present value method of
expected future cash flows using current interest rates. The carrying
amounts of commercial paper debt approximated fair values.
PacBell does not hold or issue any financial instruments for trading
purposes. PacBell's cash equivalents are recorded at cost. The carrying
amounts of cash and cash equivalents and customer deposits approximate fair
values.
8. Income Taxes
Significant components of PacBell's deferred tax assets and liabilities are
as follows at December 31:
----------------------------------------------------------------------------
1997 1996
----------------------------------------------------------------------------
Deferred tax (assets)/liabilities due to:
Depreciation and amortization $ 962 $ 947
Employee benefits (138) (420)
Unamortized investment tax credits (82) (99)
Other, net (286) (357)
----------------------------------------------------------------------------
Net deferred tax liabilities $ 456 $ 71
----------------------------------------------------------------------------
Amounts recorded in consolidated balance sheets:
Deferred tax assets* $ 329 $ 405
============================================================================
Deferred tax liabilities* $ 785 $ 476
============================================================================
* Reflects reclassification of certain current and noncurrent amounts by
federal and state tax jurisdictions to a net presentation. Amounts
include both current and noncurrent portions.
As a result of implementing Statement of Financial Accounting Standards No.
109, "Accounting for Income Taxes" in 1993, PacBell recorded a net reduction
in its deferred tax liability. This reduction was substantially offset by
the establishment of a net regulatory liability, which was eliminated with
the discontinued application of FAS 71 in September 1995 (see Note 2).
The components of income tax expense (benefit) are as follows:
----------------------------------------------------------------------------
1997 1996 1995
----------------------------------------------------------------------------
Federal
Current $ (46) $ 442 $ 406
Deferred-net 142 184 66
Amortization of investment tax credits (48) (47) (52)
----------------------------------------------------------------------------
48 579 420
----------------------------------------------------------------------------
State and local
Current (18) 130 122
Deferred-net 16 66 27
----------------------------------------------------------------------------
(2) 196 149
----------------------------------------------------------------------------
Total $ 46 $ 775 $ 569
============================================================================
A reconciliation of income tax expense and the amount computed by applying
the statutory federal income tax rate (35%) to income before income taxes,
extraordinary loss and cumulative effect of changes in accounting principles
is as follows:
-------------------------------------------------------------------------------
1997 1996 1995
-------------------------------------------------------------------------------
Taxes computed at federal statutory rate $ 19 $ 681 $ 538
Increases (decreases) in taxes resulting from:
Amortization of investment tax credits
over the life of the plant that gave rise (31) (31) (52)
to the credits
Excess deferred taxes due to rate change - - (45)
Depreciation of telephone plant
construction costs previously deducted
for tax purposes-net - - 32
State and local income taxes-net of (1) 127 97
federal tax benefit
1997 implementation of the SBC Tax 56 - -
Agreement
Other-net 3 (2) (1)
-------------------------------------------------------------------------------
Total $ 46 $ 775 $ 569
===============================================================================
9. Employee Benefits
Pensions - Substantially all employees of PacBell are covered by
noncontributory defined pension and death benefit plans, as defined by PAC
and sponsored by SBC. The pension benefit formula used in the determination
of pension cost for nonmanagement employees is based on a flat dollar amount
per year of service according to job classification. For managers, benefits
accrue in separate account balances based on a fixed percentage of each
employee's monthly salary with interest, or are determined based upon a
stated percentage of adjusted career income.
PacBell's objective in funding the plans, in combination with the standards
of the Employee Retirement Income Security Act of 1974 (as amended), is to
accumulate funds sufficient to meet its benefit obligations to employees
upon their retirement. Contributions to the plans are made to a trust for
the benefit of plan participants. Plan assets consist primarily of stocks,
U.S. government and domestic corporate bonds, index funds and real estate.
Significant assumptions used by SBC in developing pension information
include:
----------------------------------------------------------------------------
1997 1996 1995
----------------------------------------------------------------------------
Discount rate for determining projected 7.25% 7.5% 7.25%
benefit obligation
Long-term rate of return on plan assets 8.5% 9.0% 9.0%
Composite rate of compensation increase 4.3% 4.0% 4.0%
----------------------------------------------------------------------------
GAAP require certain disclosures to be made of components of net periodic
pension cost for the period and a reconciliation of the funded status of the
plans with amounts reported in the balance sheets. Since the funded status
of plan assets and obligations relates to the plans as a whole, which are
sponsored by SBC, this information is not presented for PacBell. PacBell
recognized pension cost (benefit) for 1997, 1996 and 1995 of $(246), $(174)
and $76. As of December 31, 1997, the amount of PacBell's cumulative amount
of contributions recognized in excess of its pension cost made to the trust
were $395 and as of December 31, 1996, the cumulative amount of pension cost
recognized in excess of its cumulative contributions made to the trust were
$814.
During 1997, the significant amount of lump sum pension payments resulted in
a partial settlement of PacBell's pension plans. In accordance with FAS 88,
net settlement gains in the amount of $286 were recognized in 1997. Of this
amount, $146 was recognized in the first quarter of 1997 and related
primarily to managers who terminated employment in 1996. These gains are not
included in the net pension benefit presented above.
Postretirement Benefits - Under PAC's benefit plans, PacBell provides
certain medical, dental and life insurance benefits to substantially all
retired employees and their dependents under various plans and accrues
actuarially determined postretirement benefit costs as active employees earn
these benefits. Employees retiring after certain dates will pay a share of
the costs of medical coverage that exceeds a defined dollar medical cap.
Such future cost sharing provisions have been reflected in determining
PacBell's postretirement benefit costs.
GAAP require certain disclosures to be made of components of net periodic
postretirement benefit cost and a reconciliation of the funded status of the
plans to amounts reported in the balance sheets. Since the funded status of
assets and obligations relates to the plans as a whole, this information is
not presented for PacBell. In addition, at the time of adoption of Statement
of Financial Accounting Standards No. 106, "Employers' Accounting for
Postretirement Benefits Other Than Pensions," PacBell elected to amortize
its transition benefit obligation (TBO) over 20 years. PacBell recognized
amortization of the TBO was $95 in 1997, 1996 and 1995. PacBell recognized
postretirement benefit cost for 1997, 1996 and 1995 of $260, $257 and $327.
At December 31, 1997 and 1996, the amount included in the Consolidated
Balance Sheets for accrued postretirement benefit obligation was $613 and
$568. Significant assumptions for the discount rate, long-term rate of
return on plan assets and composite rate of compensation increase used by
SBC, in developing the accumulated postretirement benefit, were the same as
those used in developing the pension information.
PAC maintains Voluntary Employee Beneficiary Association (VEBA) trusts to
fund postretirement benefits. During 1997 and 1996, PAC contributed $295 and
$129 into the VEBA trusts to be ultimately used for the payment of
postretirement benefits. Assets consist principally of stocks and U.S.
government and corporate bonds.
The assumed medical cost trend rate in 1998 is 7.5%, decreasing gradually to
5.5% in 2002 prior to adjustment for cost-sharing provisions of the plan for
active and certain recently retired employees. The assumed dental cost trend
rate in 1998 is 6.0%, reducing to 5.0% in 2002. Raising the annual medical
and dental cost trend rates by one percentage point increases the net
periodic postretirement benefit cost for the year ended December 31, 1997 by
approximately 8%.
Postemployment Benefits - Under PAC's benefit plans, PacBell provides
employees varying levels of severance pay, disability pay, workers'
compensation and medical benefits under specified circumstances and accrues
these postemployment benefits at the occurrence of an event that renders an
employee inactive or, if the benefits ratably vest, over the vesting period.
Savings Plans - Substantially all employees are eligible to participate in
contributory savings plans defined by PAC and sponsored by SBC. Under the
savings plans, PacBell matches a stated percentage of eligible employee
contributions, subject to a specified ceiling.
10. Stock Option Plans
Management employees of PacBell participate in various stock option plans
sponsored by SBC. Options issued through December 31, 1997 carry exercise
prices equal to the market price of the stock at the date of grant and have
maximum terms ranging from five to ten years. Depending upon the plan,
vesting of options occurs up to four years from the date of grant. Up to 156
million shares may be issued to SBC employees under these plans.
In 1996, PacBell elected to continue measuring compensation cost for these
plans using the intrinsic value-based method of accounting prescribed in the
Statement of Financial Accounting Standards No. 123, "Accounting for Stock
Based Compensation" (FAS 123). Accordingly, no compensation cost has been
recognized for the stock option plans. Had compensation cost for stock
option plans been recognized using the fair-value based method of accounting
at the date of grant for awards in 1997 and 1996 as defined by FAS 123,
PacBell's net income would have been $336 and $1,254.
For purposes of these pro forma disclosures, the estimated fair value of the
options granted after 1994 is amortized to expense over the options' vesting
period. Because most employee options vest over a two to three year period,
these disclosures will not be indicative of future pro forma amounts until
the FAS 123 rules are applied to all outstanding non-vested awards. SBC
estimates the fair value of stock options at the date of grant, using a
Black-Scholes option pricing model with the following weighted-average
assumptions used for grants in 1997 and 1996: risk-free interest rate of
6.57% and 6.26%; dividend yield of 2.99% and 4.92%; expected volatility
factor of 15% and 18%; and expected option life of 5.8 and 4.7 years. As
options are exercisable in SBC common stock, separate assumptions are not
developed for subsidiaries of SBC.
FAS 123 requires certain disclosures to be made about the outstanding and
exercisable options, option activity, weighted average exercise price per
option and option exercise price range for each income statement period.
Since the stock option activity relates only to SBC's shareowners' equity,
this information in not presented for PacBell.
11. Additional Financial Information
----------------------------------------------------------------------------
December 31,
-----------------------
Balance Sheets 1997 1996
----------------------------------------------------------------------------
Accounts payable and accrued liabilities
Accounts payable $ 1,797 $ 1,543
Advance billing and customer deposits 303 253
Compensated future absences 279 258
Accrued interest 147 131
Accrued payroll 84 55
Other 345 211
============================================================================
Total $ 2,955 $ 2,451
============================================================================
----------------------------------------------------------------------------
Statements of Income 1997 1996 1995
----------------------------------------------------------------------------
Interest expense incurred $ 518 $ 411 $ 421
Capitalized interest (57) (48) (11)
----------------------------------------------------------------------------
Total interest expense $ 461 $ 363 $ 410
============================================================================
Allowance for funds used during
construction - - $ 36
============================================================================
----------------------------------------------------------------------------
Statements of Cash Flows 1997 1996 1995
----------------------------------------------------------------------------
Cash paid during the year for:
Interest $ 445 $ 352 $ 417
Income taxes, net of refunds $ (359) $ 574 $ 550
----------------------------------------------------------------------------
No customer accounted for more than 10% of PacBell's consolidated revenues
in 1997 and 1996. Approximately 10% of PacBell's 1995 consolidated revenues
were from services provided to AT&T Corp.
Approximately 70% of PacBell's employees are represented by the
Communications Workers of America (CWA). A three-year contract and a 20
month contract were negotiated between the CWA and PacBell, effective in
August 1995 and December 1996. PBDirectory also is scheduled to negotiate
new contracts with the International Brotherhood of Electrical Workers in
1998. These contracts will be subject to renegotiation in mid-1998.
12. Quarterly Financial Information (Unaudited)
-------------------------------------------------------------------------------
Calendar Total Operating Operating Income
Quarter Revenues (Loss) Net Income (Loss)
--------------------------------------------------------------
1997 1996 1997 1996 1997 1996
-------------------------------------------------------------------------------
First (2) $ 2,489 $ 2,327 $ 714 $ 605 $ 715 $ 393
Second (1) 2,354 2,364 (860) 629 (647) 314
Third 2,481 2,315 423 530 195 262
Fourth 2,614 2,440 232 540 87 286
===============================================================================
Annual (2) $ 9,938 $ 9,446 $ 509 $ 2,304 $ 350 $ 1,255
===============================================================================
<FN>
(1) Includes after-tax charges of $943 of second quarter charges related to
post-merger initiatives (see Note 3) and customer number portability, $19
and $194 of third and fourth quarter merger integration costs and customer
number portability and $18 fourth quarter gain on sale of PacBell's
interest in Bell Communications Research, Inc.
(2) 1996 Net Income amounts reflect a cumulative effect of accounting change of
$85 from change in accounting for directory operations (see Note 1).
1997 Net Income amounts reflect a cumulative effect of accounting change of
$342 for merger conforming adjustments, primarily related to pensions and
postretirement benefits (see Note 3).
</FN>
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Effective April 1, 1997, Coopers & Lybrand L.L.P were replaced with Ernst &
Young LLP, however Coopers & Lybrand had been engaged to perform a review, as
defined by the American Institute of Certified Public Accountants standards, of
the March 31, 1997 interim financial statements of Pacific Bell.
No disagreements with accountants on any accounting or financial disclosure
matters occurred during the period covered by this report.
PART III
ITEMS 10 THROUGH 13.
Omitted pursuant to General Instruction I(2).
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) Documents filed as a part of the report: Page
(1) Report of Independent Auditors...................................
Financial Statements Covered by Report of Independent Auditors:
Statements of Income.............................................
Balance Sheets...................................................
Statements of Cash Flows.........................................
Statements of Shareowner's Equity................................
Notes to the Financial Statements................................
(2) Financial Statement Schedules:
II - Valuation and Qualifying Accounts...........................
Financial statement schedules other than those listed above have been
omitted because the required information is contained in the financial
statements and notes thereto, or because such schedules are not required
or applicable.
(3) Exhibits:
Exhibit
Number
4 Pursuant to Regulation S-K, Item 601(b)(4)(iii)(A), no instrument
that defines the rights of holders of long-term debt of the
registrant is filed herewith. Pursuant to this regulation, the
registrant hereby agrees to furnish a copy of any such instrument
to the SEC upon request.
12 Computation of Ratios of Earnings to Fixed Charges.
23a Consent of Ernst & Young LLP.
23b Consent of Coopers & Lybrand L.L.P.
24 Powers of Attorney.
27 Financial Data Schedule.
(b) Reports on Form 8-K:
On October 22, 1997, PacBell filed a Current Report on Form 8-K, reporting
on Item 5. Other Events. The Report contained selected PacBell financial
statement information for three-month and nine-month periods ended
September 30, 1997 and 1996.
On October 23, 1997, Pacific Bell (PacBell) filed a Current Report on Form
8-K, reporting on Item 5. Other Events and Item 7. Financial Statements and
Exhibits. The Report discussed a pending California Public Utilities
Commission (CPUC) case regarding charging of cross-connect charges. Also
exhibits were filed related to up to $1,750,000 Medium Term Notes, Series
D, Due Nine Months or More from Date of Issue.
On November 7, 1997, PacBell filed a current Report on Form 8-K, reporting
on Item 5. Other Events In the Report, PacBell indicated that the CPUC
ordered PacBell to refund cross-connect charges dating from 1993.
On November 7, 1997, PacBell filed a Current Report on Form 8-K, reporting
on Item 7. Financial Statements and Exhibits. The Report contained exhibits
related to PacBell's issuance of $150 million of 6 5/8% Notes due November
1, 2009 and $100 million of 7 1/4% Debentures due November 1, 2027.
PACIFIC BELL AND SUBSIDIARIES
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
Allowance for Uncollectibles
Dollars in Millions
- ---------------------------------------------------------------------------------------------------------------------
COL. A COL. B COL. C COL. D COL. E
- ---------------------------------------------------------------------------------------------------------------------
Additions
-------------------------------
(1) (2)
Charged
Balance at Charged to Other Balance
Beginning of to Costs and Accounts Deductions at End of
Description Period Expenses (a) -Note (b) -Note (c) Period
- ---------------------------------------------------------------------------------------------------------------------
Year 1997.............................. $ 161 245 256 425 $ 237
Year 1996.............................. $ 131 129 216 315 $ 161
Year 1995.............................. $ 132 166 147 314 $ 131
<FN>
(a) Provision for uncollectibles as stated in the Consolidated Statements of Income includes certain direct
write-offs which were not reflected in this account.
(b) Amounts previously written off which were credited directly to this account when recovered.
(c) Amounts written off as uncollectible.
</FN>
PACIFIC BELL AND SUBSIDIARIES
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
Reserve for Restructuring
Dollars in Millions
- ---------------------------------------------------------------------------------------------------------------------
COL. A COL. B COL. C COL. D COL. E
- ---------------------------------------------------------------------------------------------------------------------
Additions
-------------------------------
(1) (2)
Charged
Balance at Charged to Other Balance
Beginning of to Costs and Accounts Deductions at End of
Description Period Expenses -Note -Note (a) Period
- ---------------------------------------------------------------------------------------------------------------------
Year 1997.............................. $ 93 - - 93 $ -
Year 1996.............................. $ 219 - - 126 $ 93
Year 1995.............................. $ 819 - - 600 $ 219
<FN>
(a) The 1996 and 1995 amounts reflect $(64), and $219 of costs, respectively,
for enhanced retirement benefits paid from pension fund assets which do not
require current outlays of the Company's funds. The 1996 reversal of $64
resulted from revised estimates of these retirement costs.
</FN>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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, on the 11th day of March
1998.
PACIFIC BELL
By: /s/ Robert B. Pickering
(Robert B. Pickering
Vice President and Chief Financial
Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the date indicated.
Principal Executive Officer:
Edward A. Mueller*
President and Chief
Executive Officer
Principal Financial and
Accounting Officer:
Robert B. Pickering
Vice President and Chief Financial
Officer
/s/ Robert B. Pickering
Directors: (Robert B. Pickering, as attorney-in-fact
and on his own behalf as Principal
Royce S. Caldwell* Financial Officer and Principal
Cassandra C. Carr* Accounting Officer)
William E. Dreyer*
James D. Ellis* March 11, 1998
Charles E. Foster*
Donald E. Kiernan*
Edward A. Mueller*
T. Michael Payne*
* by power of attorney
EXHIBIT INDEX
Exhibit
Number
4 Pursuant to Regulation S-K, Item 601(b)(4)(iii)(A), no instrument that
defines the rights of holders of long-term debt of the registrant is filed
herewith. Pursuant to this regulation, the registrant hereby agrees to
furnish a copy of any such instrument to the SEC upon request.
12 Computation of Ratios of Earnings to Fixed Charges.
23a Consent of Ernst & Young LLP.
23b Consent of Coopers & Lybrand L.L.P.
24 Powers of Attorney.
27 Financial Data Schedule.