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, 1998
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
--------------- ---------------
Ten Year 7 1/4% Note, New York Stock Exchange
Due July 1, 2002
Twelve Year 6 1/4% Note, New York Stock Exchange
Due March 1, 2005
Thirty-Three Year 7 1/8% Debenture, New York Stock Exchange
Due March 15, 2026
Forty Year 7 1/2% Debenture, New York Stock Exchange
Due February 1, 2033
Thirty Year 6 7/8% Debenture, New York Stock Exchange
Due August 15, 2023
Forty-One Year 6 5/8% Debenture, New York Stock Exchange
Due October 15, 2034
TABLE OF CONTENTS
Item Page
- ---- ----
PART I
1. Business....................................................... 4
2. Properties..................................................... 7
3. Legal Proceedings.............................................. 7
4. Submission of Matters to a Vote of Security Holders............ *
PART II
5. Market for Registrant's Common Equity and Related
Stockholder Matters.......................................... 8
6. Selected Financial and Operating Data.......................... 8
7. Management's Discussion and Analysis of Results of Operations
(Abbreviated pursuant to General Instruction I(2))............. 9
7A. Quantitative and Qualitative Disclosures about Market Risk..... 18
8. Financial Statements and Supplementary Data.................... 20
9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure..................................... 42
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 43
- ----------
*Omitted pursuant to General Instruction I(2).
PART I
ITEM 1. BUSINESS
GENERAL
Pacific Bell (PacBell, which also includes its subsidiary, PacBell Information
Services (PBIS)) is a telecommunications company that operates 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 provides landline telecommunications services over
approximately 18 million access lines in California. PacBell provides local
exchange services and is 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).
On February 8, 1996, the Federal Government enacted the Telecommunications Act
of 1996 (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 regulation of RHCs under the MFJ.
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 "Regulatory Environment" beginning on page 13.
Business Combinations
With the completion of SBC's mergers with PAC in 1997 and with Southern New
England Telecommunications Corporation in 1998, SBC began reviews of operations
of PacBell, Southwestern Bell Telephone, Nevada Bell and The Southern New
England Telephone Company (collectively referred to as the Telephone Companies).
As a result of the review and recommendations of merger teams, SBC is
centralizing several key functions that will support the operations of the
Telephone Companies, 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. The Telephone
Companies will continue as separate legal entities. These initiatives continue
to 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. Additional information on this
matter is contained in Note 2 of Notes to Consolidated Financial Statements.
BUSINESS OPERATIONS
PacBell provides telecommunications services by serving approximately 18 million
access lines in the nation's most populous state, California, which includes two
of the country's five largest metropolitan areas. PacBell offers customers an
expansive range of services and products, varying by market, including: local
exchange services, long distance, telecommunications equipment and enhanced
services. Services and products (described more fully below) are provided by
PacBell and its wholly-owned subsidiary, PBIS.
PacBell's revenues are categorized for financial reporting purposes as local
service, network access, long distance service and other.
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
- ------------------------------------------------ -------------------------------
1998 1997 1996
- ------------------------------------------------ ---------- --------- ----------
Local service 52% 52% 49%
Network access 28% 29% 30%
Long distance service 13% 13% 15%
- ------------------------------------------------ ---------- --------- ----------
Local services involve the transport of wireline telecommunications traffic
between telephones and other customer premises equipment 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, voice messaging and
Caller ID 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.
Long distance services involve the transport of telecommunications traffic
between local calling areas within the same LATA (intraLATA). Long distance
services also include other services such as Wide Area Telecommunications
Service (WATS or 800 services) and other special services.
PacBell provides its services over approximately 10.9 million residential and
7.0 million business access lines in California. During 1998 total access lines
grew by 4.0%.
Customer Premises Equipment and Other Equipment Sales
Equipment offerings at PacBell range from single-line and cordless telephones to
sophisticated digital business exchange (PBX) systems, all of which can be
offered with PacBell's central office based solutions. 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.
New Products
As part of its continuing strategy to be among the leaders in the
communications services industry, PacBell is constantly developing new services
and products. It currently is introducing several new data products
including Asymmetrical Digital Subscriber Line (ADSL). ADSL enables
customers to transfer over existing telephone lines, data, graphics, audio and
video files at speeds up to 1.5 megabits per second. ADSL allows customers to
simultaneously make a phone call and access information via the Internet or an
office local area network. ADSL is the subject of a pending FCC review.
Additional information relating to the pending FCC review of ADSL is contained
in Item 7, Management's Discussion and Analysis of Results of Operations of this
report under "Regulatory Environment" beginning on page 13.
During 1998, PacBell continued to expand its offering of vertical services
throughout its operating areas. These services include, among other things,
Caller ID, a feature which displays the telephone number of the person calling
and the caller's name in certain markets; 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 has 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).
Since 1996, PacBell has been offering certain local services on a "wholesale"
basis to competitors, as well as providing elements of its networks on an
"unbundled" basis for local competition. These services are being offered as
specified by the Telecom Act and state actions and interconnection agreements.
The Telecom Act and the regulations promulgated by federal and state agencies to
implement it have resulted in PacBell facing increased competition in
significant portions of its business. At December 31, 1998, PacBell provided
wholesale services to approximately 240,000 access lines. Management cannot
quantify the impact to PacBell's business in 1999 from local exchange
competition, as uncertainty exists as to the breadth and scope of competitors'
offering of local exchange services to all portions of the market in-region, and
as certain regulations, tariffs and negotiations governing such competition are
not yet finalized, but expects continued increases in local exchange services
competition.
Operating Segments
In June 1997, the Financial Accounting Standards Board issued Statement No. 131,
"Disclosures About Segments of an Enterprise and Related Information" (FAS 131),
which establishes standards for the way that public business enterprises report
information about operating segments in quarterly and annual financial
statements. FAS 131 changes segment reporting from an industry segment basis to
an operating segment basis defined based on how the business is managed. As
PacBell operates in only one of SBC's segments, wireline telecommunications
services, separate segment reporting does not apply to PacBell.
GOVERNMENT REGULATION
PacBell is 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 services. PacBell is also subject to the jurisdiction of the
FCC with respect to interstate and international rates and services, including
interstate access charges. Access charges are designed to compensate PacBell for
the use of their facilities for the origination or termination of long distance
and other communications by other carriers.
Additional information relating to federal and state regulation of PacBell is
contained in Item 7, Management's Discussion and Analysis of Results of
Operations of this report under the heading "Regulatory Environment" on page 13.
MAJOR CUSTOMER
No customer accounted for more than 10% of PacBell's consolidated revenues in
1998, 1997 or 1996.
COMPETITION
Information relating to competition in the telecommunications industry is
contained in Item 7, Management's Discussion and Analysis of Results of
Operations of this report under the heading "Competition" beginning on page 16.
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). PacBell 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 RHCs
sold Bellcore to a third party but continue to have a research agreement with
Bellcore. 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. (TRI), a
subsidiary of SBC. TRI provides research, technology planning and evaluation
services to SBC and its subsidiaries, including PacBell.
EMPLOYEES
As of December 31, 1998, PacBell employed approximately 46,440 persons.
Approximately three-fourths of the employees are represented by the
Communications Workers of America (CWA). A new agreement between the CWA and
PacBell was reached on April 7, 1998, covering an estimated 34,000 employees
through April 1, 2001. Among other items, the agreement specifies an 11%
increase in wages over the life of the contract.
ITEM 2. PROPERTIES
The properties of PacBell do not lend themselves to description by character and
location of principal units. At December 31, 1998 network access lines
represented 40% of PacBell's investment in property, plant and equipment;
central office equipment represented 40%; 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 5%.
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 1998 1997
-------------------------------------------------------------------------------
Debt Ratio (debt, including current
maturities, as a percentage of
total capital) 65.79% 67.94%
Network access lines in service (000) 18,066 17,369
Access minutes of use (000,000) * 73,847 68,727
Resold lines (000) 240 238
Number of employees 46,440 45,740
-------------------------------------------------------------------------------
* Amounts have been restated.
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
1998 1997 1998 vs. 1997
- --------------------------------------------------------------------------------
Operating revenues $ 9,406 $ 8,726 7.8%
Operating expenses $ 7,107 $ 8,243 (13.8)%
Income before extraordinary loss and
cumulative effect of accounting changes $ 1,137 $ - -
Extraordinary loss $ (60) $ - -
Cumulative effect of accounting changes $ - $ 345 -
Net income $ 1,077 $ 345 -
- --------------------------------------------------------------------------------
PacBell recognized an extraordinary loss in 1998 relating to the early
retirement of debt (see Note 5 of Notes to Consolidated Financial Statements).
Net income for 1997 includes a cumulative effect of accounting changes related
to conforming accounting methodologies between PacBell and SBC for, among other
items, pensions and postretirement benefits. (See Note 2 of Notes to
Consolidated Financial Statements.)
PacBell's income before cumulative effect of accounting changes for 1997
includes after-tax charges of $1,023 reflecting strategic initiatives resulting
from SBC's merger with PAC, the impact of several recent regulatory rulings and
ongoing merger integration costs. In addition, 1997 was favorably affected by an
$87 after-tax settlement gain associated with lump-sum pension payments that
exceeded the projected service and interest costs for 1996 retirements and an
$18 after-tax gain on the sale of PacBell's interest in Bellcore. Excluding
these 1997 one-time charges and gains, PacBell's income before extraordinary
loss and cumulative effect of accounting changes for 1997 was $918, compared to
$1,137 for 1998, an increase of $219, or 23.9%. The primary factor for this
increase in income before extraordinary loss and cumulative effect of accounting
change during 1998 was growth in demand for services and products.
Items affecting the comparison of the operating results between 1998 and 1997
are discussed in the following sections.
Management's Discussion and Analysis, continued
Dollars in millions
Operating Revenues
PacBell's operating revenues increased $680, or 7.8%, in 1998. Components of
total operating revenues, including percentage changes from the prior year, are
as follows:
- -------------------------------------------------------------------------------
Percent Change
1998 1997 1998 vs. 1997
- -------------------------------------------------------------------------------
Local service $ 4,852 $ 4,515 7.5%
Network access:
Interstate 1,913 1,715 11.5
Intrastate 764 790 (3.3)
Long distance service 1,210 1,176 2.9
Other 667 530 25.8
================================================================
Total operating revenues $ 9,406 $ 8,726 7.8%
===============================================================================
Local Service revenues increased $337, or 7.5%, in 1998 due primarily to
increased demand, which totaled $299, including increases in access lines
and vertical services revenues. The number of access lines increased by
approximately 4.0% in 1998, with approximately 53% of access line growth due
to the sales of additional access lines to existing residential customers.
Vertical services revenues, which include custom calling services, call
control options, Caller ID, voice mail and other enhanced services,
increased by approximately 26% and totaled approximately $732 for 1998.
Additionally, local service revenues increased as a result of several
regulatory actions that also had the effect of decreasing one or more other
types of operating revenues. In 1998, federal payphone regulation and the
introduction of the California High Cost Fund (CHCFB) collectively increased
local service revenues by approximately $77 and decreased long distance
revenue by approximately $43, intrastate network access revenue by
approximately $24, interstate network access revenue by approximately $8 and
other operating revenue by approximately $7. The net effect on total
operating revenue for these items was a decrease of $5. 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 increase in local service revenues was partially offset by
decreases of $22 resulting from rate reductions under CPUC price cap orders.
Network Access The increase in interstate network access revenues in 1998
reflects second quarter 1997 one-time charges of $134. These one-time
charges included billing claim settlements related to the effect of the
change of the Percentage Interstate Usage (PIU) factor in California 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 in the federal price cap
filing. While the 1997 change in the PIU factor, which is used to allocate
network access usage 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 due to rate differences
between the two jurisdictions.
Without these impacts, interstate access revenues increased $64, or 3.5%, in
1998. The increase was due primarily to increased demand for access services
by interexchange carriers, primarily special access, and growth in end-user
charges attributable to an increasing access line base, which collectively
resulted in an increase of approximately $169. Partially offsetting these
increases were the effects of PacBell's annual rate reductions of
approximately $47 related to the FCC's productivity factor adjustment and
changes related to payphone deregulation of approximately $8 noted in local
service
Management's Discussion and Analysis, continued
Dollars in millions
above. Additional decreases in 1998 totaling approximately $38
resulted from an increase in universal service fund net payments implemented
in the first quarter of 1998 that exceeded the 1997 net payments of
long-term support, which were designed to subsidize universal service. The
net federal universal fund payments and receipts will be exogenous factors
in future federal price cap filings.
Intrastate network access revenues decreased $26, or 3.3%, in 1998 due to
the 1997 PIU settlements of $32 described above. Excluding this impact,
intrastate network access increased slightly, attributable to increased
demand of $41, offset in part by the effects of the CHCFB described above in
local service totaling approximately $24 and by CPUC rate reductions of
approximately $4.
Long Distance Service revenues increased $34, or 2.9%, in 1998. This
increase was related to a higher volume of toll messages due to the growing
California economy and alternative calling plans totaling approximately $48
and local exchange carrier billing settlements of approximately $17. As
noted in local service, the increase in long distance service revenues was
partially offset by the combined effects of payphone deregulation and the
CHCFB of $43.
Other operating revenues increased $137, or 25.8%, in 1998 due primarily to
increased sales from nonregulated products and services totaling
approximately $65 and increased equipment sales of approximately $57. These
increases were partially offset by approximately $7 related to federal
payphone regulation discussion in local service above.
Operating Expenses
Components of total operating expenses including percentage changes from the
prior year, are as follows:
- -------------------------------------------------------------------------------
Percent Change
1998 1997 1998 vs. 1997
- -------------------------------------------------------------------------------
Operations and support $ 5,242 $ 6,320 (17.1)%
Depreciation and amortization 1,865 1,923 (3.0)
- ----------------------------------------------------------------
Total operating expenses $ 7,107 $ 8,243 (13.8)%
===============================================================================
PacBell manages its financial and business operations excluding special one-time
or unusual charges and refers to these adjusted results as normalized
operations. As discussed in Note 2 of Notes to Consolidated Financial
Statements, PacBell's operating expenses in 1997 reflect $1.3 billion of
adjustments for charges related to SBC's strategic initiatives, a comprehensive
review of operations of the merged company, the impact of several regulatory
rulings and ongoing merger integration costs. In addition, 1997 includes a first
quarter settlement gain of $146 associated with lump-sum pension payments that
exceeded the projected service and interest costs for 1996 retirements.
Excluding these 1997 adjustments, PacBell's normalized operating expenses
increased $184, or 2.7%, for 1998.
Operations and Support Components of operations and support and normalizing
adjustments for 1998 and 1997 are as follows:
- -------------------------------------------------------------------------------
Percent Change
1998 1997 1998 vs. 1997
- -------------------------------------------------------------------------------
Operations and support $ 5,242 $ 6,320 (17.1)%
Adjustments - (1,194) -
- ----------------------------------------------------------------
Normalized operations and support $ 5,242 $ 5,126 2.3%
===============================================================================
Management's Discussion and Analysis, continued
Dollars in millions
Normalized operations and support increased $116, or 2.3%, in 1998. The
increase for 1998 includes costs of approximately $411 related to
progression in the merger implementation process including charges from
centralized support functions throughout SBC and other merger initiatives.
Operations and support also increased in 1998 due to 1997 pension settlement
gains relating to 1997 retirees totaling approximately $146 and increased
costs associated with reciprocal compensation for the termination of
Internet traffic of approximately $76 (see "Federal Regulation" for further
discussion about reciprocal compensation). In addition, materials,
right-to-use fees and union contract ratification fees increased
approximately $67. These increases were partially offset by reductions in
use of contract labor of approximately $181, reduced expenditures for
interconnection, customer number portability and local competition
initiatives of approximately $195 and net reductions to wages and salaries,
benefits, research and development costs and other non-labor costs totaling
approximately $199.
Depreciation and Amortization Summarization of depreciation and amortization
expense and normalizing adjustments for 1998 and 1997 is as follows:
- -------------------------------------------------------------------------------
Percent Change
1998 1997 1998 vs. 1997
- -------------------------------------------------------------------------------
Depreciation and amortization $ 1,865 $ 1,923 (3.0)%
Adjustments - (127) -
- ----------------------------------------------------------------
Normalized depreciation and
amortization $ 1,865 $ 1,796 3.8%
===============================================================================
Depreciation and amortization expense for 1997 reflects charges totaling
$127 to record impairment of plant and intangibles including analog
switching equipment. Excluding these adjustments, depreciation and
amortization increased $69, or 3.8%, in 1998. The net increase was due
primarily to increased depreciation expense of $97 resulting from overall
higher plant levels. This increase was partially offset by reduced
depreciation of $42 on analog switching equipment.
Interest Expense decreased $34, or 7.4%, in 1998 due to interest of $27
associated with the second quarter 1997 one-time charges. Excluding these
one-time charges, interest expense decreased $7, or 1.6%, due primarily to
reductions in interest expense resulting from lower average debt levels and
lower weighted average interest rates.
Other Income (Expense) - Net in 1997 included a second quarter one-time charge
of $30 for SBC's strategic initiatives, primarily writeoffs of nonoperating
plant, partially offset by the gain recognized from the sale of PacBell's
interest in Bellcore of $30.
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 and the impact of several regulatory rulings as well as taxes on
the pension settlement gain and gain on the sale of PacBell's interest in
Bellcore discussed in operations and support. Excluding these items, income
taxes for 1997 would have been $580. Income taxes for 1998 were higher due
primarily to higher income before income taxes.
Extraordinary Loss In 1998, PacBell recorded an extraordinary loss of $60
related to the refinancing of $684 of long-term debt.
Cumulative Effect of Accounting Changes, as discussed in Note 2 of Notes to
Consolidated Financial Statements, includes the effect of changes applied
retroactively to conform accounting methodologies
Management's Discussion and Analysis, continued
Dollars in millions
between PacBell and SBC effective January 1, 1997. The cumulative after-tax
effect of these one-time changes is $345.
Operating Environment and Trends of the Business
Regulatory Environment
Overview
The telecommunications industry is in a period of dynamic transition from a
tightly regulated industry overseen by multiple regulatory bodies to a
market-driven industry monitored by state and federal agencies. PacBell remains
subject to regulation by the CPUC for intrastate services and by the FCC for
interstate services.
Consolidation of companies is occurring within the marketplace for local
telephone service and across other telecommunications services, such as long
distance, cellular, cable television, Internet and other data transmission
services. Companies operating in some of these markets are also expanding into
others, such as the provision of local service by long distance companies.
Additionally, new technologies are also affecting the way people view and use
communications services.
PacBell is aggressively representing its interests before federal and state
regulatory bodies, courts, Congress and the California legislature. PacBell will
continue to evaluate the increasingly competitive nature of its business, and
develop appropriate competitive, legislative and regulatory strategies.
Federal Regulation
Under the Telecom Act, before being permitted to offer landline interLATA long
distance service in any state within the regulated operating areas, 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 the
CPUC, requires favorable determinations that PacBell has 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 PacBell has a statement of terms and
conditions effective in that state under which they offer the "competitive
checklist" items. The FCC must also make favorable public interest and
structural separation determinations in connection with such applications. See
"State Regulation" for status of the California application.
In December 1997, the United States District Court for the Northern District of
Texas ruled that parts of the Telecom Act were unconstitutional on the grounds
that they improperly discriminate against PacBell by imposing restrictions that
prohibit PacBell by name from offering interLATA long distance and other
services that other Local Exchange Carriers (LECs) are free to provide. In
September 1998, the United States Court of Appeals for the Fifth Circuit (5th
Circuit) reversed this decision and ruled that the challenged provisions of the
Telecom Act were constitutional. In January 1999, the United States Supreme
Court (Supreme Court) declined to hear an appeal of the 5th Circuit decision.
Interconnection In August 1996, the FCC issued rules by which competitors could
connect with LECs' networks, including those of PacBell. 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.
Management's Discussion and Analysis, continued
Dollars in millions
In July 1997, the United States Court of Appeals for the Eighth Circuit (8th
Circuit) held that the FCC did not have the 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.
In January 1999, the Supreme Court ruled on an appeal of the 8th Circuit's
order. The ruling held that the Telecom Act gives the FCC the authority to set
guidelines for states to follow in setting prices under the Telecom Act, and
reinstated the FCC rules allowing those seeking to interconnect to "pick and
choose" specific provisions from previous interconnection agreements. Because
the 8th Circuit's decision did not address the lawfulness of the content of the
FCC pricing guidelines, the Supreme Court remanded that issue to the 8th Circuit
for further consideration. The Supreme Court also held that, before the FCC
could require telecommunications carriers to make a particular network element
available to requesting carriers, the FCC must first consider as to proprietary
elements, whether access to the elements was necessary and whether the failure
to provide access to a particular element would impair the requesting carrier's
ability to provide the service it seeks to offer. The effect of this ruling on
PacBell cannot be determined at this time.
Reciprocal Compensation Reciprocal compensation is billed to PacBell by
Competitive Local Exchange Carriers (CLECs) for the termination of certain local
exchange traffic to CLEC customers. Several state commissions, including the
CPUC in an October 1998 order, expressed the position that Internet
communications is intrastate or local traffic and the CPUC ordered PacBell to
pay reciprocal compensation to certain CLECs pursuant to then existing
contracts. PacBell has filed an application for rehearing of this decision which
is pending.
In February 1999, the FCC ruled that a substantial portion of Internet
communications is interstate traffic and therefore subject to federal
jurisdiction. The FCC noted that carriers were bound by existing interconnection
contracts as interpreted by state commissions. The FCC will issue rules
determining the extent, if any, such communications are subject to reciprocal
compensation. The FCC also ruled that, in the context of interpreting particular
interconnection agreements, the state commissions might determine that
reciprocal compensation was appropriately based on the agreement of the parties
or other factors. SBC believes that the FCC ruling should prevent state
commissions from imposing reciprocal compensation on this traffic.
Asymmetrical Digital Subscriber Line ADSL is a high-speed data service
principally used for Internet access. In June 1998, SBC filed with the FCC a
petition requesting relief for ADSL from pricing, unbundling and resale
regulatory restrictions. The FCC denied the petition and declared that
incumbents must offer such services for resale at a discount and must offer
unbundled access to the equipment used in ADSL provisioning to the extent
possible. SBC has filed with the FCC a petition for reconsideration of this
Management's Discussion and Analysis, continued
Dollars in millions
order. The FCC sought comments on offering the incumbent LECs the option of
providing deregulated advanced services through an affiliate with appropriate
safeguards. In California, PacBell has state approved ADSL tariffs, therefore it
is uncertain what effect, if any, the FCC regulations might have on PacBell.
The effects of the FCC decisions on the above topics 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 CPUC's review and handling of
related matters within its jurisdiction. Accordingly, PacBell is not able to
assess the impact of the FCC orders and proposed rulemaking at this time.
State Regulation
Long Distance Application In October 1998, the CPUC staff released a report on
PacBell's checklist compliance efforts concluding that PacBell had not met all
items of the FCC's 14-point checklist required for entry into in-region
interLATA long distance. In December 1998, the CPUC issued a decision that set
forth items for implementation for final compliance with the checklist. By June
1, 1999, PacBell is required either to make a compliance filing or to inform the
CPUC when it will make a filing. The CPUC will then issue a proposed decision
within 60 days of the filing.
IntraLATA Toll Dialing Parity In a January 1999 decision, the Supreme Court
ruled that the FCC had the authority to issue rules implementing intrastate and
intraLATA dialing parity. The CPUC ruled in 1997 that PacBell should implement
intraLATA dialing parity under the Telecom Act at the same time its affiliate is
able to provide interLATA long distance services. Several interexchange carriers
are arguing before the CPUC that the Supreme Court ruling requires immediate
implementation of dialing parity, preempting state requirements and that the
CPUC must change its earlier decision. PacBell takes the position that dialing
parity requirements should be consistent with state laws and that it should not
be required to provide intraLATA toll dialing parity prior to interLATA long
distance authorization. In states where dialing parity exists, customers are
able to subscribe to an intraLATA toll carrier just as they do for long distance
services. The parties have filed briefs addressing these issues and are awaiting
the CPUC's position in the proceeding. It is also anticipated that the FCC will
issue an order dealing with implementation of intraLATA toll dialing parity.
California Regulation In October 1998, the CPUC issued a decision modifying the
current regulatory framework for PacBell effective January 1, 1999. The decision
adopted PacBell's proposal that the current cap on basic residential rates be
continued for three more years, through 2001, with the CPUC retaining the
ability to adjust basic telephone rates. The decision suspended earnings
sharing, rate of return reviews and the use of earnings caps and floors through
2001. In addition, the decision adopted PacBell's proposal to eliminate
depreciation reviews and granted PacBell the freedom to set its own depreciation
rates and methodology. It also continued the suspension of the productivity
factor adjustment. In addition, the CPUC decision eliminated most future
exogenous cost adjustments including the recovery of future costs related to a
1993 accounting change for postretirement benefits other than pensions.
Management currently estimates the items embodied within the new regulatory
framework will have the net effect of reducing revenue annually by approximately
$100 from 1999 through 2004.
Uniform System of Accounts Rewrite In a 1988 CPUC decision, PacBell received a
rate increase as a result of an FCC mandated change in accounting which required
the expensing of 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. PacBell filed an application in 1995 to terminate
the rate reductions and with subsequent CPUC approval, halted rate reductions
for 1996, 1997 and 1998, pending the outcome
Management's Discussion and Analysis, continued
Dollars in millions
of hearings. In September 1998, the CPUC issued a decision that grants PacBell's
request to discontinue the rate reductions. The decision became final in October
1998.
Universal Service In July 1998, the CPUC issued a rate rebalancing decision
related to its 1996 order on universal service. The CPUC's decision was
implemented prospectively beginning September 1, 1998 and reduces PacBell's
non-basic local service, network access and long distance service revenues by
$305 annually to offset the approximately $305 annually that PacBell expects to
receive from the CHCFB. Beginning in February 1997, PacBell, and all other
California telecommunications carriers, began collecting funds via customer
surcharges consistent with the CPUC's 1996 decision. The CPUC has yet to decide
on the specific mechanism to be employed to ensure the distribution of funds
collected by PacBell and other carriers from February 1997 through August 1998
is revenue neutral.
Competition
Competition continues to increase for telecommunications 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 as
well as new opportunities in significant portions of its business.
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 PacBell's networks and
exchange local calls must enter into interconnection agreements with PacBell.
These agreements are then subject to approval by the CPUC. PacBell has reached
approximately 66 interconnection and resale agreements with competitive local
service providers, and most have been approved by the CPUC. AT&T, MCI WorldCom,
Inc. and other competitors are reselling PacBell's local exchange services, and
as of December 31, 1998, there were approximately 240,000 of PacBell's 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. PacBell has incurred
substantial costs implementing local competition and customer number
portability. In November 1998, the CPUC issued a decision allowing PacBell to
begin recovery of local competition implementation costs.
PacBell expects increased competitive pressure in 1999 and beyond from multiple
providers in various markets including facilities-based CLECs, interexchange
carriers 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. Competition
also continues to intensify in PacBell's intraLATA long distance markets. For
example, it is estimated that providers other than PacBell now serve more than
half of the business intraLATA long distance customers in PacBell's service
areas. In addition, if intraLATA toll dialing parity is required, competition in
intraLATA long distance markets is expected to increase.
Management's Discussion and Analysis, continued
Dollars in millions
Other Business Matters
New Accounting Standards In June 1998, the Financial Accounting Standards Board
issued Statement No. 133, "Accounting for Derivative Instruments and Hedging
Activities" (FAS 133) which will require all derivatives to be recorded on the
balance sheet at fair value, and will require changes in the fair values of the
derivatives to be recorded in net income or comprehensive income. FAS 133 must
be adopted for years beginning after June 15, 1999 with earlier adoption
permitted. PacBell currently has no derivative financial instruments.
See Note 1 of Notes to Consolidated Financial Statements for a discussion of the
new accounting standard on software costs.
SBC's Year 2000 Project SBC and its subsidiaries and affiliates, including
PacBell, operate numerous date-sensitive computer applications and systems
throughout its businesses. Since 1996, SBC has been working to upgrade its
networks and computer systems to properly recognize the Year 2000 and continue
to process critical operational and financial information. Companywide teams are
in place to address and resolve Year 2000 issues and processes are under way to
evaluate and manage the risks and costs associated with preparing SBC's
date-impacted systems and networks for the new millennium.
SBC is using a four-step methodology to address the issue. The methodology
consists of inventory and assessment, hardware and software fixes, testing and
deployment. SBC measures its progress by tracking the number of completed
hardware and software applications, network components, personal computers and
building facilities that can correctly process Year 2000 dates.
Inventory and assessment is estimated to require 20% of the overall effort and
includes the identification of items (i.e., line-by-line review of software
code, switch generics, vendor products, etc.) that could be impacted by the Year
2000 and the determination of the work effort required to ensure compliance. The
inventory and assessment phase has been completed. This process involved
reviewing over 340 million lines of software code, 1,200 central office
switches, 7,000 company buildings, conducting an inventory and assessment of
117,000 personal computers, and coordinating with 1,300 suppliers of 14,000
products to obtain adequate assurance they will be Year 2000 compliant or
determine and address any appropriate contingency plans or backup systems.
Making the hardware and software fixes is the second phase of the process and is
estimated to require 25% of the overall effort. This activity involves modifying
program code, upgrading computer software and upgrading or replacing hardware.
As of December 31, 1998, the hardware and software fixes were substantially
complete.
Testing involves ensuring that hardware and software fixes will work properly in
1999 and beyond and occurs both before and after deployment. Testing is
estimated to comprise 45% of the overall effort. Testing began early in 1998, is
more than two-thirds complete, and will continue through 1999 to allow for
thorough testing before the Year 2000. Contingency plans and backup systems are
currently being written.
Deployment involves placing the "fixed" systems into a live environment to
ensure they are working properly. Additional testing is done after deployment as
well. Deployment is estimated to require 10% of the overall effort. More than
half of the deployment phase was completed as of December 31, 1998.
SBC expects to spend approximately $265 on the entire project, with
approximately $140 spent through December 31, 1998. As testing and hardware and
software fixes are estimated to require most of the expenditures, there is not a
strict correlation between expenditures and project completion.
Management's Discussion and Analysis, continued
Dollars in millions
The activities involved in SBC's Year 2000 project necessarily require estimates
and projections, as described above, of activities and resources that will be
required in the future. These estimates and projections could change as work
progresses on the project.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market Risk
PacBell's capital costs are managed by SBC, and are directly linked to financial
and business risks. SBC seeks to manage the potential negative effects from
market volatility and market risk. Certain financial instruments used to obtain
capital are subject to market risks from fluctuations in market interest rates.
The majority of SBC's financial instruments are medium- and long-term fixed rate
notes and debentures. Fluctuations in market interest rates can lead to
significant fluctuations in the fair value of these notes and debentures. It is
the policy of SBC to manage its debt structure in order to manage capital costs,
control financial risks and maintain financial flexibility over the long term.
Where appropriate, SBC will take actions to limit the negative effect of
interest rates, liquidity and counterparty risks on shareowner value.
Quantitative Information about Market Risk
Interest Rate Sensitivity
PacBell currently has no derivative financial instruments. The principal amount
by expected maturity, average interest rate and fair values of PacBell's
liabilities that are exposed to interest rate risk are described in Notes 4 and
5 of Notes to Consolidated Financial Statements.
There has been no material change in the updated market risks since December 31,
1997.
Qualitative Information about Market Risk
Interest Rate Risk
PacBell's interest rate risk is managed by SBC. SBC issues debt in fixed and
floating rate instruments. Interest rate swaps are used for the purpose of
controlling interest expense by fixing the interest rate of floating rate debt.
When market conditions favor issuing debt in floating rate instruments, and SBC
prefers not to take the risk of floating rates, SBC will enter interest rate
swap contracts to obtain floating rate payments to service the debt in exchange
for paying a fixed rate. SBC does not seek to make a profit from changes in
interest rates. SBC manages interest rate sensitivity by measuring potential
increases in interest expense that would result from a probable change in
interest rates. When the potential increase in interest expense exceeds an
acceptable amount, SBC reduces risk through the issuance of fixed rate
instruments and purchasing derivatives.
CAUTIONARY LANGUAGE CONCERNING FORWARD-LOOKING STATEMENTS
Information set forth in this form contains forward-looking statements that are
subject to risks and uncertainties. PacBell claims the protection of the safe
harbor for forward-looking statements provided by the Private Securities
Litigation Reform Act of 1995.
The following factors could cause PacBell's future results to differ materially
from those expressed in the forward-looking statements: (1) adverse economic
changes in the markets served by PacBell or changes in available technology; (2)
the final outcome of various FCC rulemakings and judicial review, if any, of
such
Management's Discussion and Analysis, continued
Dollars in millions
rulemakings; (3) the final outcome of various CPUC proceedings, and
judicial review, if any, of such proceedings; and (4) the timing of entry and
the extent of competition in the local and intraLATA toll markets in California.
Readers are cautioned that other factors discussed in this form, although not
enumerated here, also could materially impact PacBell's future earnings.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Independent Auditors
The Board of Directors
Pacific Bell
We have audited the accompanying consolidated balance sheets of Pacific Bell (a
wholly-owned subsidiary of Pacific Telesis Group, a wholly-owned subsidiary of
SBC Communications Inc.) as of December 31, 1998 and 1997, and the related
consolidated statements of income, shareowner's equity and cash flows for the
years 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 financial statements and schedules based on our audits.
We conducted our audits 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 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 the
Company at December 31, 1998 and 1997, and the consolidated results of its
operations and its cash flows for the years 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 1 to the consolidated financial statements, in 1998 the
Company changed its reporting entity. We have audited the adjustments described
in Note 10 that were applied to restate the financial statements of the Company.
In our opinion, such adjustments are appropriate and have been properly applied.
As discussed in Note 2 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 12, 1999
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareowner of Pacific Bell:
We have audited the accompanying consolidated statements of income and cash
flows for the year ended December 31, 1996 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 for the
year ended December 31, 1996, as included in the column `Originally reported' in
Note 10. These consolidated financial statements are the responsibility of
management. Our responsibility is to express an opinion on these financial
statements based on our audit.
We conducted our audit 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 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 results of operations of
Pacific Bell and Subsidiaries and their cash flows for the year ended December
31, 1996 in conformity with generally accepted accounting principles.
PRICEWATERHOUSECOOPERS LLP
San Francisco, California
February 27, 1997
PACIFIC BELL
- -----------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF INCOME
Dollars in millions
- -----------------------------------------------------------------------------
1998 1997 1996
- -----------------------------------------------------------------------------
Operating Revenues
Local service $ 4,852 $ 4,515 $ 4,151
Network access:
Interstate 1,913 1,715 1,807
Intrastate 764 790 718
Long distance service 1,210 1,176 1,274
Other 667 530 497
- -----------------------------------------------------------------------------
Total operating revenues 9,406 8,726 8,447
- -----------------------------------------------------------------------------
Operating Expenses
Operations and support 5,242 6,320 4,700
Depreciation and amortization 1,865 1,923 1,804
- -----------------------------------------------------------------------------
Total operating expenses 7,107 8,243 6,504
- -----------------------------------------------------------------------------
Operating Income 2,299 483 1,943
- -----------------------------------------------------------------------------
Other Income (Expense)
Interest expense (426) (460) (379)
Other income - net (2) 11 4
- -----------------------------------------------------------------------------
Total other income (expense) (428) (449) (375)
- -----------------------------------------------------------------------------
Income Before Income Taxes, Extraordinary Loss
and Cumulative Effect of Accounting Changes 1,871 34 1,568
- -----------------------------------------------------------------------------
Income Taxes 734 34 619
- -----------------------------------------------------------------------------
Income Before Extraordinary Loss and
Cumulative Effect of Accounting Changes 1,137 - 949
Extraordinary Loss from Early Extinguishment
of Debt, net of tax (60) - -
Cumulative Effect of Accounting Changes, net of tax - 345 -
- -----------------------------------------------------------------------------
Net Income $ 1,077 $ 345 $ 949
- -----------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
PACIFIC BELL
- -------------------------------------------------------------------------------
CONSOLIDATED BALANCE SHEETS
Dollars in millions except per share amounts
- -------------------------------------------------------------------------------
December 31,
-----------------------
1998 1997
- -------------------------------------------------------------------------------
Assets
Current Assets
Cash and cash equivalents $ 15 $ 43
Accounts receivable - net of allowances for
uncollectibles of $161 and $152 2,015 1,782
Prepaid expenses 90 53
Deferred income taxes 280 415
Other current assets 31 44
- -------------------------------------------------------------------------------
Total current assets 2,431 2,337
- -------------------------------------------------------------------------------
Property, Plant and Equipment - at cost 29,871 28,695
Less: Accumulated depreciation and amortization 18,272 17,442
- -------------------------------------------------------------------------------
Property, Plant and Equipment - Net 11,599 11,253
- -------------------------------------------------------------------------------
Other Assets 1,063 749
- -------------------------------------------------------------------------------
Total Assets $ 15,093 $ 14,339
- -------------------------------------------------------------------------------
Liabilities and Shareowner's Equity
Current Liabilities
Intercompany loans $ 1,551 $ 542
Current portion of long-term obligations 103 4
- -------------------------------------------------------------------------------
Total debt maturing within one year 1,654 546
Accrued taxes 122 334
Accounts payable and accrued liabilities 2,669 2,719
- -------------------------------------------------------------------------------
Total current liabilities 4,445 3,599
- -------------------------------------------------------------------------------
Long-Term Debt 4,614 5,358
- -------------------------------------------------------------------------------
Deferred Credits and Other Noncurrent Liabilities
Deferred income taxes 1,082 957
Postemployment benefit obligation 894 881
Unamortized investment tax credits 149 188
Other noncurrent liabilities 649 569
- -------------------------------------------------------------------------------
Total deferred credits and other noncurrent liabilities 2,774 2,595
- -------------------------------------------------------------------------------
Shareowner's Equity
Common shares ($1 par value, 300,000,000 authorized:
issued 224,504,982 at December 31, 1998 and 1997) 225 225
Capital in excess of par value 4,210 4,814
Retained earnings (deficit) (1,175) (2,252)
- -------------------------------------------------------------------------------
Total shareowner's equity 3,260 2,787
- -------------------------------------------------------------------------------
Total Liabilities and Shareowner's Equity $ 15,093 $ 14,339
- -------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
PACIFIC BELL
- -----------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF CASH FLOWS
Dollars in millions, increase (decrease) in cash and cash equivalents
- -----------------------------------------------------------------------------
1998 1997 1996
- -----------------------------------------------------------------------------
Operating Activities
Net income $ 1,077 $ 345 $ 949
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 1,865 1,923 1,804
Provision for uncollectible accounts 150 184 130
Amortization of investment tax credits (39) (47) (47)
Deferred income taxes 335 49 257
Extraordinary loss, net of tax 60 - -
Cumulative effect of accounting change, net of tax - (345) -
Changes in operating assets and liabilities:
Accounts receivable (383) 5 (460)
Other current assets (24) (28) 21
Accounts payable and accrued liabilities (261) 651 (76)
Other - net (336) (243) (401)
- -----------------------------------------------------------------------------
Total adjustments 1,367 2,149 1,228
- -----------------------------------------------------------------------------
Net Cash Provided by Operating Activities 2,444 2,494 2,177
- -----------------------------------------------------------------------------
Investing Activities
Construction and capital expenditures (2,140) (2,045) (1,911)
Dispositions - 65 -
Other - (14) (22)
- -----------------------------------------------------------------------------
Net Cash Used in Investing Activities (2,140) (1,994) (1,933)
- -----------------------------------------------------------------------------
Financing Activities
Net change in short-term borrowings with original
maturities of three months or less 1,009 (122) (280)
Issuance of other short-term borrowings - 610 -
Repayment of other short-term borrowings - (610) -
Issuance of long-term debt 217 252 495
Repayment of long-term debt (185) - (4)
Early extinguishment of debt and related call
premiums (765) - -
Equity received from parent 155 49 388
Dividends paid (763) (693) (879)
Other - - 33
- -----------------------------------------------------------------------------
Net Cash Used in Financing Activities (332) (514) (247)
- -----------------------------------------------------------------------------
Net decrease in cash and cash equivalents (28) (14) (3)
- -----------------------------------------------------------------------------
Cash and cash equivalents beginning of year 43 57 60
- -----------------------------------------------------------------------------
Cash and Cash Equivalents End of Period $ 15 $ 43 $ 57
- -----------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
PACIFIC BELL
- ---------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF SHAREOWNER'S EQUITY
Dollars in millions
- ---------------------------------------------------------------------------
Retained
Common Paid-in Earnings
Stock Surplus (Deficit)
- ---------------------------------------------------------------------------
Balance, December 31, 1995 $ 225 $ 5,071 $ (2,667)
Net income - - 949
Dividend to shareowner - - (879)
Equity from parent - 388 -
Other - (1) -
- ---------------------------------------------------------------------------
Balance, December 31, 1996 225 5,458 (2,597)
- ---------------------------------------------------------------------------
Net income - - 345
Dividend to shareowner - (693) -
Equity from parent - 49 -
- ---------------------------------------------------------------------------
Balance, December 31, 1997 225 4,814 (2,252)
- ---------------------------------------------------------------------------
Net income - - 1,077
Dividend to shareowner - (763) -
Equity from parent - 155 -
Other - 4 -
- ---------------------------------------------------------------------------
Balance, December 31, 1998 $ 225 $ 4,210 $ (1,175)
- ---------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
Notes to Consolidated 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 also includes its subsidiary
Pacific Bell Information Services). PacBell is a wholly-owned subsidiary of
Pacific Telesis Group (PAC), a wholly-owned subsidiary of SBC Communications
Inc. (SBC). PacBell operates in the telecommunications industry providing
landline services in California. On March 31, 1998, PacBell distributed the
shares of Pacific Bell Directory, Pacific Bell Mobile Services, Pacific Bell
Internet Services and PB COMM Switches, Inc. to PAC. PacBell has accounted
for this distribution as a change in reporting entity. The financial
statements of all periods presented have been restated to show financial
information for the new reporting entity.
All significant intercompany transactions are eliminated in the
consolidation process.
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.
Certain amounts in prior period financial statements have been reclassified
to conform to the current year's presentation.
Comprehensive Income - Comprehensive income for PacBell is the same as net
income for all periods presented.
Operating Segments - In June 1997, the Financial Accounting Standards Board
issued Statement No. 131, "Disclosures About Segments of an Enterprise and
Related Information" (FAS 131), which establishes standards for the way that
public business enterprises report information about operating segments in
quarterly and annual financial statements. FAS 131 changes segment reporting
from an industry segment basis to an operating segment basis defined based
on how the business is managed. As PacBell operates in only one of SBC's
segments, wireline telecommunications services, separate segment reporting
is not applicable to PacBell.
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 (Agreement) between PacBell and
SBC. In general, PacBell's income tax provision under the 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.
Revenue Recognition - PacBell recognizes revenues as earned. Amounts billed
in advance of the period in which service is rendered are recorded as a
liability.
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
Notes to Consolidated Financial Statements, continued
Dollars in millions
maintenance and repairs of property, plant and equipment is charged to
operating expenses. Property, plant and quipment is depreciated using
straight-line methods over their estimated economic lives, generally
ranging from 3 to 50 years. 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 estimated economic
lives of the associated hardware. The American Institute of Certified Public
Accountants has issued a Statement of Position (SOP) that requires
capitalization of certain computer software expenditures beginning in 1999.
Management continues to evaluate the impact of the change in accounting
required by the SOP and anticipates that it will increase net income by less
than $100 in 1999. With comparable levels of software expenditures, the SOP
would tend to increase net income in comparison with PacBell's current
method of accounting for software costs. However, the increases would be
largest in the year of adoption with diminishing levels of increases
compared with current accounting throughout the amortization period.
Consequently, given otherwise comparable income levels excluding software,
and otherwise comparable software expenditures, the effect of the SOP would
be to increase income in the first year and decrease income in each
subsequent year until the number of years affected by the SOP equals the
amortization period.
Advertising Costs - Costs for advertising products and services or corporate
image are expensed as incurred (see Note 9).
2. Completion of Merger
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). 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.
On October 26, 1998, SBC and Southern New England Telecommunications
Corporation (SNET) completed the merger of an SBC subsidiary with SNET, in a
transaction in which each share of SNET common stock was exchanged for
1.7568 shares of SBC common stock (equivalent to approximately 120 million
shares). SNET became a wholly-owned subsidiary of SBC effective with the
merger and the transaction has been accounted for as a pooling of interests
and a tax-free reorganization.
Conforming accounting changes
PacBell's results include merger transaction costs and the effects of
changes to conform accounting methodologies between PacBell and SBC 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 $345 net of deferred
taxes of $239, and increased income before income taxes, extraordinary loss
and cumulative effect of accounting changes and net income for 1997 by $84
and $50. 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).
Notes to Consolidated Financial Statements, continued
Dollars in millions
Post-merger initiatives
During the second quarter of 1997, PacBell recorded after-tax charges of
$883 related to SBC's June 19, 1997 announcement of several strategic
decisions resulting from the merger integration process that began with the
April 1, 1997 closing of its merger with PAC. These charges included $107
($65 after tax) of charges related to several regulatory rulings during the
second quarter of 1997 and $276 ($173 after tax) for the 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.
The charges related to the strategic decisions totaled $1 billion ($645
after tax). In the fourth quarter of 1998, SBC again performed a complete
review of all operations affected by the merger with SNET to determine the
impact on ongoing merger implementation processes. This review resulted in
no significant additional financial effect on PacBell. At December 31, 1998
and December 31, 1997, remaining accruals for anticipated cash expenditures
related to these decisions were approximately $61 and $202. Following is a
discussion of the most significant of these charges.
Reorganization SBC is centralizing several key functions that will support
the operations of PacBell and three other SBC subsidiaries, Nevada Bell,
Southwestern Bell Telephone Company (SWBell) and The Southern New England
Telephone Company (SNETel), 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, SWBell and SNETel will continue as separate legal entities. These
initiatives are resulting 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 $127 ($80 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.
The initial integration process subsequent to the PAC merger resulted in
PacBell incurring expense for these merger related items in advance of any
substantive synergistic benefits. These charges totaled $234 ($139 net of
tax) during the second half of 1997.
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 $341 ($219 after tax) recorded in the second quarter of
1997. These impairments and writeoffs related to certain analog switching
equipment, duplicate or obsolete equipment, cable within commercial
buildings, certain nonoperating plant and other assets.
Video curtailment/purchase commitments SBC also announced it was scaling
back its limited direct investment in video services. 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, 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 a net expense of
$553 ($346 after
Notes to Consolidated Financial Statements, continued
Dollars in millions
tax) associated with these activities. During the third quarter of 1997
PacBel recorded the corresponding short-term debt of $610 previously
incurred by the ACN trust on its balance sheet.
3. Property, Plant and Equipment
Property, plant and equipment is summarized as follows at December 31:
1998 1997
-----------------------------------------------------------------------------
Land $ 212 $ 207
Buildings 2,836 2,744
Central office equipment 11,809 10,929
Cable, wiring and conduit 11,890 11,673
Other equipment 2,395 2,487
Under construction 729 655
-----------------------------------------------------------------------------
29,871 28,695
Accumulated depreciation and amortization 18,272 17,442
-----------------------------------------------------------------------------
Property, plant and equipment - net $ 11,599 $ 11,253
=============================================================================
PacBell's depreciation expense as a percentage of average depreciable plant
was 6.6%, 7.1% and 6.9% for 1998, 1997 and 1996.
Certain facilities and equipment used in operations are under operating or
capital leases. Rental expenses under operating leases for 1998, 1997 and
1996 were $118, $124 and $141. At December 31, 1998, the future minimum
rental payments under noncancelable operating leases for the years 1999
through 2003 were $50, $20, $11, $7 and $5, and $13 thereafter. Capital
leases were not significant.
Notes to Consolidated Financial Statements, continued
Dollars in millions
4. Debt
Long-term debt, including interest rates and maturities, is summarized as
follows at December 31:
-------------------------------------------------------------------------------
1998 1997
-------------------------------------------------------------------------------
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 1,587 2,250
8.50% 2031 29 225
-------------------------------------------------------------------------------
3,285 4,144
Unamortized discount - net of premium (65) (89)
-------------------------------------------------------------------------------
Total debentures 3,220 4,055
-------------------------------------------------------------------------------
Notes
6.12%-8.70% 2001-2009 1,500 1,300
Unamortized discount (18) (18)
-------------------------------------------------------------------------------
Total notes 1,482 1,282
-------------------------------------------------------------------------------
Capitalized leases 15 25
-------------------------------------------------------------------------------
Total long-term debt, including current maturities 4,717 5,362
Current maturities (103) (4)
-------------------------------------------------------------------------------
Total long-term debt $ 4,614 $ 5,358
===============================================================================
In October 1998, PacBell repurchased $684 of long-term debt. The repurchases
resulted in a $60 after-tax extraordinary loss, net of taxes of $42.
At December 31, 1998, the aggregate principal amounts of long-term debt and
average interest rate scheduled for repayment for the years 1999 through
2003 were $103 (4.6%), $127 (4.6%), $203 (8.7%), $432 (6.9%), $166 (6.5%)
with $3,769 (6.9%) due thereafter. As of December 31, 1998, 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:
-------------------------------------------------------------------------------
1998 1997
-------------------------------------------------------------------------------
Intercompany loans $ 1,551 $ 542
Current maturities of long-term debt 103 4
===============================================================================
Total $ 1,654 $ 546
===============================================================================
During the third quarter of 1997, PacBell's commercial paper was replaced by
intercompany loans from SBC. The weighted average interest rate on debt
maturing with one year, excluding current maturities of long-term debt, at
December 31, 1998 and 1997 was 5.0% and 6.0%.
Notes to Consolidated Financial Statements, continued
Dollars in millions
5. 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:
-------------------------------------------------------------------------------
1998 1997
-------------------------------------------------------------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
-------------------------------------------------------------------------------
Debentures 3,220 3,463 4,055 4,337
Notes 1,482 1,590 1,282 1,342
-------------------------------------------------------------------------------
The fair values of long-term debt were estimated based on quoted market
prices. PacBell's cash equivalents are recorded at cost. The carrying
amounts of cash and cash equivalents and customer deposits approximate fair
values.
PacBell does not hold or issue any financial instruments for trading
purposes.
6. Income Taxes
Significant components of PacBell's deferred tax assets and liabilities are
as follows at December 31:
-------------------------------------------------------------------------------
1998 1997
-------------------------------------------------------------------------------
Deferred tax (assets)/liabilities due to:
Depreciation and amortization $ 1,192 $ 1,083
Employee benefits (179) (280)
Unamortized investment tax credits (51) (76)
Jurisdictional revenues (286) (311)
Other, net (12) (44)
-------------------------------------------------------------------------------
Net deferred tax liabilities $ 664 $ 372
-------------------------------------------------------------------------------
Amounts recorded in consolidated balance sheets:
-------------------------------------------------------------------------------
Deferred tax assets* $ 418 $ 585
===============================================================================
Deferred tax liabilities* $ 1,082 $ 957
===============================================================================
*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.
Notes to Consolidated Financial Statements, continued
Dollars in millions
The components of income tax expense (benefit) are as follows:
-------------------------------------------------------------------------------
1998 1997 1996
-------------------------------------------------------------------------------
Federal
Current $ 349 $ 32 $ 313
Deferred - net 260 57 193
Amortization of investment tax credits (39) (47) (47)
-------------------------------------------------------------------------------
570 42 459
-------------------------------------------------------------------------------
State and local
Current 89 - 96
Deferred - net 75 (8) 64
-------------------------------------------------------------------------------
164 (8) 160
===============================================================================
Total $ 734 $ 34 $ 619
===============================================================================
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:
- -------------------------------------------------------------------------------
1998 1997 1996
- -------------------------------------------------------------------------------
Taxes computed at federal statutory rate $ 655 $ 12 $ 549
Increases (decreases) in taxes resulting from:
Amortization of investment tax credits over
the life of the plant that gave
rise to the credits (25) (31) (31)
State and local income taxes - net of
federal tax benefit 107 (5) 104
1997 implementation of the Tax Allocation
Agreement - 56 -
Other - net (3) 2 (3)
===============================================================================
Total $ 734 $ 34 $ 619
===============================================================================
7. Employee Benefits
Pensions - Substantially all employees of PacBell are covered by
noncontributory 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.
Notes to Consolidated Financial Statements, continued
Dollars in millions
Significant assumptions used by SBC in developing pension information
include:
- --------------------------------------------------------------------------------
1998 1997 1996
- --------------------------------------------------------------------------------
Discount rate for determining projected
benefit obligation 7.0% 7.25% 7.5%
Long-term rate of return on plan assets 8.5% 8.5% 9.0%
Composite rate of compensation increase 4.3% 4.3% 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 benefit for 1998, 1997 and 1996 of $256, $243 and $168.
As of December 31, 1998, the amount of PacBell's cumulative amount of
contributions recognized in excess of its pension cost made to the trust
were $728 and as of December 31, 1997, the cumulative amount of
contributions recognized in excess of its pension cost made to the trust
were $403.
During 1998, certain bargained employees accepted early retirement benefit
offers that resulted in special termination benefits recognized of $53 that
are excluded from the pension benefit amount disclosed above.
During 1997, a significant amount of lump sum pension payments resulted in a
partial settlement of PacBell's pension plans. Therefore, 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.
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 the 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 of $92 in 1998, 1997 and 1996. PacBell
recognized postretirement benefit cost for 1998, 1997 and 1996 of $222, $252
and $250. At December 31, 1998 and 1997, the amount included in the
Consolidated Balance Sheets for accrued postretirement benefit obligation
was $562 and $581. 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 1998 and 1997, PacBell contributed $239
and $295 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 1999 is 7.0%, decreasing linearly to
5.5% in 2002 prior to adjustment for cost-sharing provisions of the plan for
active and certain recently retired employees. The
Notes to Consolidated Financial Statements, continued
Dollars in millions
assumed dental cost trend rate in 1999 is 5.75%, 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, 1998 by approximately 5.2%. Decreasing the annual
medical and dental cost trend rates by one percentage point decreases
the net periodic postretirement benefit cost for 1998 by approximately
$4.1%.
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.
8. Stock Option Plans
Management employees of PacBell participate in various stock option plans
sponsored by SBC. Options issued through December 31, 1998 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 206
million shares may be issued 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 Board 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 1998, 1997 and 1996 as defined by FAS
123, PacBell's net income would have been $1,055, $331 and $948.
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 1998, 1997 and 1996: risk-free interest
rate of 5.72%, 6.56% and 6.25%; dividend yield of 2.21%, 3.07% and 4.91%;
expected volatility factor of 15%, 15% and 18%; and expected option life
of 5.3, 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.
Notes to Consolidated Financial Statements, continued
Dollars in millions
9. Additional Financial Information
-------------------------------------------------------------------------------
December 31,
----------------------
Balance Sheets 1998 1997
-------------------------------------------------------------------------------
Accounts payable and accrued liabilities:
Accounts payable $ 1,501 $ 1,620
Advance billing and customer deposits 359 300
Compensated future absences 252 260
Accrued interest 129 145
Accrued payroll 87 77
Other 341 317
===============================================================================
Total $ 2,669 $ 2,719
===============================================================================
-------------------------------------------------------------------------------
Statements of Income 1998 1997 1996
===============================================================================
Advertising expense $ 157 $ 120 $ 94
===============================================================================
Interest expense incurred $ 461 $ 497 $ 412
Capitalized interest (35) (37) (33)
-------------------------------------------------------------------------------
Total interest expense $ 426 $ 460 $ 379
===============================================================================
-------------------------------------------------------------------------------
Statements of Cash Flows 1998 1997 1996
-------------------------------------------------------------------------------
Cash paid during the year for:
Interest $ 441 $ 445 $ 370
Income taxes, net of refunds $ 651 $ (184) $ 320
===============================================================================
No customer accounted for more than 10% of PacBell's consolidated revenues
in 1998, 1997 and 1996.
Approximately three-fourths of PacBell's employees are represented by the
Communications Workers of America (CWA). In April 1998, a three-year
contract was negotiated between the CWA and PacBell. This contract was the
result of renegotiations of a contract that expired in mid-1998. No
contracts are expiring in 1999.
10. Change in Entity
On March 31, 1998, PacBell distributed the shares of Pacific Bell Directory,
Pacific Bell Mobile Services, Pacific Bell Internet Services and PB COMM
Switches, Inc. to PAC. PacBell has accounted for this distribution as a
change in reporting entity. The financial statements of all periods
presented have been restated to show financial information for the new
reporting entity.
The following financial statements present the pre-distribution entity,
adjustments to effect the distribution and reclassify certain amounts to
conform to the 1998 presentation, and the restated entity amounts. The
Consolidated Statements of Income and the Consolidated Statements of Cash
Flows are presented for the twelve months ended December 31, 1997 and 1996.
The Consolidated Balance Sheets are presented for December 31, 1997.
Notes to Consolidated Financial Statements, continued
Dollars in millions
PACIFIC BELL
- -----------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF INCOME
Dollars in millions
For the year ended December 31, 1997
- -----------------------------------------------------------------------------------
Originally
Reported Distribution* Restated
- -----------------------------------------------------------------------------------
Operating Revenues
Local service $ 4,386 $ 129 $ 4,515
Network access:
Interstate 1,714 1 1,715
Intrastate 790 - 790
Long distance service 1,182 (6) 1,176
Directory advertising and other 1,866 (1,336) 530
- -----------------------------------------------------------------------------------
Total operating revenues 9,938 (1,212) 8,726
- -----------------------------------------------------------------------------------
Operating Expenses
Operations and support 7,408 (1,088) 6,320
Depreciation and amortization 2,021 (98) 1,923
- -----------------------------------------------------------------------------------
Total operating expenses 9,429 (1,186) 8,243
- -----------------------------------------------------------------------------------
Operating Income 509 (26) 483
- -----------------------------------------------------------------------------------
Other Income (Expense)
Interest expense (461) 1 (460)
Other income - net 6 5 11
- -----------------------------------------------------------------------------------
Total other income (expense) (455) 6 (449)
- -----------------------------------------------------------------------------------
Income Before Income Taxes and Cumulative
Effect of Accounting Changes 54 (20) 34
- -----------------------------------------------------------------------------------
Income Taxes 46 (12) 34
- -----------------------------------------------------------------------------------
Income Before Cumulative Effect of Accounting Changes 8 (8) -
- -----------------------------------------------------------------------------------
Cumulative Effect of Accounting Changes, net of tax 342 3 345
- -----------------------------------------------------------------------------------
Net Income $ 350 $ (5) $ 345
- -----------------------------------------------------------------------------------
* Also includes certain reclassifications to conform to the current year's presentation.
Notes to Consolidated Financial Statements, continued
Dollars in millions
PACIFIC BELL
- -----------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF INCOME
Dollars in millions
For the year ended December 31, 1996
- -----------------------------------------------------------------------------------
Originally
Reported Distribution* Restated
- -----------------------------------------------------------------------------------
Operating Revenues
Local service $ 3,956 $ 195 $ 4,151
Network access:
Interstate 1,805 2 1,807
Intrastate 718 - 718
Long distance service 1,274 - 1,274
Directory advertising and other 1,693 (1,196) 497
- -----------------------------------------------------------------------------------
Total operating revenues 9,446 (999) 8,447
- -----------------------------------------------------------------------------------
Operating Expenses
Operations and support 5,316 (616) 4,700
Depreciation and amortization 1,826 (22) 1,804
- -----------------------------------------------------------------------------------
Total operating expenses 7,142 (638) 6,504
- -----------------------------------------------------------------------------------
Operating Income 2,304 (361) 1,943
- -----------------------------------------------------------------------------------
Other Income (Expense)
Interest expense (363) (16) (379)
Other income - net 4 - 4
- -----------------------------------------------------------------------------------
Total other income (expense) (359) (16) (375)
- -----------------------------------------------------------------------------------
Income Before Income Taxes and Cumulative
Effect of Accounting Change 1,945 (377) 1,568
- -----------------------------------------------------------------------------------
Income Taxes 775 (156) 619
- -----------------------------------------------------------------------------------
Income Before Cumulative Effect of Accounting
Change 1,170 (221) 949
- -----------------------------------------------------------------------------------
Cumulative Effect of Accounting Change, net of tax 85 (85) -
- -----------------------------------------------------------------------------------
Net Income $ 1,255 $ (306) $ 949
- -----------------------------------------------------------------------------------
* Also includes certain reclassifications to conform to the current year's presentation.
Notes to Consolidated Financial Statements, continued
Dollars in millions
PACIFIC BELL
- ----------------------------------------------------------------------------------------
CONSOLIDATED BALANCE SHEETS
Dollars in millions except per share amounts
December 31, 1997
- ----------------------------------------------------------------------------------------
Originally
Reported Distribution Restated
- ----------------------------------------------------------------------------------------
Assets
Current Assets
Cash and cash equivalents $ 43 $ - $ 43
Accounts receivable - net of allowances for
uncollectibles 2,199 (417) 1,782
Prepaid expenses 54 (1) 53
Deferred income taxes 329 86 415
Other current assets (including deferred charges) 78 (34) 44
- ----------------------------------------------------------------------------------------
Total current assets 2,703 (366) 2,337
- ----------------------------------------------------------------------------------------
Property, Plant and Equipment - at cost 29,681 (986) 28,695
Less: Accumulated depreciation and amortization 17,606 (164) 17,442
- ----------------------------------------------------------------------------------------
Property, Plant and Equipment - Net 12,075 (822) 11,253
- ----------------------------------------------------------------------------------------
Other Assets 725 24 749
- ----------------------------------------------------------------------------------------
Total Assets $ 15,503 $ (1,164) $ 14,339
- ----------------------------------------------------------------------------------------
Liabilities and Shareowner's Equity
Current Liabilities
Debt maturing within one year $ 716 $ (170) $ 546
Accrued taxes 340 (6) 334
Accounts payable and accrued liabilities 2,955 (236) 2,719
- ----------------------------------------------------------------------------------------
Total current liabilities 4,011 (412) 3,599
- ----------------------------------------------------------------------------------------
Long-Term Debt 5,588 (230) 5,358
- ----------------------------------------------------------------------------------------
Deferred Credits and Other Noncurrent Liabilities
Deferred income taxes 952 5 957
Postemployment benefit obligation 917 (36) 881
Unamortized investment tax credits 188 - 188
Other noncurrent liabilities 574 (5) 569
- ----------------------------------------------------------------------------------------
Total deferred credits and other noncurrent liabilities 2,631 (36) 2,595
- ----------------------------------------------------------------------------------------
Shareowner's Equity
Common shares ($1 par value, 300,000,000 authorized:
issued 224,504,982 at December 31, 1997) 225 - 225
Capital in excess of par value 5,096 (282) 4,814
Retained earnings (deficit) (2,048) (204) (2,252)
- ----------------------------------------------------------------------------------------
Total shareowner's equity 3,273 (486) 2,787
- ----------------------------------------------------------------------------------------
Total Liabilities and Shareowner's Equity $ 15,503 $ (1,164) $ 14,339
- ----------------------------------------------------------------------------------------
Notes to Consolidated Financial Statements, continued
Dollars in millions
PACIFIC BELL
- -----------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF CASH FLOWS
Dollars in millions, increase (decrease) in cash and cash equivalents
For the year ended December 31, 1997
- -----------------------------------------------------------------------------------
Originally
Reported Distribution Restated
- ------------------------------------------------------------------------------------
Operating Activities
Net income (loss) $ 350 $ (5) $ 345
Adjustments to reconcile net income (loss) to
net cash provided by operating activities:
Depreciation and amortization 2,021 (98) 1,923
Provision for uncollectible accounts 245 (61) 184
Amortization of investment tax credits (48) 1 (47)
Deferred income taxes 158 (109) 49
Cumulative effect of accounting change, net of tax (342) (3) (345)
Changes in operating assets and liabilities:
Accounts receivable (312) 317 5
Other current assets (13) (15) (28)
Accounts payable and accrued liabilities 749 (98) 651
Other - net (209) (34) (243)
- ------------------------------------------------------------------------------------
Total adjustments 2,249 (100) 2,149
- ------------------------------------------------------------------------------------
Net Cash Provided by (Used in) Operating Activities 2,599 (105) 2,494
- ------------------------------------------------------------------------------------
Investing Activities
Construction and capital expenditures (2,312) 267 (2,045)
Dispositions 65 - 65
Other (14) - (14)
- ------------------------------------------------------------------------------------
Net Cash Provided by (Used in) Investing Activities (2,261) 267 (1,994)
- ------------------------------------------------------------------------------------
Financing Activities
Net change in short-term borrowings with original
maturities of three months or less 406 (528) (122)
Issuance of other short-term borrowings 610 - 610
Repayment of other short-term borrowings (610) - (610)
Issuance of long-term debt 253 (1) 252
Repayment of long-term debt (8) 8 -
Equity received from parent 156 (107) 49
Dividends paid (1,160) 467 (693)
- ------------------------------------------------------------------------------------
Net Cash Used in Financing Activities (353) (161) (514)
- ------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents (15) 1 (14)
- ------------------------------------------------------------------------------------
Cash and cash equivalents beginning of year 58 (1) 57
- ------------------------------------------------------------------------------------
Cash and Cash Equivalents End of Period $ 43 $ - $ 43
- ------------------------------------------------------------------------------------
Notes to Financial Statements - Continued
Dollars in millions
PACIFIC BELL
- -----------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF CASH FLOWS
Dollars in millions, increase (decrease) in cash and cash equivalents
For the year ended December 31, 1996
- -----------------------------------------------------------------------------------
Originally
Reported Distribution Restated
- ------------------------------------------------------------------------------------
Operating Activities
Net income (loss) $ 1,255 $ (306) $ 949
Adjustments to reconcile net income (loss) to
net cash provided by operating activities:
Depreciation and amortization 1,826 (22) 1,804
Provision for uncollectible accounts 167 (37) 130
Amortization of investment tax credits (47) - (47)
Deferred income taxes 250 7 257
Cumulative effect of accounting change, net of tax (85) 85 -
Changes in operating assets and liabilities:
Accounts receivable (719) 259 (460)
Other current assets 294 (273) 21
Accounts payable and accrued liabilities (114) 38 (76)
Other - net (305) (96) (401)
- ------------------------------------------------------------------------------------
Total adjustments 1,267 (39) 1,228
- ------------------------------------------------------------------------------------
Net Cash Provided by (Used in) Operating Activities 2,522 (345) 2,177
- ------------------------------------------------------------------------------------
Investing Activities
Construction and capital expenditures (2,334) 423 (1,911)
Other (29) 7 (22)
- ------------------------------------------------------------------------------------
Net Cash Provided by (Used in) Investing Activities (2,363) 430 (1,933)
- ------------------------------------------------------------------------------------
Financing Activities
Net change in short-term borrowings with original
maturities of three months or less (504) 224 (280)
Issuance of long-term debt 770 (275) 495
Repayment of long-term debt (4) - (4)
Equity received from parent 713 (325) 388
Dividends paid (1,151) 272 (879)
Other 7 26 33
- ------------------------------------------------------------------------------------
Net Cash Used in Financing Activities (169) (78) (247)
- ------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents (10) 7 (3)
- ------------------------------------------------------------------------------------
Cash and cash equivalents beginning of year 68 (8) 60
- ------------------------------------------------------------------------------------
Cash and Cash Equivalents End of Period $ 58 $ (1) $ 57
- ------------------------------------------------------------------------------------
Notes to Consolidated Financial Statements, continued
Dollars in millions
11. Quarterly Financial Information (Unaudited)
- ------------------------------------------------------------------------------
Calendar Total Operating Operating Net
Quarter Revenue Income (Loss) Income (Loss)
- ------------------------------------------------------------------------------
1998 1997 1998 1997 1998 1997
- ------------------------------------------------------------------------------
First 1 $ 2,272 $ 2,139 $ 521 $ 564 $ 252 $ 626
Second 2 2,323 2,093 636 (789) 321 (605)
Third 2 2,386 2,221 631 485 320 231
Fourth 2 2,425 2,273 511 223 184 93
===============================================================================
Annual 1,2 $ 9,406 $ 8,726 $ 2,299 $ 483 $ 1,077 $ 345
===============================================================================
1 1997 Net Income amounts reflect a cumulative effect of accounting changes of
$345 for merger conforming adjustments, primarily related to pensions and
postretirement benefits (see Note 2).
2 1997 includes after-tax charges of $884 of second quarter charges related to
post-merger initiatives (see Note 2), $2 and $137 of third and fourth
quarter merger integration costs and $18 fourth quarter gain on sale of
PacBell's interest in Bell Communications Research, Inc.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE
Effective April 1, 1997, Coopers & Lybrand L.L.P (a predecessor of
PricewaterhouseCoopers LLP) 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.........................20-21
Financial Statements Covered by Report of Independent Auditors:
Statements of Income.................................. 22
Balance Sheets........................................ 23
Statements of Cash Flows.............................. 24
Statements of Shareowner's Equity..................... 25
Notes to Consolidated Financial Statements............ 26
(2) Financial Statement Schedules:
II - Valuation and Qualifying Accounts.................44-45
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 PricewaterhouseCoopers LLP.
24 Powers of Attorney.
27 Financial Data Schedule.
(b) Reports on Form 8-K:
On October 28, 1998, 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, 1998 and 1997.
On October 30, 1998, Pacific Bell (PacBell) filed a Current Report on Form
8-K, reporting on Item 5. Other Events. The Report discussed the
commencement of a debenture buyback.
PACIFIC BELL SCHEDULE II - SHEET 1
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 -Note (a) -Note (b) Period
- ---------------------------------------------------------------------------------------------------------------------
Year 1998.............................. $ 152 150 155 296 $ 161
Year 1997.............................. $ 127 184 217 376 $ 152
Year 1996.............................. $ 131 130 160 294 $ 127
<FN>
(a) Amounts previously written off which were credited directly to this account
when recovered.
(b) Amounts written off as uncollectible.
</FN>
PACIFIC BELL SCHEDULE II - SHEET 2
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)
Balance at Charged Charged Balance
Beginning of to Costs and to Other Deductions at End of
Description Period Expenses Accouts -Note (a) Period
- ---------------------------------------------------------------------------------------------------------------------
Year 1998.............................. $ - - - - $ -
Year 1997.............................. $ 93 - - 93 $ -
Year 1996.............................. $ 219 - - 126 $ 93
<FN>
(a) The 1996 amount reflect $(64) of costs, for enhanced retirement benefits
paid from pension fund assets which do not require current outlays of
PacBell's funds. This 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 12th day of March
1999.
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)
James D. Ellis*
Charles E. Foster* March 12, 1999
Karen Jennings*
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 PricewaterhouseCoopers LLP.
24 Powers of Attorney.
27 Financial Data Schedule.