FORM 10-Q United States SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 (Mark One) |X| Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended June 30, 1999 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 THE REGISTRANT, AN INDIRECTLY HELD WHOLLY-OWNED SUBSIDIARY OF SBC COMMUNICATIONS INC., MEETS THE CONDITIONS SET FORTH IN GENERAL INSTRUCTION H(1)(a) AND (b) OF FORM 10-Q AND IS THEREFORE FILING THIS FORM WITH REDUCED DISCLOSURE FORMAT PURSUANT TO GENERAL INSTRUCTION H(2). 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 PART I - FINANCIAL INFORMATION Item 1. Financial Statements PACIFIC BELL - ---------------------------------------------------------------------------------------- CONSOLIDATED STATEMENTS OF INCOME Dollars in millions (Unaudited) Three months ended Six months ended June 30, June 30, --------------------------------------- 1999 1998 1999 1998 - ---------------------------------------------------------------------------------------- Operating Revenues Local service $ 1,242 $ 1,220 $ 2,461 $ 2,386 Network access: Interstate 525 484 1,038 963 Intrastate 189 189 375 369 Long distance service 275 306 544 612 Other 196 124 372 265 - ---------------------------------------------------------------------------------------- Total operating revenues 2,427 2,323 4,790 4,595 - ---------------------------------------------------------------------------------------- Operating Expenses Operations and support 1,318 1,224 2,625 2,524 Depreciation and amortization 475 463 943 914 - ---------------------------------------------------------------------------------------- Total operating expenses 1,793 1,687 3,568 3,438 - ---------------------------------------------------------------------------------------- Operating Income 634 636 1,222 1,157 - ---------------------------------------------------------------------------------------- Other Income (Expense) Interest expense (100) (110) (203) (216) Other income (expense) - net 3 2 31 - - ---------------------------------------------------------------------------------------- Total other income (expense) (97) (108) (172) (216) - ---------------------------------------------------------------------------------------- Income Before Income Taxes 537 528 1,050 941 - ---------------------------------------------------------------------------------------- Income Taxes 212 207 415 368 - ---------------------------------------------------------------------------------------- Net Income $ 325 $ 321 $ 635 $ 573 - ---------------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements. PACIFIC BELL - ------------------------------------------------------------------------------ CONSOLIDATED BALANCE SHEETS Dollars in millions except per share amounts - ------------------------------------------------------------------------------ June 30, December 31, ------------------------------ 1999 1998 - ------------------------------------------------------------------------------ Assets (Unaudited) Current Assets Cash and cash equivalents $ 12 $ 15 Accounts receivable - net of allowances for uncollectibles of $149 and $161 1,860 2,015 Prepaid expenses 250 90 Deferred income taxes 438 280 Other current assets 32 31 - ------------------------------------------------------------------------------ Total current assets 2,592 2,431 - ------------------------------------------------------------------------------ Property, Plant and Equipment - at cost 30,475 29,871 Less: Accumulated depreciation and amortization 18,803 18,272 - ------------------------------------------------------------------------------ Property, Plant and Equipment - Net 11,672 11,599 - ------------------------------------------------------------------------------ Other Assets 1,269 1,063 - ------------------------------------------------------------------------------ Total Assets $ 15,533 $ 15,093 - ------------------------------------------------------------------------------ Liabilities and Shareowner's Equity Current Liabilities Intercompany loans $ 1,319 $ 1,551 Current portion of long-term obligations 127 103 - ------------------------------------------------------------------------------ Total debt maturing within one year 1,446 1,654 - ------------------------------------------------------------------------------ Accrued taxes 532 122 Accounts payable and accrued liabilities 2,393 2,669 - ------------------------------------------------------------------------------ Total current liabilities 4,371 4,445 - ------------------------------------------------------------------------------ Long-Term Debt 4,490 4,614 - ------------------------------------------------------------------------------ Deferred Credits and Other Noncurrent Liabilities Deferred income taxes 1,290 1,082 Postemployment benefit obligation 883 894 Unamortized investment tax credits 133 149 Other noncurrent liabilities 646 649 - ------------------------------------------------------------------------------ Total deferred credits and other noncurrent liabilities 2,952 2,774 - ------------------------------------------------------------------------------ Shareowner's Equity Common shares ($1 par value) 225 225 Capital in excess of par value 4,035 4,210 Retained earnings (deficit) (540) (1,175) - ------------------------------------------------------------------------------ Total shareowner's equity 3,720 3,260 - ------------------------------------------------------------------------------ Total Liabilities and Shareowner's Equity $ 15,533 $ 15,093 - ------------------------------------------------------------------------------ See Notes to Consolidated Financial Statements. PACIFIC BELL - ----------------------------------------------------------------------------- CONSOLIDATED STATEMENTS OF CASH FLOWS Dollars in millions, increase (decrease) in cash and cash equivalents (Unaudited) - ----------------------------------------------------------------------------- Six months ended June 30, --------------------------- 1999 1998 - ----------------------------------------------------------------------------- Operating Activities Net income $ 635 $ 573 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 943 914 Provision for uncollectible accounts 67 79 Amortization of investment tax credits (16) (20) Deferred income tax expense 98 90 Other - net (185) (476) - ----------------------------------------------------------------------------- Total adjustments 907 587 - ----------------------------------------------------------------------------- Net Cash Provided by Operating Activities 1,542 1,160 - ----------------------------------------------------------------------------- Investing Activities Construction and capital expenditures (1,038) (957) - ----------------------------------------------------------------------------- Net Cash Used in Investing Activities (1,038) (957) - ----------------------------------------------------------------------------- Financing Activities Net change in short-term borrowings with original maturities of three months or less (231) 17 Issuance of long-term debt - 198 Repayment of long-term debt (101) (178) Net equity from parent 8 164 Dividends paid (183) (388) - ----------------------------------------------------------------------------- Net Cash Used in Financing Activities (507) (187) - ----------------------------------------------------------------------------- Net increase (decrease) in cash and cash equivalents (3) 16 - ----------------------------------------------------------------------------- Cash and cash equivalents beginning of year 15 43 - ----------------------------------------------------------------------------- Cash and Cash Equivalents End of Period $ 12 $ 59 - ----------------------------------------------------------------------------- <FN> Cash paid during the six months ended June 30 for: Interest $ 204 $ 213 Income taxes, net of refunds $ ( 81) $ 94 See Notes to Consolidated Financial Statements. </FN> PACIFIC BELL - ----------------------------------------------------------------------------------- STATEMENT OF SHAREOWNER'S EQUITY Dollars in millions (Unaudited) - ----------------------------------------------------------------------------------- Capital in Retained Common Excess of Earnings Shares Par Value (Deficit) - ----------------------------------------------------------------------------------- Balance, December 31, 1998 $ 225 $ 4,210 $ (1,175) Net income - - 635 Dividends to shareowner - (183) - Net equity from parent - 8 - - ----------------------------------------------------------------------------------- Balance, June 30, 1999 $ 225 $ 4,035 $ (540) - ----------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements. * * * * SELECTED FINANCIAL AND OPERATING DATA At June 30, or for the six months then ended: 1999 1998 ----------- ---------- Debt ratio................................. 61.48% 65.44% Network access lines in service (000)...... 18,312 17,730 Access minutes of use (000,000)*........... 37,944 36,026 Resold lines (000)......................... 270 251 Number of employees........................ 48,320 45,800 *1998 amounts have been restated. PACIFIC BELL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Dollars in millions 1. BASIS OF PRESENTATION The consolidated financial statements have been prepared by Pacific Bell (PacBell, which also includes its subsidiary Pacific Bell Information Services) pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) and, in the opinion of management, include all adjustments (consisting only of normal recurring accruals) necessary to present fairly the results for the interim periods shown. PacBell is a wholly-owned subsidiary of Pacific Telesis Group (PAC), a wholly-owned subsidiary of SBC Communications Inc. (SBC). Certain information and footnote disclosures, normally included in financial statements prepared in accordance with generally accepted accounting principles, have been condensed or omitted pursuant to SEC rules and regulations. Certain reclassifications have been made to the 1998 consolidated financial statements to conform with the 1999 presentation. The results for the interim periods are not necessarily indicative of results for the full year. The consolidated financial statements contained herein should be read in conjunction with the consolidated financial statements and notes thereto included in PacBell's 1998 Annual Report on Form 10-K filed with the SEC. Comprehensive income for PacBell is the same as net income for all periods presented. As PacBell operates in only one of SBC's segments, wireline telecommunications services, separate segment reporting is not applicable to PacBell. 2. CONSOLIDATION The consolidated financial statements include the accounts of PacBell. All significant intercompany transactions within PacBell are eliminated in the consolidation process. 3. COMPLETION OF MERGERS 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 has been accounted for 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 by SBC as a pooling of interests and a tax-free reorganization. Post-merger initiatives During the second quarter of 1997, SBC announced PacBell had incurred after-tax charges of $883 related to several strategic decisions resulting from the merger integration process that began with the April 1, 1997 closing of its merger with PAC, which included $107 ($65 after tax) of charges related to several regulatory rulings during the second quarter of 1997 and $276 ($173 after tax) for merger approval costs. The decisions resulted from an extensive review of operations throughout the merged company and include significant integration of operations and consolidation of some administrative and support functions. One-time charges related to the strategic decisions reached by the review teams totaled $1 billion ($645 after tax) in the second quarter of 1997. During 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 integration processes. This review resulted in no significant additional financial effect PACIFIC BELL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued Dollars in millions on PacBell. At June 30, 1999 and December 31, 1998, remaining accruals for anticipated cash expenditures related to these decisions were approximately $34 and $61. 4. SOFTWARE COSTS The American Institute of Certified Public Accountants issued a Statement of Position (SOP) that requires capitalization of certain computer software expenditures beginning in 1999. The SOP, which has been adopted prospectively as of January 1, 1999, requires the capitalization of certain costs incurred in connection with developing or obtaining internal use software. Prior to the adoption of the SOP, the costs of computer software purchased or developed for internal use were expensed as incurred. However, initial operating system software costs were, and continue to be, capitalized. With comparable levels of software expenditures, the SOP would tend to increase net income in comparison with PacBell's former 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. The effect of adopting the SOP was to increase net income by approximately $17 for the second quarter and $24 for the first six months of 1999. PACIFIC BELL Item 2. Management's Discussion and Analysis Dollars in millions RESULTS OF OPERATIONS Overview Financial results for Pacific Bell (PacBell, which includes its subsidiary) for the first six months of 1999 and 1998 are summarized as follows: - --------------------------------------------------------------------------- Six-Month Period ----------------------------- Percent 1999 1998 Change - --------------------------------------------------------------------------- Operating revenues $ 4,790 $ 4,595 4.2% Operating expenses $ 3,568 $ 3,438 3.8% Net income $ 635 $ 573 10.8% =========================================================================== PacBell reported net income of $635 for the first six months of 1999 and $573 for the first six months of 1998. The primary factor contributing to this increase was growth in demand for services and products and a slowing of growth in operating expenses due to merger related initiatives and benefits. Operating Revenues PacBell's operating revenues increased $195, or 4.2%, in the first six months of 1999. Components of operating revenues for the first six months of 1999 and 1998 are as follows: - ---------------------------------------------------------------------------- Six-Month Period ------------------------------ Percent 1999 1998 Change - ---------------------------------------------------------------------------- Local service $ 2,461 $ 2,386 3.1% Network access: Interstate 1,038 963 7.8 Intrastate 375 369 1.6 Long distance service 544 612 (11.1) Other 372 265 40.4 - ---------------------------------------------------------------------------- Total $ 4,790 $ 4,595 4.2% ============================================================================ Local service revenues increased for the first six months of 1999 by $75, or 3.1%, due primarily to increases in demand totaling approximately $139, including increases in access lines, data-related and vertical services revenues. The number of access lines increased by approximately 3.3% since June 30, 1998, with approximately 45% of access line growth due to the sales of additional access lines to existing residential customers. Vertical services revenues, which include custom calling services such as Caller ID, Call Waiting, voice mail and other enhanced services, increased by approximately 20% and totaled approximately $410 for the first six months of 1999. This increase in demand was partially offset by a decline in the public telephone business totaling nearly $40. Additionally, local service revenues increased as a result of the California High Cost Fund (CHCFB) which also had the effect of decreasing two other types of operating revenues. In the first six months of 1999, the CHCFB increased local service revenues by approximately $51 and decreased long distance revenues by approximately $43 and intrastate network access revenues by approximately $25. The net effect on total operating revenues for the CHCFB was a decrease of $17. The California Public Utilities Commission (CPUC) has stated that the CHCFB is PACIFIC BELL Item 2. Management's Discussion and Analysis Dollars in millions RESULTS OF OPERATIONS - Continued 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 approximately $59 resulting from rate reductions under CPUC price cap orders and approximately $23 related to the deregulation of 911 revenues that were shifted to other revenues. Network access Interstate network access revenues increased $75, or 7.8%, in the first six months of 1999 due primarily to increased demand for access services by interexchange carriers, special access, and growth in end-user charges attributable to an increasing access line base, which collectively resulted in an increase of approximately $99. In addition, customer number portability cost recovery, net of a Federal Communications Commission (FCC) retroactive rate decrease implemented in the second quarter of 1999, effective February 1999, contributed approximately $28 to the increase. Partially offsetting these increases were the effects of PacBell's rate reduction of approximately $55 related to the FCC's productivity factor adjustment. Intrastate network access revenues increased $6, or 1.6%, in the first six months of 1999 attributable to increased demand of $48, offset in part by the effect of the CHCFB described above in local service of approximately $25, by CPUC rate reductions of approximately $8 and by a reduction in contract settlements in comparison to the prior year of approximately $4. Long distance service decreased $68, or 11.1%, in the first six months of 1999 due to the effect of the CHCFB noted in local service of approximately $43 and by CPUC rate reductions of approximately $15. Other operating revenues increased $107, or 40.4%, in the first six months of 1999 due primarily to increased sales from nonregulated products and services totaling approximately $33, increased equipment sales, primarily consumer equipment, of approximately $51 and the deregulation of 911 revenues shifted to other revenues noted in local service above of approximately $23. Operating Expenses PacBell's operating expenses increased $130, or 3.8%, in the first six months of 1999. Components of total operating expenses for the first six months of 1999 and 1998 are as follows: - --------------------------------------------------------------------------- Six-Month Period ----------------------------- Percent 1999 1998 Change - --------------------------------------------------------------------------- Operations and support $ 2,625 $ 2,524 4.0% Depreciation and amortization 943 914 3.2 - ------------------------------------------------------------------ Total operating expenses $ 3,568 $ 3,438 3.8% =========================================================================== Operations and support increased $101, or 4.0%, in the first six months of 1999. The increase includes costs of approximately $120 related to progression in the merger implementation process including charges from centralized support functions throughout SBC Communications Inc. (SBC) and other merger initiatives and increased expenditures related to implementation of PACIFIC BELL Item 2. Management's Discussion and Analysis Dollars in millions RESULTS OF OPERATIONS - Continued PacBell's Asymmetrical Digital Subscriber Line (ADSL) product of approximately $61. Operations and support also increased due to increased costs for materials, wages and salaries, and other costs of approximately $117. In addition, costs associated with reciprocal compensation for the termination of Internet traffic increased approximately $22 and costs associated with intraLATA presubscription, (where a customer is able to subscribe to an intraLATA toll carrier just as they do for long distance service), were approximately $8. These increases were partially offset by reductions in contract labor, benefits, contract fees and employee training and development of approximately $52 and a reduction in other non-labor costs of approximately $68 due in part to merger initiative benefits and higher first quarter 1998 storm related costs. In addition, expenditures for interconnection, customer number portability and local competition initiatives decreased approximately $66. Also offsetting the increase in operations and support expense was the change in accounting for software costs (see Note 4 of Notes to Consolidated Financial Statements), which resulted in approximately $41 of such costs being capitalized rather than expensed at June 30, 1999. Depreciation and amortization expense increased $29, or 3.2%, in the first six months of 1999. The increase was due primarily to overall higher plant levels of approximately $32. Interest expense decreased $13, or 6.0%, in the first six months of 1999 due to lower average debt levels. Other income (expense) - net was income of $31 in the first six months of 1999 due primarily to a gain recognized from the sale of PacBell's interest in Advanced Communications Network (ACN) of $24. In 1997, ACN was written down as an impairment in conjunction with the merger with Pacific Telesis Group. Income Taxes increased $47, or 12.8%, in the first six months of 1999 primarily due to higher income before income taxes. COMPETITIVE AND REGULATORY ENVIRONMENT Reciprocal Compensation is billed to PacBell by Competitive Local Exchange Carriers (CLECs) for the termination of certain local exchange traffic to CLEC customers. SBC believes that under the Telecommunications Act of 1996 (Telecom Act) the state commissions have authority to order reciprocal compensation only for intrastate or local traffic, while the FCC has authority over interstate and interexchange traffic. SBC believes most Internet traffic is interexchange and interstate. In February 1999, the FCC declared that Internet traffic is not intrastate or local traffic but instead is primarily interstate, subject to interstate jurisdiction. However, the FCC added that state commissions, interpreting existing contracts and consistent with federal law, might nevertheless order payment of reciprocal compensation for Internet traffic in certain circumstances. In March 1999, MCI WorldCom filed an appeal of the FCC ruling and certain local exchange carriers also appealed; the outcome of these appeals is pending. PACIFIC BELL Item 2. Management's Discussion and Analysis Dollars in millions COMPETITIVE AND REGULATORY ENVIRONMENT - Continued In June 1999, the CPUC in arbitration between PacBell and a CLEC customer voted to treat Internet traffic as local pending a further CPUC proceeding to examine the issue. The CPUC also approved a reduction in the reciprocal compensation rate between PacBell and the CLEC customer beginning June 29, 1999. In July 1999, the CPUC issued a draft decision in another arbitration between PacBell and a CLEC customer upholding reciprocal compensation fees. The final decision is expected to result in a reduction of the reciprocal compensation rate paid by PacBell to the CLEC customer beginning in the fourth quarter of 1999. In July 1999, the CPUC also affirmed an order that had concluded that Internet traffic is local. PacBell is currently evaluating the impact of this order. PacBell has been recording expense for amounts sought by certain CLECs for the termination of Internet traffic to Internet Service Providers. Customer Local Number Portability Long-term customer local number portability (LNP) allows customers to change local exchange carriers while maintaining their existing telephone numbers. In December 1998, the FCC issued an order on recovery of costs incurred for LNP by local exchange carriers. This order provides for the levying of federally tariffed LNP monthly end-user charges for a five-year period, beginning in February 1999. PacBell began recovering LNP costs at the rate of 50 cents per access line per month. In July 1999, the FCC issued an order on PacBell's rate, revising the rate to 34 cents, with a refund obligation for the period of February through July 1999. PacBell recorded $13 in the second quarter of 1999 related to the rate reduction. Federal Access Rates In May 1999, the United States Court of Appeals for the District of Columbia Circuit (Court of Appeals) ruled that the FCC failed to adequately explain certain changes to part of the formula used to calculate the access rates local carriers, such as PacBell, charge long distance carriers. Specifically, the Court of Appeals disagreed with the FCC's rationale for making certain changes to the "X factor" adjustment, the purpose of which is to ensure that access rates decrease as local phone company productivity increases, and ordered the FCC to reevaluate the formula. The Court of Appeals did not state whether the FCC should have made specific adjustments that would have resulted in either higher or lower access rates. In a subsequent order, the Court of Appeals stayed the mandate of this decision until April 1, 2000. The effect of the Court of Appeal's decision on PacBell's results of operations and financial position cannot be determined at this time. Shared Transport In June 1999, the United States Supreme Court (Supreme Court) set aside an August 1998 United States Court of Appeals for the Eighth Circuit (8th Circuit) ruling that major carriers, such as PacBell, could be forced to lease, at a discount, shared transport service for carrying phone calls among telephone company central switching offices. The 8th Circuit had held that such shared transport was subject to mandatory leasing under the Telecom Act. The Supreme Court previously ruled that the FCC ignored some limits in the Telecom Act when it drew up rules for mandatory leasing and in light of that prior ruling, ordered the 8th Circuit to reconsider the shared transport ruling. The effect of this ruling on PacBell cannot be determined at this time. PACIFIC BELL Item 2. Management's Discussion and Analysis Dollars in millions COMPETITIVE AND REGULATORY ENVIRONMENT - Continued California Rate Ruling In June 1999, the CPUC issued a ruling recategorizing certain of PacBell's services, including the maintenance of inside wiring, collect, calling card and person to person calls and the provisioning of directory assistance to interexchange carriers, as competitive products. In its ruling, the CPUC approved an increase in the ceiling price for both inside wire repair services and interexchange directory assistance. Although the effect of this ruling on PacBell's results of operations and financial position cannot be determined at this time, it is expected to be favorable. OTHER BUSINESS MATTERS New Accounting Standards In June 1998, the Financial Accounting Standards Board (FASB) 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 changes in the fair value of the derivatives to be recorded in net income or comprehensive income. In June 1999, the FASB issued Statement No. 137, "Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of the FASB Statement No. 133" (FAS 137), that among other items, defers the date that FAS 133 must be adopted to years beginning after June 15, 2000. Earlier adoption is permitted. SBC is currently evaluating the impact of the change in accounting required by FAS 133 and FAS 137, but is not able to quantify the effect at this time. See Note 4 of Notes to Consolidated Financial Statements for a discussion of the new accounting standard on software costs. SBC's Year 2000 Project SBC operates 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. Company-wide 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 century. 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. The inventory and assessment phase was estimated to require 20% of the overall effort and included the identification and prioritization of items that could be impacted by the Year 2000 and the determination of the work effort required to ensure compliance. The inventory and assessment phase was completed in 1998. 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 124,000 personal computers and coordinating with 1,500 suppliers. SBC must obtain adequate assurance that the 15,000 products they provide will be Year 2000 compliant or determine and address any appropriate contingency plans or backup systems. Making the hardware and software fixes was the second phase of the process and was estimated to require 25% of the overall effort. This activity involved modifying program code, upgrading computer PACIFIC BELL Item 2. Management's Discussion and Analysis Dollars in millions OTHER BUSINESS MATTERS - Continued software and upgrading or replacing hardware. The hardware and software fixes were completed as of June 30, 1999. 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 and is substantially complete. Contingency plans have been written and will be finalized by August 31, 1999. 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. Ninety-eight percent of the deployment phase was completed as of June 30, 1999. SBC has budgeted $265 on the entire project, with approximately $197 spent through June 30, 1999. The activities involved in SBC's Year 2000 project 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. PACIFIC BELL Item 3. Quantitative and Qualitative Disclosures About Market Risk Dollars in millions There has been no material change in PacBell's market risks since December 31, 1998. 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 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. PACIFIC BELL PART II - OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit 12 Computation of Ratios of Earnings to Fixed Charges. Exhibit 27 Financial Data Schedule. (b) Reports on Form 8-K There were no reports on Form 8-K filed during the quarter ended June 30, 1999. SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PACIFIC BELL August 6, 1999 /s/ Robert B. Pickering Robert B. Pickering Vice President and Chief Financial Officer