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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
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[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
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For the fiscal year ended December 31, 1997
or
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[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
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For the transition period from to
Commission File Number 1-6417
GTE CALIFORNIA INCORPORATED
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
CALIFORNIA 95-0510200
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)
600 Hidden Ridge, HQE04B12 - Irving, Texas 75038
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
Registrant's telephone number, including area code 972-718-5600
Securities registered pursuant to Section 12(b) of the Act:
NONE
Securities registered pursuant to Section 12(g) of the Act:
41/2% SERIES CUMULATIVE PREFERRED STOCK $20 PAR VALUE
41/2% SERIES CUMULATIVE PREFERRED STOCK $20 PAR VALUE
5 % SERIES CUMULATIVE PREFERRED STOCK $20 PAR VALUE
(TITLE OF CLASS)
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. X
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THE COMPANY HAD 70,000,000 SHARES OF $20 PAR VALUE COMMON STOCK OUTSTANDING AT
FEBRUARY 28, 1998. THE COMPANY'S COMMON STOCK IS 100% OWNED BY GTE CORPORATION.
THE AGGREGATE MARKET VALUE OF THE REGISTRANT'S VOTING PREFERRED STOCK HELD BY
NON-AFFILIATES AT FEBRUARY 28, 1998, AMOUNTED TO $4,064,524.
DOCUMENT INCORPORATED BY REFERENCE: PROXY STATEMENT FOR ANNUAL MEETING OF
SHAREHOLDERS TO BE HELD ON APRIL 8, 1998 (INCORPORATED IN PART III).
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TABLE OF CONTENTS
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Item Page
Part I
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1. Business 1
2. Properties 5
3. Legal Proceedings 5
4. Submission of Matters to a Vote of Security Holders 5
Part II
5. Market for the Registrant's Common Equity and Related 6
Shareholder Matters
6. Selected Financial Data 7
7. Management's Discussion and Analysis of Financial 8
Condition and Results of Operations
8. Financial Statements and Supplementary Data 17
9. Changes in and Disagreements with Accountants on 44
Accounting and Financial Disclosure
Part III
10. Directors and Executive Officers of the Registrant 45
11. Executive Compensation 47
12. Security Ownership of Certain Beneficial Owners and Management 47
13. Certain Relationships and Related Transactions 47
Part IV
14. Exhibits, Financial Statement Schedules and Reports on Form 8-K 48
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PART I
Item 1. Business
GTE California Incorporated (the Company) was incorporated in California in
1929. The Company is a wholly-owned subsidiary of GTE Corporation (GTE) and
provides communications services in the states of California, Nevada and
Arizona.
The Company has a wholly-owned subsidiary, Contel Advance Systems, Inc., which
markets telecommunications customer premise equipment and other products and
services.
The Company's principal line of business is providing communications services
ranging from local telephone service for the home and office to highly complex
voice and data services for industry. The Company provides local telephone
service within its franchise area and intraLATA (Local Access Transport Area)
toll service between the Company's facilities and the facilities of other
telephone companies within the Company's LATAs. InterLATA service to other
points in and out of the states in which the Company operates is provided
through connection with interexchange (long distance) common carriers. These
common carriers are charged fees (access charges) for interconnection to the
Company's local facilities. Business and residential customers also pay access
charges to connect to the local network to obtain long distance service. The
Company earns other revenues by providing such services as billing and
collection and operator services to interexchange carriers. At December 31,
1997, the Company served 5,059,427 access lines in its service territories.
At December 31, 1997, the Company had 12,314 employees.
The Company has written agreements with the Communications Workers of America
(CWA) and the International Brotherhood of Electrical Workers (IBEW) covering
substantially all non-management employees. In 1996 contracts were reached with
the CWA and IBEW. No contracts will expire during 1998.
REGULATORY AND COMPETITIVE TRENDS
The Company is subject to regulation by the regulatory bodies of the states of
California, Nevada and Arizona for its intrastate business operations and by the
Federal Communications Commission (FCC) for its interstate operations.
Advances in technology, together with a number of regulatory, legislative and
judicial actions, continue to accelerate and expand the level of competition and
opportunities available to the Company. The Company continues to face additional
competition from numerous sources, such as competitive local-exchange carriers,
wireless carriers, cable television service providers and long distance
companies.
Much of the regulatory and legislative activity that occurred in the United
States in 1997 was a direct result of the Telecommunications Act of 1996 (the
Telecommunications Act) adopted by Congress. The Telecommunications Act is
intended to promote competition in all sectors of the telecommunications
marketplace while preserving and advancing universal telephone service.
The Company supports greater competition in telecommunications, provided that
consumers benefit from an opportunity for all service providers to participate
in a competitive marketplace under comparable conditions. The Company believes
that a number of recent FCC and state regulatory agency decisions did not
establish comparable conditions; consequently, the Company and its parent, GTE,
have exercised their right to challenge actions they believe act to increase
competition at the expense of the shareholders of incumbent firms.
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In July 1997, the U.S. Court of Appeals for the Eighth Circuit (Eighth Circuit)
released its decision on the challenge filed in 1996 by GTE and numerous other
parties to rules developed by the FCC to implement the interconnection
provisions of the Telecommunications Act. The Telecommunications Act required
local-exchange carriers (LECs) to make their retail services and the underlying
network elements available to competitors. The FCC required that prices for both
resold services and network elements be set using a methodology created by the
FCC. The court challenge asserted that the FCC's rules were inconsistent with
the Telecommunications Act. The July 1997 court decision found that the FCC
overstepped its authority in many instances and upheld GTE's position that state
regulatory agencies bear the primary responsibility for determining the prices
which competing firms must pay when interconnecting their networks. In January
1998, the U.S. Supreme Court announced that it would review this decision. Oral
argument in the Supreme Court is expected to take place in October 1998, with a
final decision likely to be issued no later than June 1999.
The favorable ruling by the Eighth Circuit did not impede the progress of
competition. The Company has finalized interconnection agreements with various
competitive LECs in California, Nevada and Arizona. A number of these
interconnection agreements, adopted as a result of the arbitration process
established by the Telecommunications Act, incorporate prices or terms and
conditions based upon the FCC's rules that were overturned by the Eighth
Circuit. Thus, the Company has exercised its right to challenge such agreements
in California.
In May 1997, the FCC released two new major decisions related to implementation
of the Telecommunications Act's provisions - the universal service and access
charge reform orders. The universal service order established the support
mechanisms to ensure continued availability of affordable local telephone
service and created new programs to provide discounted telecommunications
services to schools, libraries and rural health care providers. GTE and numerous
other parties have challenged the FCC's decision before the U.S. Court of
Appeals for the Fifth Circuit on the grounds that the FCC did not follow the
requirements of the Telecommunications Act to develop a sufficient, explicit and
competitively neutral universal service program. A decision is expected in 1998.
The access charge reform order, also released in May 1997, revamped the rate
structure for use of the local network by interexchange carriers to originate
and complete long distance calls. GTE and numerous other parties also challenged
this decision before the Eighth Circuit based on the belief that the FCC not
only failed to remove all of the universal service subsidies hidden within
interstate access charges, but in fact created additional subsidy charges paid
only by business and multi-line residential customers. Oral argument has been
held and a decision is expected in 1998.
Also in May 1997, the FCC released a decision completing a periodic review of
its price cap regulatory oversight of interstate access charges. GTE and
numerous other LECs have challenged this decision before the Eighth Circuit
based on the belief that the FCC established a fundamentally unfair annual price
reduction formula and required retroactive price reductions. Oral argument has
been held and a decision on this challenge is also expected in 1998.
Federal and state regulatory activity continued to change the traditional
cost-based, rate-of-return regulatory framework for intrastate and interstate
telephone service. Regulatory authorities in California have adopted various
forms of alternative regulation, which provide economic incentives for telephone
service providers to improve productivity and provide the foundation for
implementing pricing flexibility necessary to address competitive entry into the
Company's markets. The regulatory commissions in the states of Nevada and
Arizona continue to remain under the traditional cost-based, rate-of-return
regulatory framework for intrastate telephone service.
For the provision of interstate access services, the Company operates under the
terms of the FCC's price cap incentive plan. The price cap mechanism serves to
limit the rates a carrier may charge, rather than just regulating the rate of
return which may be achieved. Under this approach, the maximum prices that the
LEC may charge are increased or decreased each year by a price cap index based
upon inflation less a predetermined productivity target. LECs have limited
pricing flexibility provided they do not exceed the allowed price cap.
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In the May 1997 order on its price cap triennial review, the FCC revised the
price cap plan for LECs by adopting a uniform productivity factor of 6.0% with
an additive consumer productivity dividend of 0.5%. The FCC also eliminated the
sharing requirements of the price cap rules.
The Company filed interstate access revisions during 1997 that became effective
June 3, 1997 and July 1, 1997. Overall, these filings resulted in a net annual
price reduction of $36.9 million. On December 1, 1997, the FCC issued an order
to file revised access rates effective January 1, 1998, which resulted in
additional interstate access charge reductions of approximately $10 million. In
1997, the FCC also ordered significant changes that altered the structure of
access charges collected by the Company, effective January 1, 1998. Generally,
the FCC reduced and restructured the per minute charges paid by long distance
carriers and implemented new per line charges. The FCC also created an access
charge structure that resulted in different access charges for residential
primary and secondary lines and for single line and multi-line business lines.
In aggregate, the reductions in usage sensitive access charges paid by long
distance carriers were partially offset by new per line charges and the charges
paid by end-users.
During 1997, other regulatory and legislative developments occurred at the state
level to further open the telecommunications marketplace to competition. For
example, the California Public Utilities Commission (CPUC) continued its efforts
to promote competition by addressing unbundling of network elements and updating
its March 1996 resale decision to expand the scope of retail services to be
discounted and offered for resale. The CPUC also opened an investigation to
examine the level of access to the Operational Support System (OSS) of incumbent
LECs as well as the quality and speed of access to the OSS.
During 1997, the CPUC introduced two new universal service programs. In order to
meet California's universal service goal in a competitive arena, the California
High Cost Fund-B revised the mechanism for maintaining affordable basic local
service rates in high cost areas. The California Teleconnect program offers
discounts to eligible schools, libraries, government-owned hospitals and health
care organizations and tax exempt community-based organizations to encourage the
use of advanced telecommunications services. Subsequent to the FCC order on
universal service, the CPUC adopted the FCC discount matrix for schools and
libraries and modified its California Teleconnect program to be compatible.
California operates under a state price cap mechanism. On December 20, 1996, the
CPUC approved GTE's 1997 price cap filing. The decision authorized GTE to
collect $27.5 million in rates via a surcharge commencing January 1, 1997. The
1998 price cap filing did not result in any changes to revenues; however, rate
adjustments, effective in 1998, were included as a result of rate and surcharge
integration with the former Contel of California serving territories.
Further information regarding the Company's activities with the various
regulatory agencies and revenue arrangements with other telephone companies is
discussed in Note 11 of the Company's consolidated financial statements included
in Item 8.
The Company continues to support greater competition in telecommunications,
provided that, overall, the actions to eliminate existing legal and regulatory
barriers benefit consumers by allowing an opportunity for all service providers
to participate equally in a competitive marketplace under comparable conditions.
The Company intends to continue to respond aggressively to regulatory and legal
developments that allow for increased competition and opportunities in the
marketplace. The Company expects its financial results to benefit from reduced
costs and the introduction of new products and services that will result in
increased usage of its telephone networks. However, it is likely that such
improvements will be offset, in part, by continued strategic pricing reductions
and the effects of increased competition.
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INITIATIVES
In 1997, the Company's parent, GTE, continued to position itself to respond
aggressively to competitive developments and benefit from new opportunities.
In May 1997, GTE announced plans to become a leading national provider of data
communications services that included the acquisition of BBN Corporation (BBN),
a leading supplier of end-to-end Internet solutions. BBN brings valuable skills,
a leading position in the Internet market and an impressive list of Fortune 500
clients. In addition, GTE announced a strategic alliance with Cisco Systems,
Inc. to jointly develop enhanced data and Internet services for customers; and
the purchase of a national, state-of-the-art fiber-optic network from Qwest
Communications. This expansion of data services continued in November 1997 with
the announcement of the acquisition of Genuity Inc. (Genuity), a subsidiary of
Bechtel Enterprises. Genuity is a premier value-added provider of distributed
application hosting solutions.
ENVIRONMENTAL MATTERS
GTE maintains monitoring and compliance programs related to environmental
matters. The Company's annual expenditures for environmental compliance have not
been and are not expected to be material. Costs incurred include outlays
required to keep existing operations in compliance with environmental
regulations and an underground storage tank replacement program.
4
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Item 2. Properties
The Company's property consists principally of land, structures and equipment
required to provide various telecommunications services. All of these
properties, located in the states of California, Nevada and Arizona, are
generally in good operating condition and are adequate to satisfy the needs of
the business. Substantially all of the Company's property is subject to the
liens of its respective mortgages securing funded debt. From January 1, 1993 to
December 31, 1997, the Company made capital expenditures of $2.6 billion for new
plant and facilities required to meet telecommunication service needs and to
modernize plant and facilities. These additions were equal to 26% of gross plant
of $10.1 billion at December 31, 1997.
In the fourth quarter of 1995, the Company discontinued the use of Statement of
Financial Accounting Standards No. 71, "Accounting for the Effects of Certain
Types of Regulation" (FAS 71). In general, FAS 71 required the Company to
depreciate its telephone plant and equipment over lives approved by regulators
which, in many cases, extended beyond the assets' economic lives. FAS 71 also
required the deferral of certain costs based upon approvals received from
regulators to recover such costs in the future. As a result of these
requirements, the recorded net book value of certain assets and liabilities,
primarily telephone plant and equipment, were in many cases higher than that
which would otherwise have been recorded based on their economic lives. See Note
2 to the Company's consolidated financial statements included in Item 8.
Item 3. Legal Proceedings
There are no pending legal proceedings which would have a material impact on the
Company's consolidated financial statements.
Item 4. Submission of Matters to a Vote of Security Holders
None.
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PART II
Item 5. Market for the Registrant's Common Equity and Related Shareholder
Matters
Market information is omitted since the Company's common stock is wholly-owned
by GTE Corporation (GTE).
SHAREHOLDER SERVICES
BankBoston, N.A., Transfer Agent and Registrar for GTE and the Company's common
stock and preferred stock, should be contacted with any questions relating to
shareholder accounts. This includes the following:
o Account information
o Dividends
o Market prices
o Transfer instructions
o Statements and reports
o Change of address
Shareholders may call toll-free at 1-800-225-5160 anytime, seven days a week.
Customer Service Representatives are available Monday through Friday between the
hours of 8 a.m. and 5 p.m. Eastern Time. Outside the United States call
1-718-575-2990.
Or write to:
BankBoston, N.A.
c/o Boston EquiServe, L.P.
P.O. Box 8031
Boston, MA 02206-8031
For overnight delivery services, use the following address:
BankBoston, N.A.
c/o Boston EquiServe, L.P.
Blue Hills Office Park
150 Royall Street
Mail Stop 4502-60
Canton, MA 02021
The BankBoston, N.A. address where shareholders, banks and brokers may deliver
certificates is Securities Transfers and Reporting Services, 55 Broadway in New
York City.
PARENT COMPANY ANNUAL REPORT
To obtain a copy of the 1997 annual report of our parent company or the annual
Form 10-K filed with the Securities and Exchange Commission, call
1-800-225-5160.
INFORMATION VIA THE INTERNET
Internet World Wide Web users can access information on GTE through the
following universal resource:
http://www.gte.com
PRODUCTS AND SERVICES HOTLINE
Shareholders may call 1-800-828-7280 to receive information concerning GTE
products and services.
DIVERSITY AT GTE
The Company and GTE strive to be a workplace of choice in which people of
diverse backgrounds are valued, challenged, acknowledged and rewarded, leading
to higher levels of fulfillment and productivity. A copy of our Diversity at GTE
brochure is available upon request from the GTE Corporate Secretary's Office.
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Item 6. Selected Financial Data (See Note 3 to the Company's consolidated
financial statements included in Item 8)
GTE California Incorporated and Subsidiary
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Years Ended December 31,
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Selected Income Statement Items (a) 1997 1996 1995 1994 1993(b)
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(Thousands of Dollars)
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Revenues and sales $ 3,322,436 $ 3,141,166 $ 3,144,816 $ 3,319,871 $ 3,349,525
Operating costs and expenses 2,186,544 2,198,552 2,454,598 2,374,199 2,973,050
----------- ----------- ----------- ----------- -----------
Operating income 1,135,892 942,614 690,218 945,672 376,475
Interest - net 101,910 98,567 111,823 105,801 122,617
Gain on disposition of assets -- (1,117) -- -- --
Other - net 670 -- -- -- (2,762)
Income taxes 390,548 329,326 235,534 339,585 107,932
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Income before extraordinary charges 642,764 515,838 342,861 500,286 148,688
Extraordinary charges -- -- (711,048)(c) -- (20,214)
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Net income (loss) $ 642,764 $ 515,838 $ (368,187) $ 500,286 $ 128,474
=========== =========== =========== =========== ===========
Dividends declared on common stock $ 659,566 $ 504,154 $ 325,863 $ 422,791 $ 461,471
Dividends declared on preferred stock 3,194 4,784 4,784 4,850 4,891
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As of December 31,
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Selected Balance Sheet Items 1997 1996 1995 1994 1993
- ---------------------------- -------------------------------------------------------------------------
(Thousands of Dollars)
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Property, plant and equipment, net (c) $ 3,799,321 $ 3,754,635 $ 3,994,596 $ 5,361,502 $ 5,495,604
Total assets 5,320,330 5,083,385 5,345,522 6,718,720 6,628,075
Long-term debt and preferred stock,
subject to mandatory redemption 1,466,679 1,280,151 1,375,771 1,370,157 957,908
Shareholders' equity 1,795,809 1,848,628 1,841,728 2,540,562 2,467,917
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(a) Per share data is omitted since the Company's common stock is 100% owned by
GTE Corporation.
(b) Operating income in 1993 included a $494.2 million pre-tax charge for
restructuring costs which reduced net income by $304.4 million.
(c) See Note 2 to the consolidated financial statements included in Item 8.
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Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations
(Dollars in Millions)
BUSINESS OPERATIONS
GTE California Incorporated (the Company) provides a wide variety of
communications services ranging from local telephone service for the home and
office to highly complex voice and data services for various industries. At
December 31, 1997, the Company served 5,059,427 access lines in the states of
California, Nevada and Arizona.
The Company is a wholly-owned subsidiary of GTE Corporation (GTE).
On September 10, 1992, the Company entered into an Agreement of Merger with
Contel of California, Inc., a California corporation (Contel California). The
agreement provided that Contel California would merge with and into the Company,
with the Company to be the surviving corporation in the merger (the Merger). On
October 5, 1995, the Governor of the State of California signed a law which
clarified the authority of the California Public Utilities Commission (CPUC) to
allocate the merger savings between ratepayers and shareholders with not less
than 50% going to the ratepayers of the merged company. On April 10, 1996, in
accordance with the enacted legislation, the CPUC granted final approval of the
Merger. As part of the order, the CPUC ordered $69.7 of merger savings to be
returned to the ratepayers of both companies, which represented half of the
total savings expected to be realized by the Merger over a five-year period. The
Company received approval to return these savings to local, toll and access
customers beginning in mid-1996. On December 16, 1997, the CPUC approved a
stipulation agreement which included the incorporation of the remaining merger
savings into the Company's prospective rates.
The Merger was completed on December 31, 1996 and was accounted for in a manner
consistent with a transfer of entities under common control which is similar to
a "pooling of interests." Accordingly, the financial statements include the
combined historical results of operations and financial position of the Company
and Contel California as though the Merger had occurred at the beginning of each
period presented and reflect the elimination of all significant intercompany
transactions.
RESULTS OF OPERATIONS
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Years Ended December 31,
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1997 1996 1995
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Net income (loss) $ 642.8 $ 515.8 $ (368.2)
</TABLE>
Net income increased 25% or $127 during 1997, largely due to revenue growth from
local and network access services and the impact of the stipulation agreement
approved by the CPUC in December 1997, mentioned previously. The net loss for
1995 includes one-time extraordinary charges (net of tax) of $711 related to the
discontinuance of Statement of Financial Accounting Standards No. 71,
"Accounting for the Effects of Certain Types of Regulation" (FAS 71) and the
early retirement of debt recorded in the fourth quarter of 1995. Excluding these
special items, net income increased 50% or $172.9 in 1996 due to the impact of
the revenue reduction experienced in 1995 as a result of the CPUC order
discussed below, and significant improvements in the level of 1996 operating
costs and expenses.
On January 1, 1995, pursuant to an order issued by the CPUC, competition in toll
services (without customer pre-subscription) became effective in California. The
order also provided for rate rebalancing with significant rate reductions for
toll services and access charges while increasing basic local service rates
closer to the actual cost of providing such service. Although this rate
rebalancing was intended by the CPUC to be revenue neutral, the actual increase
in volumes did not fully compensate for the toll and access rate reductions.
Revenue reductions attributed to the implementation of this order were $232.3 in
1995.
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REVENUES AND SALES
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Years Ended December 31,
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1997 1996 1995
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Local services $ 1,477.1 $ 1,333.2 $ 1,375.7
Network access services 924.6 870.5 812.6
Toll services 399.1 490.1 510.6
Other services and sales 521.6 447.4 445.9
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Total revenues and sales $ 3,322.4 $ 3,141.2 $ 3,144.8
</TABLE>
Total revenues and sales increased 6% or $181.2 in 1997 and decreased less than
1% or $3.6 in 1996.
Local Services
Local service revenues are based on fees charged to customers for providing
local-exchange service within designated franchise areas. Local service revenues
increased 11% or $143.9 in 1997 and decreased 3% or $42.5 in 1996. In the fourth
quarter of 1997, the CPUC approved a stipulation agreement in which the
remaining merger expense savings, discussed previously, will be incorporated
into the Company's prospective rates. Accordingly, the Company reversed the
remaining reserve balance, of which $46.1 was recorded during 1996, resulting in
a $91.5 favorable impact on the 1997 revenues compared to 1996. Excluding the
effect of this item, local service revenues in 1997 increased 4% or $52.4.
Access line growth of 5% in 1997 generated additional revenues of $30.8 from
basic local services, $15.9 from CentraNet(R) services and $11.4 from Integrated
Services Digital Network (ISDN) and Digital Channel Services (DCS). Demand for
custom calling features, such as SmartCall(R) and CLASS services, contributed
$25.3 to the increase. In addition, the Company's 1997 California Price Cap
Index (PCI) generated $25.1 of additional revenues, partially offset by $19.4 in
lower revenues resulting from the removal of Extended Area Service transitional
support payments. The 1997 increase was also partially offset by settlement
reserves recorded in 1997 totaling $11.5, reduced support payments received from
the California High Cost Fund, described below, of $11.4 and a net reduction of
$11.3 associated with the CPUC's Implementation Rate Design (IRD) ruling in 1996
(as discussed in Note 11 of the Company's consolidated financial statements
included in Item 8).
The 1996 decrease was due to a combination of several factors. Reserves
established in 1996 for anticipated merger savings refunds and operating tax
settlements reduced revenues by $34 and $20.6, respectively. The Company's 1996
PCI resulted in a $27.3 revenue reduction. Net refunds received from the
California High Cost Fund, a fund established to subsidize rural providers for
the costs of providing universal service, declined in 1996 by $14.8. Other
factors contributing to the decrease include an $11.5 scheduled reduction in
revenues associated with a previous rate order, and an $11.1 decrease in
directory and operator service revenues. These decreases in 1996 were offset by
a $34.6 increase in revenues resulting from the CPUC's IRD ruling, mentioned
above, and a total of $35.5 from a 5% growth in access lines. In addition,
revenues from custom calling features, such as SmartCall(R), increased $8 in
1996.
Network Access Services
Network access service revenues are based on fees charged to interexchange
carriers that use the Company's local-exchange network in providing long
distance services. In addition, residential and business customers pay end-user
access fees to connect to the local network to obtain long distance service.
Cellular service providers and other local-exchange carriers also pay access
charges for cellular and intraLATA (Local Access Transport Area) toll calls
hauled or terminated by the Company. Network access service revenues increased
6% or $54.1 in 1997 and 7% or $57.9 in 1996. Increased demand in 1997 for access
services by interexchange carriers resulted in a 21% increase in minutes of use
and $85.4 in additional revenues. Special access revenues grew $26 due to
greater demand for increased bandwidth services by Internet Service Providers
(ISPs) and other high capacity users. These increases
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were partially offset by a $26.4 revenue reduction from the sharing provisions
and rate changes associated with the Federal Communications Commission's (FCC)
1996 and 1997 price cap filings. In addition, revenues from intrastate sharing
arrangements and end-user access charges declined by $11.6 and $6, respectively.
The 1996 increase is due to a 12% increase in minutes of use, which generated
additional revenues of $45.9. The 1996 increase also reflects a $22 increase in
special access revenues associated with growth in dedicated access lines and
$9.7 of favorable meet point billing settlements. Access line growth contributed
toward a $5.9 increase in end-user access charge revenues. The increase also
reflects a revenue adjustment of $4 associated with the IRD ruling mentioned
previously. These increases were partially offset by a $2.4 reserve associated
with operating tax settlements and $22.1 of nonrecurring favorable carrier
settlement activities recorded in the first quarter of 1995, the most
significant of which was a meet point billing settlement with Pacific Bell for
the period January 1, 1990 through December 31, 1994. The net effect of changes
in interstate access rates associated with the FCC's 1995 and 1996 price cap
filings also resulted in a $4.4 revenue reduction.
Toll Services
The Company's toll services are based on fees charged for service beyond a
customer's local calling area but within the LATA. Toll service revenues
decreased 19% or $91 and 4% or $20.5 in 1997 and 1996, respectively. The 1997
decrease reflects reduced toll revenues of $80.9 resulting from increased
intraLATA toll competition, including 10XXX and 1+ presubscription, and the
impact of optional discount calling plans, which effectively lowered intrastate
long distance rates. The decrease also includes a net reduction of $10.8
associated with the CPUC's IRD ruling in 1996 (as discussed in Note 11 of the
Company's consolidated financial statements included in Item 8), partially
offset by the positive impact of the $8.6 reserve recorded in 1996 for operating
tax settlements.
The 1996 decrease is largely the result of optional discount calling plans,
which effectively lowered intrastate long distance rates. Other factors include
an $11.5 revenue reduction associated with the Company's 1996 California PCI and
an $8.6 reserve for operating tax settlements. These reductions were partially
offset by a $14.5 increase resulting from the CPUC's IRD ruling, mentioned
above. The decrease is also offset by an increase in toll volumes and a $9.9
increase resulting from unfavorable revenue adjustments recorded in the first
quarter of 1995.
Other Services and Sales
Other services and sales revenues increased 17% or $74.2 in 1997 and remained
essentially unchanged in 1996. The 1997 increase reflects a $14.3 favorable
impact from the FCC's order on payphone interim compensation (as discussed in
Note 11 of the Company's consolidated financial statements included in Item 8)
and an $18.8 growth in revenues from Emergency 911 equipment and voice messaging
services. Other factors contributing to the increase include: $11.5 from higher
billing and collection revenues, $5.4 from growth in Tele-Go(R) phone service
revenues, and $5.1 from increased sales of products and services to ISPs. In
addition, the revenue reduction recorded in 1996 related to a settlement on the
State of California's telecommunications network (CALNET) project produced a
$9.5 favorable impact on 1997 revenues.
10
<PAGE> 13
OPERATING COSTS AND EXPENSES
<TABLE>
<CAPTION>
Years Ended December 31,
---------------------------------------------
1997 1996 1995
----------- ----------- -----------
<S> <C> <C> <C>
Cost of services and sales $ 1,056.4 $ 1,052.5 $ 1,198.6
Selling, general and administrative 511.8 477.7 583.5
Depreciation and amortization 618.3 668.4 672.5
----------- ----------- -----------
Total operating costs and expenses $ 2,186.5 $ 2,198.6 $ 2,454.6
</TABLE>
Total operating costs and expenses decreased 1% or $12.1 and 10% or $256 in 1997
and 1996, respectively.
A change in depreciation rates to reflect higher net salvage values related to
certain telephone plant and equipment caused a $59.9 decrease in 1997
depreciation expense, which was partially offset by a $9.9 increase related to
1997 additions to plant. A net decrease in 1997 pension settlement gains
resulting from lump-sum payments from the Company's benefit plans, offset by the
impact of other pension-related adjustments recorded in 1997, reduced total
expenses by $49.2. In addition, billing and collection expense, order processing
costs, and operating taxes were lower in 1997 by a combined $21.6. These
decreases were partially offset by $30.1 in higher labor and benefits costs, and
a $38.3 increase in selling and marketing expenses resulting from efforts aimed
at stimulating customer demand for enhanced services and preserving market share
in an increasingly competitive environment. Total expense reductions were also
partially offset by the negative impact of the reversal, in 1996, of the $28.9
reserve established for the Communications Workers of America (CWA) arbitration,
discussed below, and $9.2 in higher data processing costs.
The decrease in operating costs and expenses for 1996 was largely due to a $79.5
reduction in labor and benefit costs associated with productivity gains from
process re-engineering and other cost containment programs, and the $28.9
reversal of the CWA arbitration reserve due to a favorable ruling. The decrease
also reflects a $27.3 reduction in regulation expense recorded in 1995 and a $16
decrease in expenses reflecting labor charges relating to flood damage incurred
in first quarter of 1995. Other expense reductions resulted from a $17 decrease
in the provision for uncollectible accounts, a $12.4 decline in data processing
costs, and an $8.1 reduction in contract labor charges. The 1996 decrease was
also due to $25.6 of pension settlement gains recorded in 1996, partially offset
by $13.7 of settlement gains recorded in 1995 which resulted from lump-sum
payments from the Company's pension plans.
OTHER EXPENSES
<TABLE>
<CAPTION>
Years Ended December 31,
-----------------------------------------------
1997 1996 1995
------- ------- -------
<S> <C> <C> <C>
Interest - net $ 101.9 $ 98.6 $ 111.8
Income taxes 390.5 329.3 235.5
</TABLE>
Interest - net increased 3% or $3.3 in 1997 and decreased 12% or $13.2 in 1996.
The 1997 increase is primarily attributable to higher short-term debt levels.
The 1996 decrease was attributable to favorable effects of the long-term debt
refinancing program completed in June 1996.
Income taxes increased 19% or $61.2 in 1997 and 40% or $93.8 in 1996. The 1997
increase is primarily due to the increase in pre-tax income, partially offset by
adjustments to prior years' tax liabilities. The 1996 change was primarily due
to corresponding changes in pre-tax income.
11
<PAGE> 14
CAPITAL RESOURCES AND LIQUIDITY
Management believes the Company has adequate internal and external resources
available to meet ongoing operating requirements for construction of new plant,
modernization of facilities and payment of dividends. The Company generally
funds its construction program from operations, although external financing is
available. Short-term financings can be obtained through borrowings from the
Company's parent, GTE, or GTE Funding Incorporated, an affiliate of the Company.
The Company participates with other affiliates in a $1.5 billion, 364-day
syndicated line of credit. In December 1997, the Company began participating
with GTE and other of its affiliates in a series of five bilateral credit
agreements for an additional $2 billion in credit capacity. These facilities,
which are shared by the participating companies, are aligned with the maturity
date of the existing 364-day line of credit. The additional capacity provides
greater flexibility to incur additional indebtedness of a shorter-term duration
during periods when it may not be desirable to access the capital markets to
refinance short-term debt. The Company also has an existing shelf registration
statement for an additional $400 of debentures.
The Company's primary source of funds during 1997 was cash from operations of
$1,032.1 compared to $1,071.1 in 1996. The decrease is primarily reflective of
an increase in working capital requirements, partially offset by improved
results from operations.
Net cash used in investing activities was $625.6 and $411.8 during 1997 and
1996, respectively. The Company's capital expenditures during 1997 totaled
$629.3 compared to $434.1 in 1996. The 1997 increase in capital expenditures
reflects the Company's continued growth in primary and secondary access lines
and the modernization of interoffice facilities to mitigate Internet congestion.
The Company's construction costs for 1998 are expected to be slightly lower than
the 1997 level.
In June 1996, proceeds of $15.4 were generated from the sale of selected real
estate properties. The Company recognized a pre-tax gain of $1.1 as a result of
this sale.
In 1996, the video network originally constructed by the Company was transferred
at its cost of $6.9 to Media Ventures Incorporated, a separate subsidiary of
GTE.
Cash used in financing activities was $418.8 in 1997 compared to $670.4 in 1996.
This included dividend payments of $617 in 1997 compared to $485.2 in 1996.
Short-term financings, including the net change in affiliate notes, increased
$221.9 in 1997 compared to a decrease of $243.3 in 1996. The Company retired
$318.9 of long-term debt and preferred stock in 1997 compared to total
retirements of $45.3 in 1996. The amount retired in 1997 included $1.6 in
premiums paid on the May 1997 retirement of $206.9 of long-term debt and
preferred stock redeemed prior to stated maturity. The Company issued $300 of
6.7% debentures in September 1997 for the repayment of short-term borrowings
incurred to finance the Company's construction program and for general corporate
purposes. In May 1996, the Company issued $100 of 7% debentures to repay
short-term borrowings incurred in connection with the redemption of long-term
debt, to finance the Company's construction program and for general corporate
purposes. During 1996, the Company entered into forward contracts to hedge
against changes in interest rates related to the 1996 refinancing. A $5 gain on
the settlement of forward contracts is being amortized over the life of the
refinanced debt as an offset to interest expense.
On October 15, 1997, the Company's parent, GTE, proposed a merger with MCI
Communications Corporation (MCI) valued at approximately $28 billion. As a
result of the proposed merger, the rating agencies placed GTE, the Company and
its affiliates on "Credit Watch" for possible rating reductions. On November 10,
1997, MCI announced that it had reached an agreement to merge with WorldCom,
Inc.
12
<PAGE> 15
REGULATORY AND COMPETITIVE TRENDS
The Company is subject to regulation by the regulatory bodies of the states of
California, Nevada and Arizona as to its intrastate business operations and by
the Federal Communications Commission (FCC) as to its interstate operations.
Much of the regulatory and legislative activity that occurred in the United
States in 1997 was a direct result of the Telecommunications Act of 1996 (the
Telecommunications Act) adopted by Congress. The Telecommunications Act is
intended to promote competition in all sectors of the telecommunications
marketplace while preserving and advancing universal telephone service.
The Company is a strong supporter of competition in all telecommunications
markets. The Company's position remains constant: the benefits of competition
should not be divided between customers or industry segments. There must be
fair, reasonable rules at the state and federal levels that enable all service
providers to participate equitably in the marketplace and benefit everyone. The
Company believes the FCC and a number of state regulatory agencies did not
establish these comparable conditions. The Company and its parent, GTE, have
consequently exercised their right to challenge regulatory actions they believe
unfairly disadvantage their customers and shareholders.
In July 1997, the U.S. Court of Appeals for the Eighth Circuit (Eighth Circuit)
released its decision on the challenge filed in 1996 by the Company's parent,
GTE, and numerous other parties to rules developed by the FCC to implement the
interconnection provisions of the Telecommunications Act. The Telecommunications
Act required local-exchange carriers (LECs) to make their retail services and
the underlying network elements available to competitors. The FCC required that
prices for both resold services and network elements be set using a methodology
created by the FCC. The court challenge asserted the FCC's rules were
inconsistent with the Telecommunications Act. The July 1997 court decision found
that the FCC overstepped its authority in a number of areas and upheld GTE's
position that state regulatory agencies bear the primary responsibility for
determining the prices which competing firms must pay when interconnecting their
networks. On January 26, 1998, the U.S. Supreme Court announced that it would
review this decision. Oral argument in the Supreme Court is expected to take
place in October 1998, with a final decision likely to be issued no later than
June 1999.
The favorable ruling by the Eighth Circuit did not impede the progress of
competition. The Company has finalized interconnection agreements with various
competitive LECs in California, Arizona and Nevada. A number of these
interconnection agreements, adopted as a result of the arbitration process
established by the Telecommunications Act, incorporate prices or terms and
conditions based upon the FCC's rules that were overturned by the Eighth
Circuit. Thus, the Company has exercised its right to challenge such agreements
in California.
Interim rates for interconnection and unbundled network elements (UNEs) have
been established through negotiation and arbitration decisions. These interim
rates will be used until permanent rates are established through state
commission proceedings investigating cost studies. Cost studies have been filed
in California and additional studies in other states are expected to be filed
throughout 1998.
In May 1997, the FCC released two new major decisions related to implementation
of the Telecommunications Act's provisions - the universal service and access
charge reform orders. The universal service order established the support
mechanisms to ensure continued availability of affordable local telephone
service and created new programs to provide discounted telecommunications
services to schools, libraries and rural health care providers. GTE and numerous
other parties have challenged the FCC's decision before the U.S. Court of
Appeals for the Fifth Circuit on the grounds that the FCC did not follow the
requirements of the Telecommunications Act to develop a sufficient, explicit and
competitively neutral universal service program. A decision is expected in 1998.
13
<PAGE> 16
The FCC access charge reform order, also released in May 1997, revamped the rate
structure through which local and long distance companies charge customers for
using the local phone network to make long distance calls. The FCC ordered
decreases for long distance companies to be accomplished by increasing the
access charges for business and residential customers with more than one phone
line. GTE and numerous other parties also challenged this decision before the
Eighth Circuit based on the belief that the FCC did not eliminate the universal
service subsidies hidden within interstate access charges as directed by the
Telecommunications Act, and that the FCC created additional subsidy charges paid
only by business and multi-line residential customers. Oral argument has been
held and a decision is expected in 1998.
Also in May 1997, the FCC released a decision completing a periodic review of
its price cap regulatory oversight of interstate access charges. GTE and
numerous other LECs have challenged this decision before the Eighth Circuit
based on the belief that the FCC established a fundamentally unfair annual price
reduction formula and required retroactive price reductions. Oral argument has
been held and a decision on this challenge is also expected in 1998.
Federal and state regulatory activity continued to change the traditional
cost-based, rate-of-return regulatory framework for intrastate and interstate
telephone service. Regulatory authorities in California have adopted various
forms of alternative regulation, which provide economic incentives for telephone
service providers to improve productivity and provide the foundation for
implementing pricing flexibility necessary to address competitive entry into the
Company's markets. The regulatory commissions in the states of Nevada and
Arizona continue to remain under the traditional cost-based, rate-of-return
regulatory framework for intrastate telephone service.
For the provision of interstate access services, the Company operates under the
terms of the FCC's price cap incentive plan. The price cap mechanism serves to
limit the rates a carrier may charge, rather than just regulating the rate of
return which may be achieved. Under this approach, the maximum prices that the
LEC may charge are increased or decreased each year by a price cap index based
upon inflation less a predetermined productivity target. LECs have limited
pricing flexibility provided they do not exceed the allowed price cap.
In the May 1997 order on its price cap triennial review, the FCC revised the
price cap plan for LECs by adopting a uniform productivity factor of 6.0% with
an additive consumer productivity dividend of 0.5%. The FCC also eliminated the
sharing requirements of the price cap rules.
The Company filed interstate access revisions during 1997 that became effective
June 3, 1997 and July 1, 1997. Overall, these filings resulted in a net annual
price reduction of $36.9. On December 1, 1997, the FCC issued an order to file
revised access rates effective January 1, 1998, which resulted in additional
interstate access charge reductions of approximately $10. In 1997, the FCC also
ordered significant changes that altered the structure of access charges
collected by the Company, effective January 1, 1998. Generally, the FCC reduced
and restructured the per minute charges paid by long distance carriers and
implemented new per line charges. The FCC also created an access charge
structure that resulted in different access charges for residential primary and
secondary lines and single line and multi-line business lines. In aggregate, the
reductions in usage sensitive access charges of $35.1 paid by long distance
carriers were partially offset by $30 of new per line charges and the charges
paid by end-users.
On June 4, 1996, the FCC issued the first Report and Order implementing Section
276 of the Telecommunications Act. As part of the overall goal of promoting
competition among payphone service providers (PSPs), this order mandated
compensation to all PSPs for all calls originating from payphones, including
"dial-around" access calls and toll-free subscriber calls for which PSPs were
not previously compensated. This compensation was to occur in two separate
phases. During phase one, from April 15, 1997 through October 6, 1997, PSPs were
to be paid a monthly, flat-rate compensation from interexchange carriers (IXCs).
During phase two, beginning October 7, 1997, PSPs were to be compensated on a
per-call basis, with the prevailing local coin rate of 35 cents established as
the default rate.
14
<PAGE> 17
On July 19, 1997, the U.S. Court of Appeals in Washington, D.C. vacated the
FCC's directive concerning per-call compensation, stating that the FCC had not
shown that the 35 cent rate was a reasonable surrogate for fair compensation.
The court also set aside the FCC's flat-rate compensation mandate. Subsequently,
on October 9, 1997, the FCC issued a second Report and Order to address some of
the issues vacated by the court. In this second order, the FCC established a new
per-call rate of 28.4 cents for phase two compensation that all PSPs were
eligible to receive beginning October 9, 1997. The FCC tentatively concluded
that this per-call rate should also be used to calculate phase one compensation.
The Company has recorded approximately $14.3 of payphone revenues associated
with phase one and phase two estimates. It is likely that the phase one
compensation directive will be revisited in a subsequent order.
During 1997, other regulatory and legislative developments occurred at the state
level to further open the telecommunications marketplace to competition. For
example, the California Public Utilities Commission (CPUC) continued its efforts
to promote competition by addressing unbundling of network elements and updating
its March 1996 resale decision to expand the scope of retail services to be
discounted and offered for resale. The CPUC also opened an investigation to
examine the level of access to the Operational Support System (OSS) of incumbent
local-exchange carriers as well as the quality and speed of access to the OSS.
During 1997, the CPUC introduced two new universal service programs. In order to
meet California's universal service goal in a competitive arena, the California
High Cost Fund-B revised the mechanism for maintaining affordable basic local
service rates in high cost areas. The California Teleconnect program offers
discounts to eligible schools, libraries, government-owned hospitals and health
care organizations and tax exempt community-based organizations to encourage the
use of advanced telecommunications services. Subsequent to the FCC order on
universal service, the CPUC adopted the FCC discount matrix for schools and
libraries and modified its California Teleconnect program to be compatible.
California operates under a state price cap mechanism. On December 20, 1996, the
CPUC approved GTE's 1997 price cap filing. The decision authorized GTE to
collect $27.5 in rates via a surcharge commencing January 1, 1997. The 1998
price cap filing did not result in any changes to revenues; however, rate
adjustments, effective in 1998, were included as a result of rate and surcharge
integration with the former Contel of California serving territories.
Further information regarding the Company's activities with the various
regulatory agencies and revenue arrangements with other telephone companies is
discussed in Note 11 of the Company's consolidated financial statements included
in Item 8.
YEAR 2000 CONVERSION
The Year 2000 issue has an industry-wide impact. The Company has had an active
Year 2000 Program in place. The Company's Year 2000 methodology and processes
were certified in 1997 by the Information Technology Association of America.
This program is necessary because the Year 2000 issue could impact systems,
networks and business processes at the Company. This program includes:
inventory; assessment and analysis of systems, networks and business processes;
remediation of any impacted software; and validation testing. The current
estimate for the cost of remediation for the Company is approximately $52. Year
2000 remediation costs are expensed in the year incurred. Through 1997,
expenditures totaled $7.4. The Company currently has employees and contractors
mobilized to address the Year 2000 issue. Continued success is dependent on the
timely delivery of Year 2000 compliant products and services from the Company's
suppliers. The Company currently believes that its essential processes, systems
and business functions will be ready for the millennium transition.
15
<PAGE> 18
LOCAL NUMBER PORTABILITY REQUIREMENTS
The Telecommunications Act mandated competition in the local telephone
marketplace. Local Number Portability (LNP) is one vehicle chosen by the FCC to
facilitate local competition. Local Service Provider Portability is the first
phase of LNP, which will allow residential and business customers to change
local service providers without changing their telephone numbers. The FCC has
mandated that Local Service Provider Portability be implemented in the top 100
Metropolitan Service Areas (MSAs) by the end of 1998. The second and third
phases of LNP will allow customers to retain their telephone numbers when they
move from one location to another or change services (e.g., landline to
cellular).
Through December 31, 1997, the Company had recorded approximately $34.2 to
implement Local Service Provider Portability within eleven of the top 100 MSAs.
As a result of the major investment required to implement LNP, the FCC has
stated that local service providers should be allowed to recover a portion of
their costs. The Company is seeking regulatory recovery of LNP implementation
costs.
OTHER MATTERS
The California Public Utilities Commission (CPUC) is conducting an investigation
of allegations that personnel of the Company destroyed or altered documents
during a 1992-1993 CPUC probe of sales improprieties at the Company's Foreign
Language Assistance Center. During 1997, the Company asked former California
Supreme Court Chief Justice Malcolm M. Lucas to investigate the allegations. In
October 1997, Chief Justice Lucas submitted his report to the Company and the
CPUC. In response to the Lucas report, the Company has disciplined four
employees. In February 1998, the CPUC ordered a formal investigation into the
marketing practices of the Foreign Language Assistance Center as well as
allegations that the Company provided misleading information. The Company
refunded approximately $2 to customers of the Foreign Language Assistance Center
and paid $3.2 to the state for consumer education. The formal investigation by
the CPUC may result in additional financial penalties against the Company.
Management believes that the Company has adequately provided for this settlement
in its financial statements.
INFLATION
The Company's management generally does not believe inflation has a significant
impact on the Company's earnings. However, increases in costs or expenses not
otherwise offset by increases in revenues could have an adverse effect on
earnings.
16
<PAGE> 19
Item 8. Financial Statements and Supplementary Data
GTE California Incorporated and Subsidiary
CONSOLIDATED STATEMENTS OF INCOME (Note 3)
<TABLE>
<CAPTION>
Years Ended December 31 1997 1996 1995
- ----------------------- ----------- ----------- -----------
(Thousands of Dollars)
<S> <C> <C> <C>
REVENUES AND SALES (a)
Local services $ 1,477,067 $ 1,333,203 $ 1,375,700
Network access services 924,569 870,496 812,570
Toll services 399,135 490,128 510,650
Other services and sales 521,665 447,339 445,896
----------- ----------- -----------
Total revenues and sales 3,322,436 3,141,166 3,144,816
----------- ----------- -----------
OPERATING COSTS AND EXPENSES (b)
Cost of services and sales 1,056,431 1,052,423 1,198,628
Selling, general and administrative 511,808 477,715 583,476
Depreciation and amortization 618,305 668,414 672,494
----------- ----------- -----------
Total operating costs and expenses 2,186,544 2,198,552 2,454,598
----------- ----------- -----------
OPERATING INCOME 1,135,892 942,614 690,218
OTHER (INCOME) EXPENSE
Interest - net (c) 101,910 98,567 111,823
Gain on disposition of assets -- (1,117) --
Other - net 670 -- --
----------- ----------- -----------
INCOME BEFORE INCOME TAXES 1,033,312 845,164 578,395
Income taxes 390,548 329,326 235,534
----------- ----------- -----------
INCOME BEFORE EXTRAORDINARY CHARGES 642,764 515,838 342,861
Extraordinary charges -- -- (711,048)
----------- ----------- -----------
NET INCOME (LOSS) $ 642,764 $ 515,838 $ (368,187)
=========== =========== ===========
</TABLE>
(a) Includes billings to affiliates of $128,496, $130,621, and $122,591 for the
years 1997 - 1995, respectively.
(b) Includes billings from affiliates of $184,416, $194,022, and $228,512 for
the years 1997 - 1995, respectively.
(c) Includes interest paid to affiliates of $15,306.
See Notes to Consolidated Financial Statements.
17
<PAGE> 20
GTE California Incorporated and Subsidiary
CONSOLIDATED BALANCE SHEETS (Note 3)
<TABLE>
<CAPTION>
December 31 1997 1996
- ----------- ---------- ----------
(Thousands of Dollars)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 9,871 $ 22,158
Receivables, less allowances of $65,169 and $72,010 684,846 587,577
Note receivable from affiliate 14,192 13,241
Inventories and supplies 51,050 25,658
Deferred income tax benefits 1,684 58,364
Other 33,715 14,387
---------- ----------
Total current assets 795,358 721,385
---------- ----------
Property, plant and equipment, net 3,799,321 3,754,635
Employee benefit plans 706,556 567,065
Other assets 19,095 40,300
---------- ----------
Total assets $5,320,330 $5,083,385
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Short-term obligations, including current maturities $ 246,052 $ 196,284
Accounts payable 181,005 125,923
Affiliate payables and accruals 175,317 159,278
Advanced billings and customer deposits 65,548 61,797
Taxes payable 26,760 54,418
Accrued interest 30,163 25,272
Accrued payroll costs 89,221 97,680
Dividends payable 158,246 112,466
Other 192,574 134,514
---------- ----------
Total current liabilities 1,164,886 967,632
---------- ----------
Long-term debt 1,466,679 1,280,151
Deferred income taxes 394,883 342,349
Employee benefit plans 225,425 229,914
Other liabilities 272,648 414,711
---------- ----------
Total liabilities 3,524,521 3,234,757
---------- ----------
Shareholders' equity:
Preferred stock 49,984 81,866
Common stock (70,000,000 shares issued) 1,400,000 1,400,000
Additional paid-in capital 82,239 82,239
Retained earnings 263,586 284,523
---------- ----------
Total shareholders' equity 1,795,809 1,848,628
---------- ----------
Total liabilities and shareholders' equity $5,320,330 $5,083,385
========== ==========
</TABLE>
See Notes to Consolidated Financial Statements.
18
<PAGE> 21
GTE California Incorporated and Subsidiary
CONSOLIDATED STATEMENTS OF CASH FLOWS (Note 3)
<TABLE>
<CAPTION>
Years Ended December 31 1997 1996 1995
- ----------------------- ----------- ----------- -----------
(Thousands of Dollars)
<S> <C> <C> <C>
OPERATIONS
Income before extraordinary charges $ 642,764 $ 515,838 $ 342,861
Adjustments to reconcile income before extraordinary
charges to net cash from
operations:
Depreciation and amortization 618,305 668,414 672,494
Deferred income taxes 133,060 53,455 34,309
Provision for uncollectible accounts 71,263 69,439 84,365
Change in current assets and current liabilities:
Receivables - net (142,710) 27,971 (92,149)
Other current assets (27,025) 5,441 14,396
Accrued taxes and interest (40,462) (35,286) (9,626)
Other current liabilities 56,702 (97,724) (107,125)
Other - net (279,817) (136,490) (66,411)
----------- ----------- -----------
Net cash from operations 1,032,080 1,071,058 873,114
----------- ----------- -----------
INVESTING
Capital expenditures (629,348) (434,053) (438,201)
Proceeds from sale of assets 3,794 15,414 --
Proceeds from transfer of assets -- 6,851 --
Other - net -- -- 5,469
----------- ----------- -----------
Net cash used in investing (625,554) (411,788) (432,732)
----------- ----------- -----------
FINANCING
Long-term debt issued 295,098 98,405 --
Long-term debt and preferred stock retired, including
premiums paid on early retirement (318,865) (45,283) (150,347)
Dividends (616,980) (485,226) (390,556)
Increase (decrease) in short-term obligations,
excluding current maturities 221,934 (243,273) 88,424
Other - net -- 5,000 --
----------- ----------- -----------
Net cash used in financing (418,813) (670,377) (452,479)
----------- ----------- -----------
Decrease in cash and cash equivalents (12,287) (11,107) (12,097)
Cash and cash equivalents:
Beginning of year 22,158 33,265 45,362
----------- ----------- -----------
End of year $ 9,871 $ 22,158 $ 33,265
=========== =========== ===========
Cash paid during the year for:
Interest $ 101,031 $ 106,167 $ 121,005
----------- ----------- -----------
Income taxes $ 331,955 $ 310,763 $ 203,980
----------- ----------- -----------
</TABLE>
See Notes to Consolidated Financial Statements.
19
<PAGE> 22
GTE California Incorporated and Subsidiary
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (Note 3)
<TABLE>
<CAPTION>
Additional
Preferred Common Paid-In Retained
Stock Stock Capital Earnings Total
----------- ----------- ----------- ----------- -----------
(Thousands of Dollars)
<S> <C> <C> <C> <C> <C>
Shareholders' equity, December 31, 1994 $ 81,866 $ 1,400,000 $ 82,239 $ 976,457 $ 2,540,562
Net loss (368,187) (368,187)
Dividends declared (330,647) (330,647)
----------- ----------- ----------- ----------- -----------
Shareholders' equity, December 31, 1995 81,866 1,400,000 82,239 277,623 1,841,728
Net income 515,838 515,838
Dividends declared (508,938) (508,938)
----------- ----------- ----------- ----------- -----------
Shareholders' equity, December 31, 1996 81,866 1,400,000 82,239 284,523 1,848,628
Net income 642,764 642,764
Dividends declared (662,760) (662,760)
Redemption of preferred stock (31,882) (941) (32,823)
----------- ----------- ----------- ----------- -----------
Shareholders' equity, December 31, 1997 $ 49,984 $ 1,400,000 $ 82,239 $ 263,586 $ 1,795,809
=========== =========== =========== =========== ===========
</TABLE>
See Notes to Consolidated Financial Statements.
20
<PAGE> 23
GTE California Incorporated and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF BUSINESS
GTE California Incorporated (the Company) provides a wide variety of
communications services ranging from local telephone service for the home and
office to highly complex voice and data services for various industries. At
December 31, 1997, the Company served 5,059,427 access lines in the states of
California, Nevada and Arizona. The Company is a wholly-owned subsidiary of GTE
Corporation (GTE).
BASIS OF PRESENTATION
The Company prepares its financial statements in accordance with generally
accepted accounting principles, which require management to make estimates and
assumptions that affect the reported amounts. Actual results could differ from
those estimates.
The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiary, Contel Advanced Systems, Inc. All significant
intercompany transactions have been eliminated.
Reclassifications of prior-year data have been made, where appropriate, to
conform to the 1997 presentation.
TRANSACTIONS WITH AFFILIATES
GTE Supply (100% owned by GTE) provides construction and maintenance equipment,
supplies and electronic repair services to the Company. These purchases and
services amounted to $176.9 million, $119.5 million, and $104.6 million for the
years 1997-1995, respectively. Such purchases and services are recorded in the
accounts of the Company, at cost, which includes a return realized by GTE
Supply.
The Company is billed for certain printing and other costs associated with
telephone directories, data processing services and equipment rentals, and
receives management, consulting, research and development, and pension
management services from other affiliated companies. These charges amounted to
$184.4 million, $194 million, and $228.5 million for the years 1997-1995,
respectively. The amounts charged for these affiliated transactions are based on
a proportional cost allocation method.
The Company's consolidated financial statements include allocated expenses based
on the sharing of certain executive, administrative, financial, accounting,
marketing, personnel, engineering, and other support services being performed at
consolidated work centers among GTE's domestic telephone operating subsidiaries.
The amounts charged for these affiliated transactions are based on proportional
cost allocation methodologies.
GTE Funding Incorporated (an affiliate of the Company) provides short-term
financing and investment vehicles and cash management services for the Company.
The Company is contractually obligated to repay all amounts borrowed on its
behalf by GTE Funding Incorporated. Interest expense on these borrowings
amounted to approximately $15.3 million in 1997.
The Company has an agreement with GTE Directories Corporation (Directories)
(100% owned by GTE), whereby the Company provides its subscriber lists, billing
and collection and other services to Directories. Revenues from these activities
amounted to $128.5 million, $130.6 million, and $122.6 million for the years
1997-1995, respectively.
21
<PAGE> 24
DEPRECIATION AND AMORTIZATION
The Company provides for depreciation on a straight-line basis over the
estimated economic lives of its assets. Prior to 1996, the Company provided for
depreciation on a straight-line basis over asset lives approved by regulators
(see Note 2). Maintenance and repairs of property are charged to income as
incurred. Additions to, replacements and renewals of property are charged to
telephone plant accounts. Property retirements are charged in total to the
accumulated depreciation account. No adjustment to depreciation is made at the
time properties are retired or otherwise disposed of, except in the case of
significant sales or extraordinary retirements of property where profit or loss
is recognized.
Franchises, goodwill and other intangibles are amortized on a straight-line
basis over the periods to be benefited, or 40 years, which ever is less.
REVENUE RECOGNITION
Revenues are recognized when earned. This is generally based on usage of the
Company's local-exchange networks or facilities. For other products and
services, revenues are generally recognized when services are rendered or
products are delivered to customers. Long-term contracts are generally accounted
for using the percentage-of-completion method with revenues recognized in the
proportion that costs incurred bear to the estimated total costs to completion.
Expected losses, if any, are charged to income currently.
INVENTORIES AND SUPPLIES
Inventories and supplies are stated at the lower of cost, determined principally
by the average cost method, or net realizable value.
EMPLOYEE BENEFIT PLANS
Pension and postretirement health care and life insurance benefits earned during
the year as well as interest on projected benefit obligations are accrued
currently. Prior service costs and credits resulting from changes in plan
benefits are amortized over the average remaining service period of the
employees expected to receive benefits. Material curtailment/settlement gains
and losses associated with employee separations are recognized in the period in
which they occur.
INCOME TAXES
The Company's results are included in GTE's consolidated federal income tax
return. The Company participates in a tax-sharing agreement with GTE and remits
tax payments to GTE based on its tax liability on a separate company basis.
Deferred tax assets and liabilities are established for temporary differences
between the way certain income and expense items are reported for financial
reporting and tax purposes and are subsequently adjusted to reflect changes in
tax rates expected to be in effect when the temporary differences reverse. A
valuation allowance is established for deferred tax assets for which realization
is not likely.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include investments in short-term, highly liquid
securities, which have maturities when purchased of three months or less.
22
<PAGE> 25
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1997, the FASB issued Statement of Financial Accounting Standards No.
130, "Reporting Comprehensive Income" (FAS 130). FAS 130 establishes standards
for reporting and displaying comprehensive income and its components in the
financial statements. FAS 130 is effective for fiscal years beginning after
December 15, 1997. Reclassification of financial statements for earlier periods
provided for comparative purposes is required. The adoption of this standard
will have no impact on the Company's results of operations, financial position
or cash flows.
2. EXTRAORDINARY CHARGES
In response to legislation (see Note 11) and the increasingly competitive
environment, the Company discontinued the use of Statement of Financial
Accounting Standards No. 71, "Accounting for the Effects of Certain Types of
Regulation" (FAS 71) in the fourth quarter of 1995.
As a result of the decision to discontinue FAS 71, the Company recorded a
non-cash, after-tax extraordinary charge of $710.8 million (net of tax benefits
of $493.9 million) in the fourth quarter of 1995. The charge primarily
represented a reduction in the net book value of telephone plant and equipment
through an increase in accumulated depreciation. In addition to the one-time
charge, beginning in 1996, the Company shortened the depreciable lives of its
telephone plant and equipment as follows:
<TABLE>
<CAPTION>
Average Depreciable Lives
-------------------------
Asset Category Before After
- ------------------- ------ -----
<S> <C> <C>
Copper 20-30 15
Switching 17-19 10
Circuit 11-13 8
Fiber 25-30 20
</TABLE>
In addition, during 1995, the Company redeemed prior to stated maturity, $75
million of long-term debt. This redemption resulted in an after-tax
extraordinary charge of $0.2 million (net of tax benefits of $0.1 million).
23
<PAGE> 26
3. LEGAL ENTITY MERGER
On September 10, 1992, the Company entered into an Agreement of Merger with
Contel of California, Inc., a California corporation (Contel California). The
agreement provided that Contel California would merge with and into the Company,
with the Company to be the surviving corporation in the merger (the Merger).
The Merger, which occurred on December 31, 1996, was accounted for in a manner
consistent with a transfer of entities under common control which is similar to
a "pooling of interests." All material intercompany transactions have been
eliminated.
Listed below are details of the results of operations of the previously separate
enterprises that are included in the current combined net income (loss):
<TABLE>
<CAPTION>
GTE Contel GTE
California California California
(Pre-Merger) (Pre-Merger) (Post-Merger)
-----------------------------------------------
(Thousands of Dollars)
<S> <C> <C> <C>
Year Ended December 31, 1996
Revenues and sales $ 2,789,919 $ 351,247 $ 3,141,166
Operating income 796,105 146,509 942,614
Net income 435,664 80,174 515,838
Year Ended December 31, 1995
Revenues and sales $ 2,801,333 $ 343,483 $ 3,144,816
Operating income 593,735 96,483 690,218
Net loss (a) (290,306) (77,881) (368,187)
</TABLE>
(a) Net loss for 1995 includes $711 million of extraordinary charges (net of
tax) for the discontinuance of FAS 71 and the early retirement of debt (see
Note 2).
24
<PAGE> 27
4. PREFERRED STOCK
Cumulative preferred stock, not subject to mandatory redemption and exclusive of
amounts held in treasury, is as follows:
<TABLE>
<CAPTION>
December 31
--------------------------------------------
1997 1996
--------- ---------
Shares Shares
--------- ---------
<S> <C> <C>
Authorized:
$ 20 par value 2,499,174 2,499,174
$ 100 par value -- 500,000
--------- ---------
2,499,174 2,999,174
========= =========
</TABLE>
<TABLE>
<CAPTION>
December 31
-------------------------------------------------------
1997 1996
------------------------- -------------------------
Shares Amount Shares Amount
---------- ---------- ---------- ----------
Outstanding: (Thousands (Thousands
of Dollars) of Dollars)
<S> <C> <C> <C> <C>
$ 20 par value
4 1/2% Series (issued in 1945) 280,312 $ 5,606 280,312 $ 5,606
4 1/2% Series (issued in 1956) 718,862 14,378 718,862 14,378
5 % Series (issued in 1957) 1,500,000 30,000 1,500,000 30,000
$ 100 par value
7.48 % Series (issued in 1973) -- -- 318,821 31,882
---------- ---------- ---------- ----------
Total 2,499,174 $ 49,984 2,817,995 $ 81,866
========== ========== ========== ==========
</TABLE>
At the Company's option, these series of preferred stock are redeemable at
premiums, in whole or in part, on thirty days notice.
In May 1997, the Company redeemed all outstanding shares of 7.48% Series
preferred stock with cash from operations. The Company incurred $0.9 million in
premiums associated with this redemption.
The 4 1/2% Series (1945 issue) is entitled to one vote per share, with the right
to vote cumulatively in the election of directors. Otherwise, the preferred
shareholders have no voting rights.
No shares of preferred stock were reserved for officers and employees, or for
options, warrants, conversions or other rights. The Company is not in arrears in
its dividend payments at December 31, 1997.
25
<PAGE> 28
5. COMMON STOCK
The authorized common stock of the Company consists of 100,000,000 shares with a
par value of $20 per share. All outstanding shares of common stock are held by
GTE.
There were no shares of common stock held by or for the account of the Company
and no shares were reserved for officers and employees, or for options,
warrants, conversions or other rights.
At December 31, 1997, $49.3 million of retained earnings were restricted as to
the payment of cash dividends on common stock under the most restrictive terms
of the Articles of Incorporation.
26
<PAGE> 29
6. DEBT
Long-term debt as of December 31, was as follows:
<TABLE>
<CAPTION>
1997 1996
--------- ---------
(Thousands of Dollars)
First mortgage bonds:
<S> <C> <C> <C>
7 5/8 % Series J, due 1997 $ -- $ 10,000
6 3/4 % Series T, due 1997 -- 55,000
7 1/8 % Series U, due 1998 -- 60,000
9.45 % Series V, due 1997 -- 10,000
9.41 % Series W, maturing through 2014 40,000 40,000
7 5/8 % Series X, due 2001 -- 50,000
9.44 % Series X, due 2015 30,000 30,000
6 1/4 % Series TT, due 1998 150,000 150,000
---------- ----------
220,000 405,000
---------- ----------
Debentures:
5 5/8 % Series A, due 2001 300,000 300,000
6 3/4 % Series B, due 2004 250,000 250,000
8.07 % Series C, due 2024 250,000 250,000
7 % Series D, due 2008 100,000 100,000
6.70 % Series E, due 2009 300,000 --
---------- ----------
1,200,000 900,000
---------- ----------
Other:
7.38% GTE Finance Corporation promissory note, due 1997 -- 50,000
6.60% GTE Finance Corporation promissory note, due 2000 -- 50,000
Notes payable expected to be refinanced on a long-term basis 200,000 --
Capitalized leases 489 856
---------- ----------
Total principal amount 1,620,489 1,405,856
Less: discount and premium - net (3,591) (422)
---------- ----------
Total 1,616,898 1,405,434
Less: current maturities (150,219) (125,283)
---------- ----------
Total long-term debt $1,466,679 $1,280,151
========== ==========
</TABLE>
In May and December 1997, the Company retired, prior to stated maturity, $225
million of long-term debt. The Company incurred $0.7 million in premiums
associated with these retirements. In June and September 1997, the Company
retired at maturity $60 million of long-term debt.
In September 1997, the Company issued $300 million of 6.7% Series E Debentures,
due 2009. The net proceeds were applied toward the repayment of short-term
borrowings incurred to finance the Company's construction program and for
general corporate purposes.
Long-term debt as of December 31, 1997 includes $200 million of affiliate notes
payable which the Company expects to refinance during the first half of 1998.
27
<PAGE> 30
In May 1996, the Company issued $100 million of 7% Series D Debentures, due
2008. The net proceeds were applied toward the repayment of short-term
borrowings incurred in connection with the redemption of long-term debt in
December 1995 prior to stated maturity (see Note 2). Net proceeds were also used
to finance the Company's construction program and for general corporate
purposes.
The aggregate principal amount of bonds and debentures that may be issued is
subject to the restrictions and provisions of the Company's indentures. None of
the securities shown above were held in sinking or other special funds of the
Company or pledged by the Company. Debt discounts and premiums on the Company's
outstanding long-term debt are amortized over the lives of the respective
issues. Substantially all of the Company's telephone plant is subject to the
liens of the indentures under which the bonds listed above were issued.
Estimated payments of long-term debt during the next five years are: $150.2
million in 1998; $0.1 million in 1999; $2.5 million in 2000; $302.5 million in
2001; and $2.5 million in 2002.
Total short-term obligations as of December 31, were as follows:
<TABLE>
<CAPTION>
1997 1996
-------- --------
(Thousands of Dollars)
<S> <C> <C>
Commercial paper - average rate 5.5% $ -- $ 71,001
Notes payable to affiliate - average rate 6.2% 95,833 --
Current maturities of long-term debt 150,219 125,283
-------- --------
Total $246,052 $196,284
======== ========
</TABLE>
The Company participates with other affiliates in a $1.5 billion, 364-day
syndicated line of credit. In December 1997, the Company began participating
with its parent, GTE, and other of its affiliates in a series of five bilateral
credit agreements for an additional $2 billion in credit capacity. These
facilities, which are shared by the participating companies, are aligned with
the maturity date of the existing 364-day line of credit. The Company also has
an existing shelf registration statement for an additional $400 million of
debentures.
28
<PAGE> 31
7. FINANCIAL INSTRUMENTS
At December 31, 1997, the Company had entered into forward interest rate swap
agreements and forward contracts to sell U.S. Treasury Bonds to hedge against
changes in market interest rates on $310 million of planned long-term debt
issuances expected to be completed within the next twelve months. Gains and
losses recognized upon the expiration or settlement of forward interest rate
swap agreements and forward contracts to sell U.S. Treasury Bonds are amortized
over the life of the associated long-term debt issuance as an offset or addition
to interest expense.
The risk associated with these off-balance-sheet financial instruments arises
from the possible inability of counterparties to meet the contract terms and
from movements in interest rates. The Company carefully evaluates and
continually monitors the creditworthiness of its counterparties and believes the
risk of nonperformance is remote.
The fair values of financial instruments, other than long-term debt, closely
approximate their carrying value. As of December 31, 1997 and 1996, the
estimated fair value of long-term debt based on either reference to quoted
market prices or an option pricing model, exceeded the carrying value by
approximately $24 million and $11 million, respectively.
29
<PAGE> 32
8. INCOME TAXES
The income tax provision is as follows:
<TABLE>
<CAPTION>
1997 1996 1995
--------- --------- ---------
(Thousands of Dollars)
<S> <C> <C> <C>
Current:
Federal $ 202,633 $ 231,579 $ 149,317
State 54,855 44,292 51,908
--------- --------- ---------
257,488 275,871 201,225
Deferred:
Federal 118,525 51,549 37,893
State 26,501 17,080 14,901
--------- --------- ---------
145,026 68,629 52,794
Amortization of deferred investment tax credits - net (11,966) (15,174) (18,485)
--------- --------- ---------
Total $ 390,548 $ 329,326 $ 235,534
========= ========= =========
</TABLE>
A reconciliation between taxes computed by applying the statutory federal income
tax rate to pre-tax income and income taxes provided in the consolidated
statements of income is as follows:
<TABLE>
<CAPTION>
1997 1996 1995
--------- --------- ---------
(Thousands of Dollars)
<S> <C> <C> <C>
Amounts computed at statutory rates $ 360,212 $ 294,133 $ 200,764
State and local income taxes, net of federal income tax benefits 52,881 39,892 43,426
Amortization of deferred investment tax credits, net of federal
income tax benefits (7,778) (9,864) (18,485)
Depreciation of telephone plant construction costs
previously deducted for tax purposes - net -- -- 17,864
Rate differentials applied to reversing temporary differences -- -- (7,589)
Other differences - net (14,767) 5,165 (446)
--------- --------- ---------
Total provision $ 390,548 $ 329,326 $ 235,534
========= ========= =========
</TABLE>
The tax effects of temporary differences that give rise to the deferred income
tax benefits and deferred income tax liabilities at December 31, are as follows:
<TABLE>
<CAPTION>
1997 1996
--------- ---------
(Thousands of Dollars)
<S> <C> <C>
Depreciation and amortization $ 264,742 $ 255,088
Employee benefit obligations (106,292) (111,575)
Prepaid pension cost 197,050 121,727
Investment tax credits 14,539 22,317
Other - net 23,160 (27,418)
--------- ---------
Total $ 393,199 $ 260,139
========= =========
</TABLE>
30
<PAGE> 33
9. EMPLOYEE BENEFIT PLANS
RETIREMENT PLANS
The Company sponsors noncontributory defined benefit pension plans covering
substantially all employees. The benefits to be paid under these plans are
generally based on years of credited service and average final earnings. The
Company's funding policy, subject to the minimum funding requirements of U.S.
employee benefit and tax laws, is to contribute such amounts as are determined
on an actuarial basis to accumulate funds sufficient to meet the plans' benefit
obligation to employees upon their retirement. The assets of the plans consist
primarily of corporate equities, government securities and corporate debt
securities.
The components of the net pension credit for 1997-1995 were as follows:
<TABLE>
<CAPTION>
1997 1996 1995
--------- --------- ---------
(Thousands of Dollars)
<S> <C> <C> <C>
Benefits earned during the year $ 35,186 $ 36,801 $ 32,481
Interest cost on projected benefit obligations 106,813 105,886 108,517
Return on plan assets:
Actual (554,426) (421,922) (502,472)
Deferred 321,923 201,375 300,107
Other - net (35,920) (37,120) (45,487)
--------- --------- ---------
Net pension credit $(126,424) $(114,980) $(106,854)
========= ========= =========
</TABLE>
The expected long-term rate of return on plan assets was 9.0% for 1997 and 1996
and 8.5% for 1995.
The funded status of the plans and the net prepaid pension cost at December 31,
were as follows:
<TABLE>
<CAPTION>
1997 1996
----------- -----------
(Thousands of Dollars)
<S> <C> <C>
Vested benefit obligations $ 1,121,749 $ 1,054,805
=========== ===========
Accumulated benefit obligations $ 1,246,331 $ 1,155,684
=========== ===========
Plan assets at fair value $ 3,356,663 $ 2,964,345
Less: projected benefit obligations 1,513,539 1,431,393
----------- -----------
Excess of assets over projected benefit obligations 1,843,124 1,532,952
Unrecognized net transition asset (105,210) (126,793)
Unrecognized net gain (1,031,358) (839,094)
----------- -----------
Net prepaid pension cost $ 706,556 $ 567,065
=========== ===========
</TABLE>
Assumptions used to develop the projected benefit obligations at December 31,
were as follows:
<TABLE>
<CAPTION>
1997 1996
---- ----
<S> <C> <C>
Discount rate 7.25% 7.50%
Rate of compensation increase 5.00% 5.25%
</TABLE>
31
<PAGE> 34
POSTRETIREMENT BENEFITS OTHER THAN PENSIONS
Substantially all of the Company's employees are covered under postretirement
health care and life insurance benefit plans. The determination of benefit cost
for postretirement health plans is generally based on comprehensive hospital,
medical and surgical benefit plan provisions. The Company funds amounts for
postretirement benefits as deemed appropriate from time to time. Plan assets
consist primarily of corporate equities, government securities and corporate
debt securities.
The postretirement benefit cost for 1997-1995 included the following components:
<TABLE>
<CAPTION>
1997 1996 1995
-------- -------- --------
(Thousands of Dollars)
<S> <C> <C> <C>
Benefits earned during the year $ 6,386 $ 7,545 $ 7,282
Interest on accumulated postretirement benefit obligations 45,143 49,305 56,202
Actual return on plan assets (23,043) (5,499) (19,476)
Amortization of transition obligation 26,356 28,202 29,044
Other - net (2,470) (11,367) 9,348
-------- -------- --------
Postretirement benefit cost $ 52,372 $ 68,186 $ 82,400
======== ======== ========
</TABLE>
The following table sets forth the plans' funded status and the accrued
postretirement benefit obligations as of December 31:
<TABLE>
<CAPTION>
1997 1996
--------- ---------
(Thousands of Dollars)
<S> <C> <C>
Accumulated postretirement benefit obligations attributable to:
Retirees $ 499,646 $ 508,792
Fully eligible active plan participants 22,349 24,212
Other active plan participants 147,550 158,382
--------- ---------
Total accumulated postretirement benefit obligations 669,545 691,386
Less: fair value of plan assets 257,576 205,750
--------- ---------
Excess of accumulated obligations over plan assets 411,969 485,636
Unrecognized transition obligation (395,342) (443,945)
Unrecognized net gain 194,038 172,766
--------- ---------
Accrued postretirement benefit obligations $ 210,665 $ 214,457
========= =========
</TABLE>
The assumed discount rates used to measure the accumulated postretirement
benefit obligations were 7.25% at December 31, 1997 and 7.5% at December 31,
1996. The assumed health care cost trend rate was 8.25% in 1997 and 8.75% in
1996 and is assumed to decrease gradually to an ultimate rate of 6% in the year
2004. A one percentage point increase in the assumed health care cost trend
rates for each future year would have increased 1997 costs by approximately $5.2
million and the accumulated postretirement benefit obligations as of December
31, 1997 by approximately $64.2 million.
SAVINGS PLANS
The Company sponsors employee savings plans under section 401(k) of the Internal
Revenue Code. The plans cover substantially all full-time employees. Under the
plans, the Company provides matching contributions in GTE common stock based on
qualified employee contributions. Matching contributions charged to income were
$11.2 million, $10.8 million and $10.5 million in 1997-1995, respectively.
32
<PAGE> 35
10. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment is summarized as follows at December 31:
<TABLE>
<CAPTION>
1997 1996
------------ ------------
(Thousands of Dollars)
<S> <C> <C>
Land $ 60,850 $ 60,729
Buildings 718,579 677,040
Plant and equipment 8,396,209 8,043,861
Other 902,234 925,317
------------ ------------
Total 10,077,872 9,706,947
Accumulated depreciation (6,278,551) (5,952,312)
------------ ------------
Total property, plant and equipment - net $ 3,799,321 $ 3,754,635
============ ============
</TABLE>
Depreciation expense in 1997-1995 was equivalent to a composite average
percentage of 6.3%, 7.0%, and 7.2%, respectively. During 1997, depreciation was
partially offset by a reduction in depreciation rates to reflect higher net
salvage values related to certain telephone plant and equipment.
11. REGULATORY AND COMPETITIVE MATTERS
The Company is subject to regulation by the regulatory bodies of the states of
California, Nevada and Arizona for its intrastate business operations and by the
Federal Communications Commission (FCC) for its interstate operations.
INTRASTATE SERVICES
The Company provides local-exchange services to customers within its designated
franchise areas. The Company also provides toll services within designated
geographic areas called Local Access and Transport Areas (LATAs) under
agreements with connecting local-exchange carriers (LECs) in conformity with
state regulatory orders. The Company also provides long distance access services
directly to interexchange carriers (IXCs) and other customers who provide
service between LATAs.
New Regulatory Framework (NRF)
Effective January 1, 1990, the California Public Utilities Commission (CPUC)
adopted the NRF for the Company. The new framework replaced the traditional
"rate case" process with a framework that centers around a Price Cap Index (PCI)
mechanism with "sharing" of intrastate earnings (those earnings subject to CPUC
regulation) above a benchmark rate of return. This plan was designed to
stimulate productivity and efficiencies with a portion of these gains flowing
directly to the customer. In a decision issued December 1, 1993, the CPUC
eliminated the sharing of earnings above the benchmark rate of return. The
Company remains, however, under an overall rate of return earnings cap of 15.5%.
33
<PAGE> 36
Under the NRF, rates are adjusted annually by the PCI which is based on
inflation minus a productivity improvement factor. Rates for partially
competitive services, such as Centrex and custom calling features, may be priced
below the price cap within a range set by the CPUC. Rates are also adjusted for
exogenous events that are beyond the control of management as defined in this
plan. Fully competitive services, such as directory advertising, are not subject
to pricing limits set by the CPUC.
On December 21, 1994, the CPUC approved the Company's 1995 PCI filing which
resulted in a rate reduction of $12 million. On December 20, 1995, the CPUC
approved the 1996 PCI filing in which the terms of the Company's price cap-based
incentive regulation plan was modified in recognition of growing competition. In
1996, the Company was ordered to continue using a price cap formula to adjust
prices for 1996. The price cap formula included a productivity factor of 4.6% as
an offset to inflation which resulted in a $41.7 million rate reduction for
1996. On December 20, 1996, the CPUC approved the Company's 1997 price cap
filing. Rates for 1997 and 1998 remained unchanged due to the order's adoption
of a productivity factor equal to the inflation factor. Although there was no
revenue impact from the productivity factor, other components of the price cap
mechanism generated a revenue increase of $27.5 million effective in 1997. The
1998 price cap filing did not impact revenues but included rate adjustments
resulting from rate and surcharge integration with tariffs relating to the
former Contel of California service territories.
On October 12, 1994, the CPUC issued a decision which authorized further
proceedings to be held with regard to a previous CPUC decision that adopted
accrual accounting for Statement of Financial Accounting Standards No. 106
"Employers' Accounting for Postretirement Benefits Other Than Pensions" (FAS
106), which permitted the Company to recover its FAS 106 costs as an exogenous
factor in annual price cap filings. This decision reaffirmed the CPUC's decision
to adopt FAS 106 for rate making purposes. However, the issue of exogenous
recovery was to be further reviewed and any revenues collected in rates
subsequent to October 12, 1994 were subject to refund pending further
investigation. On April 9, 1997, the CPUC issued a decision concluding that the
exogenous recovery for FAS 106 accounting changes previously granted is
consistent with its NRF and should be upheld. On December 16, 1997, the CPUC
resolved to determine in 1998 a non-controversial means to quantify the annual
amount of postretirement benefits other than pension costs (PBOP) that will be
permitted to be recovered. In December 1997, the Company filed a motion with the
CPUC to delay the 1998 review of PBOP costs, citing that such a review would
have no impact on either the Company or ratepayers.
Implementation Rate Design (IRD)
In September 1994, the CPUC issued a final order that authorized intraLATA toll
competition (without pre-subscription) in California, effective January 1, 1995,
associated with the IRD. The final order also provided for rate rebalancing with
significant rate reductions for toll service and access charges while increasing
basic local-exchange rates closer to the actual cost of providing such service.
Specifically, the CPUC reduced rates for the Company's toll services by an
average of 42% and its switched access rates by more than 50%, while offsetting
the revenue impacts by increasing other rates closer to cost. Monthly service
rates for flat-rate residential customers increased from $11.21 to $17.25 and
measured business customers' rates increased from $10.46 to $19.22. Although
this rate rebalancing was intended by the CPUC to be revenue neutral, the actual
increase in volume did not fully compensate for the toll and access rate
reductions. This decision did not permit rate increases to compensate for
competitive losses of market share. Revenues decreased by approximately $232.3
million in 1995 as a result of the implementation of this order. The Company's
request for reconsideration of this aspect of the order was denied on February
7, 1996. On April 17, 1996, the Company filed a petition to modify the February
7 decision to allow recovery of the revenue shortfall associated with the
elasticity factor error surcharge applicable to all of its intrastate
surchargeable services. On June 6, 1996, the CPUC approved the Company's request
to correct mathematical errors, which resulted in a favorable ruling of $53
million. The full amount was recorded in 1996 as follows: local services, $35
million; toll services, $14 million; network access services, $4 million.
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<PAGE> 37
On September 1, 1995, the Company and Pacific Bell filed a joint petition
requesting that the CPUC revise erroneous elasticity estimates used in the
original IRD order with available actual data. The Company asked for recovery of
$107 million through increases in specific rates and through the surcharge
mechanism. The amount of requested recovery was subsequently reduced to $80
million as a result of the favorable June 6, 1996 decision. On February 19,
1997, the CPUC voted 4-1 to reject the joint petition.
Universal Service (US)
On October 25, 1996, the CPUC issued a decision which established permanent
rules and procedures to meet California's US goal in a competitive
telecommunications marketplace. The CPUC concluded that a statewide subsidy fund
of $351 million will be required to sustain basic residential service in high
cost areas and will be paid for by instituting a 2.87% end user surcharge on
customer bills. This surcharge will be collected by all telecommunication
providers.
Incumbent LECs are initially designated as carriers of last resort (COLR) and
are eligible to receive subsidies from the fund for providing service in high
cost areas. The authorized subsidy per line is the difference between the higher
of a statewide average cost benchmark of $20.30 or the COLR's average revenue
(basic service rate plus the end-user line charge plus the common carrier line
charge) and the LEC's cost proxy model estimate, which is different for each
geographic study area (GSA). COLRs who receive high cost support must implement
an offsetting surcredit applied to all competitive services excluding basic
residential service.
The decision also established a "Teleconnect Fund" to support discounting of
high speed services to schools, libraries, government owned hospitals and health
care organizations, and tax exempt community-based organizations.
On December 4, 1996, the Company filed an application for rehearing of the
October 25 decision. In the application, the Company stated that the decision
was unreasonable and discriminatory because: (1) the fund size is seriously
understated; (2) the decision does not provide the Company adequate support in
high cost areas; (3) the Company's customers are penalized by subsidizing
Pacific Bell's below cost rates; and (4) the decision fails to properly
calculate revenues-per-line that the Company will receive in high cost areas.
During 1997, the CPUC introduced two new universal service programs. In order to
meet California's universal service goal in a competitive arena, the California
High Cost Fund-B revised the mechanism for maintaining affordable basic local
service rates in high cost areas. The California Teleconnect program offers
discounts to eligible schools, libraries, government-owned hospitals and health
care organizations and tax exempt community-based organizations to encourage the
use of advanced telecommunications services. Subsequent to the FCC order on
universal service, the CPUC adopted the FCC discount matrix for schools and
libraries and modified its California Teleconnect program to be compatible. On
December 16, 1997, the CPUC also granted the Company status as an eligible
telecommunications provider which allows the Company to participate in the FCC
high cost and lifeline support programs.
Competition
The CPUC issued interim rules for local competition on July 24, 1995, which
permitted facilities-based local competition on January 1, 1996, with resale
authority granted two months later. On September 1, 1995, the Company filed with
the CPUC for a certificate of public convenience and necessity (CPCN) which
would enable the Company to compete within Pacific Bell franchised service areas
to provide customers with facilities-based and resale-based local-exchange
services, high-speed digital private line services, and intraLATA toll services.
Pacific Bell and over 120 other carriers have made similar filings seeking CPCNs
to compete in both the Company's and Pacific Bell's service territories. On
December 20, 1995, the CPUC approved the Company's request to provide intraLATA
toll, high-speed digital private line services, and facilities-based local
services outside of its current
35
<PAGE> 38
franchise areas in competition with other LECs. On February 23, 1996, the CPUC
approved the Company's request to provide resale-based local services outside of
its current franchise areas. In addition, the CPUC adopted additional local
competition rules addressing interconnection terms and conditions, joint
provisioning of access services, information-mass announcement services and
additional intercompany arrangements.
Evidentiary hearings were held in the first quarter of 1996 to address whether
the CPUC's local competition rules had changed the CPUC's regulatory structure
so drastically that they violated their obligation to ensure the Company an
opportunity to earn a fair return on investment and a fair opportunity to
recover invested capital. On April 17, 1996, the Company filed a petition to
reopen LEC franchise impact hearings for the limited purpose of submitting
additional evidence quantifying the financial impact the Company will suffer
under the resale and pricing flexibility rules recently adopted by the CPUC. On
September 20, 1996, the CPUC issued a decision which concluded that the CPUC
could not determine if its recently adopted local competition rules impaired the
Company's ability to earn a fair return on investment and recover invested
capital. In response to this decision, the Company was allowed to file, no
earlier than January 1, 1997, an application to provide additional evidence
supporting its impairment and also recommend alternative recovery methods. The
Company provided evidence supporting the fact that the CPUC's new regulatory
program, combined with the NRF, established depreciation methods that adversely
affected the Company's opportunity to earn a fair return on its assets in a
competitive environment. On October 17, 1997, the Company and the Office of
Ratepayer Advocates reached an agreement on the appropriate depreciation lives
to be used for ratemaking purposes.
Effective March 31, 1996, the CPUC approved rules permitting local resale
competition. The CPUC required the Company to provide wholesale discounts of 7%
on basic residential service and 12% on toll and business services to future
resale competitors. On April 12, 1996, the Company filed an Application for
Rehearing of the resale decision, which the CPUC denied on April 23, 1997.
However, the CPUC granted competitive LECs a rehearing concerning the interim
discount rate for residential service. The CPUC determined that the record
supports the use of avoided cost wholesale discounts of 12% rather than 7% for
the Company for residential services. The CPUC determined that no further
proceedings are necessary, as the existing evidentiary record, the application
for rehearings, and any responses to it provide an adequate basis for its order
on rehearing.
On May 1, 1996, the Company provided the CPUC with service category specific
cost studies for resale services in the CPUC's unbundling proceedings. On
January 24, 1997, an Administrative Law Judge (ALJ) ruling was issued setting
forth a schedule for submission of permanent resale rate proposals and avoided
costs models. The Company submitted its resale pricing proposal and avoided cost
model on April 14, 1997. A final decision adopting permanent wholesale rates for
resold services is expected in the first half of 1998.
On January 13, 1997, the CPUC issued its decision in the Company's arbitration
with AT&T to determine interconnection, resale and unbundling terms and
conditions. The interim discount rate for the Company's resold services was set
at 12%. On January 23, 1997, an arbitration agreement conforming to this
decision was executed under protest. Also on January 23, 1997, the CPUC issued
its decision in the Company's arbitration with MCI reaffirming the rate
established in the AT&T proceeding.
The Company filed suit on January 14, 1997 in U.S. District Court seeking
judicial review of the CPUC's final arbitration order in the AT&T proceeding,
pursuant to Section 252 of the Telecommunications Act. The Company's suit
focused on various aspects of the decision including: rates for UNEs; rate
arbitrage opportunities created by the decision for AT&T; unbundled rate
elements which do not allow recovery of actual costs; collocation requirements;
rules for reservations of pole and duct space; and imposition of contractual
terms not before the CPUC for arbitration. On January 24, 1997, a similar suit
was filed requesting review of the CPUC's final order in the MCI arbitration.
The Company requested a review of the same issues as in the AT&T suit except for
the issue of collocation which was not included in the MCI review request. On
March 18, 1997, the CPUC issued a decision granting Sprint's request to adopt
the AT&T agreement pursuant to Section 252 (I) of the Telecommunications Act.
36
<PAGE> 39
On May 17, 1996, the CPUC consolidated a joint petition filed by AT&T, MCI,
Sprint and the California Association of Long Distance Carriers (CALTEL) and a
motion by Pacific Bell. The consolidated filing requested a procedural order
requiring the Company to initiate immediate implementation of intraLATA equal
access and pre-subscription rulings as a result of the Telecommunications Act.
In July 1996, the Company received "provisional" authority to begin converting
its central offices to intraLATA equal access. The Company completed conversion
of its central offices on July 8, 1997.
Open Access and Network Architecture Development (OANAD) Proceeding
On June 18, 1997, a ruling was issued suspending the schedule for supplementary
pricing testimony associated with unbundled network elements (UNEs). Specific
issues to be addressed included: 1) what constituted a reasonable markup over
costs for the UNEs; 2) special pricing issues for the additional FCC UNEs; and
3) how to deal with arbitrage between rates for rebundled network elements and
wholesale services. A new schedule will be set when the CPUC determines when the
interim costing order for Pacific Bell will be issued.
On September 15, 1997, the Company submitted cost studies for UNEs and retail
services. A final order on the Company's UNE costs is anticipated in June 1998
and a final order on UNE prices is anticipated in late 1998.
In a separate phase of the OANAD proceeding, the CPUC will allow for comments on
parties' Operational Support Systems (OSS) cost studies which were submitted in
September 1997. The Company expects to file a pricing proposal for OSS in March
1998 along with testimony regarding what constitutes a "reasonable markup" for
UNEs, arbitrage, and price floor determinations. A final order on these matters
is expected in late 1998.
In October 1997, in another phase of the OANAD, the Company submitted testimony
regarding the proper avoided cost model and the resulting permanent resale
discount. Hearings were held November 12 through December 9, 1997. Eight parties
submitted testimony and four avoided cost models will be subject to review. The
CPUC's goal is to select one model to determine the proper resale discount. A
final order is anticipated during the third quarter of 1998.
Merger
In March 1991, the merger of the Company's parent, GTE, and Contel Corporation
(Contel) was consummated. In a decision issued on March 13, 1991, the CPUC
approved a stipulation agreement which tentatively approved the merger of GTE
and Contel. The decision also established a second phase of the proceeding in
which GTE was directed to show that the merger met certain California statutory
requirements. GTE was also ordered to submit a plan for the merger of Contel of
California, Inc. (Contel California) into the Company. On September 10, 1992,
the Company and Contel California joined with GTE and Contel in filing a
comprehensive plan with the CPUC to merge Contel California into the Company
(the Merger).
On December 23, 1993, an ALJ issued a proposed Phase II order approving the
Merger. The proposed order added a third phase to the Merger proceeding in which
the issues of a start-up revenue requirement for Contel California's pre-merger
operations and rate integration of the respective company tariffs would be
considered.
On April 20, 1994, the CPUC issued a decision to approve the Merger. The
decision required the merging companies to flow through to their ratepayers all
of the estimated savings that would be produced from the Merger. This flow
through requirement was based on the CPUC's interpretation of certain statutory
requirements. The CPUC, however, provided the parties with the opportunity to
supplement the evidentiary record to show why the estimated merger savings
should be apportioned between ratepayers and shareholders. The Company and other
interested parties filed reports and comments pursuant to this proceeding. On
October 5, 1995, the Governor of the State of California signed a law which
clarified the authority of the CPUC to allocate utility merger benefits between
ratepayers and shareholders, with not less than 50% going to ratepayers.
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<PAGE> 40
The CPUC granted final approval to Phase II of the Merger proceedings on April
10, 1996 and directed the initiation of Phase III to address Contel California's
pre-merger start-up revenue requirement and consider how to integrate the rates
of the merged entities. As part of the order, the CPUC ordered $69.7 million of
merger savings to be returned to the ratepayers of both companies, which
represented half of the total savings expected to be realized by the Merger over
a five-year period. The Company received approval to return these savings to
local, toll and access customers beginning in mid-1996. The Merger was completed
on December 31, 1996.
On December 6, 1996, the Company filed the Phase III start-up revenue
requirement and rate integration proposal for the former Contel California
service territories. On December 16, 1997 the CPUC approved a stipulation
agreement which incorporates the remaining merger savings into the Company's
prospective rates.
Merger applications were also filed with the Arizona Corporation Commission
(ACC) on October 4, 1993 and the Nevada Public Service Commission (NPSC) on
April 2, 1993. These applications were approved during 1994 but were made
subject to final approval in California, which was granted in April 1996. Contel
California is now part of GTE California Incorporated and operates in California
and Arizona under that name. The Nevada Company does business as "GTE of
Nevada."
INTERSTATE SERVICES
Much of the regulatory and legislative activity that occurred in the United
States in 1997 was a direct result of the Telecommunications Act of 1996 (the
Telecommunications Act) adopted by Congress. The Telecommunications Act is
intended to promote competition in all sectors of the telecommunications
marketplace while preserving and advancing universal telephone service.
In July 1997, the U.S. Court of Appeals for the Eighth Circuit (Eighth Circuit)
released its decision on the challenge filed in 1996 by the Company's parent,
GTE, and numerous other parties to rules developed by the FCC to implement the
interconnection provisions of the Telecommunications Act. The Telecommunications
Act required LECs to make their retail services and the underlying network
elements available to competitors. The FCC required that prices for both resold
services and network elements be set using a methodology created by the FCC. The
court challenge asserted the FCC's rules were inconsistent with the
Telecommunications Act. The July 1997 court decision found that the FCC
overstepped its authority in a number of areas and upheld GTE's position that
state regulatory agencies bear the primary responsibility for determining the
prices which competing firms must pay when interconnecting their networks. On
January 26, 1998, the U.S. Supreme Court announced that it would review this
decision. Oral argument in the Supreme Court is expected to take place in
October 1998, with a final decision likely to be issued no later than June 1999.
In May 1997, the FCC released two new major decisions related to implementation
of the Telecommunications Act's provisions - the universal service and access
charge reform orders. The universal service order established the support
mechanisms to ensure continued availability of affordable local telephone
service and created new programs to provide discounted telecommunications
services to schools, libraries and rural health care providers. GTE and numerous
other parties have challenged the FCC's decision before the U.S. Court of
Appeals for the Fifth Circuit on the grounds that the FCC did not follow the
requirements of the Telecommunications Act to develop a sufficient, explicit and
competitively neutral universal service program. A decision is expected in 1998.
The FCC access charge reform order, also released in May 1997, revamped the rate
structure through which local and long distance companies charge customers for
using the local phone network to make long distance calls. The FCC ordered
decreases for long distance companies to be accomplished by increasing the
access charges for business and residential customers with more than one phone
line. GTE and numerous other parties also challenged
38
<PAGE> 41
this decision before the Eighth Circuit based on the belief that the FCC did not
eliminate the universal service subsidies hidden within interstate access
charges as directed by the Telecommunications Act, and that the FCC created
additional subsidy charges paid only by business and multi-line residential
customers. Oral argument has been held and a decision is expected in 1998.
Also in May 1997, the FCC released a decision completing a periodic review of
its price cap regulatory oversight of interstate access charges. GTE and
numerous other LECs have challenged this decision before the Eighth Circuit
based on the belief that the FCC established a fundamentally unfair annual price
reduction formula and required retroactive price reductions. Oral argument has
been held and a decision on this challenge is also expected in 1998.
For the provision of interstate services, the Company operates under the terms
of the FCC's price cap incentive plan. The price cap mechanism serves to limit
the rates a carrier may charge, rather than just regulating the rate of return
which may be achieved. Under this approach, the maximum price that the LEC may
charge is increased or decreased each year by a price index based upon inflation
less a predetermined productivity target. LECs have limited pricing flexibility
provided they do not exceed the allowed price cap.
In the May 1997 order on its price cap triennial review, the FCC revised the
price cap plan for local-exchange carriers by adopting a uniform productivity
factor of 6.0% with an additive consumer productivity dividend of 0.5%. The FCC
also eliminated the sharing requirements of the price cap rules.
The Company filed interstate access revisions during 1997 that became effective
June 3, 1997 and July 1, 1997. Overall, these filings resulted in a net annual
price reduction of $36.9 million. On December 1, 1997, the FCC issued an Order
to file revised access rates effective January 1, 1998, which resulted in
additional interstate access charge reductions of approximately $10 million. In
1997, the FCC also ordered significant changes that altered the structure of
access charges collected by the Company, effective January 1, 1998. Generally,
the FCC reduced and restructured the per minute charges paid by long distance
carriers and implemented new per line charges. The FCC also created an access
charge structure that resulted in different access charges for residential
primary and secondary lines and single line and multi-line business lines. In
aggregate, the reductions in usage sensitive access charges of $35.1 million
paid by long distance carriers were partially offset by $30 million of new per
line charges and charges paid by end-users.
On June 4, 1996, the FCC issued the first Report and Order implementing Section
276 of the Telecommunications Act. As part of the overall goal of promoting
competition among payphone service providers (PSPs), this order mandated
compensation to all PSPs for all calls originating from payphones, including
"dial-around" access calls and toll-free subscriber calls for which PSPs were
not previously compensated. This compensation was to occur in two separate
phases. During phase one, from April 15, 1997 through October 6, 1997, PSPs were
to be paid a monthly, flat-rate compensation from interexchange carriers (IXCs).
During phase two, beginning October 7, 1997, PSPs were to be compensated on a
per-call basis, with the prevailing local coin rate of 35 cents established as
the default rate.
On July 19, 1997, the U.S. Court of Appeals in Washington, D.C. vacated the
FCC's directive concerning per-call compensation, stating that the FCC had not
shown that the 35 cent rate was a reasonable surrogate for fair compensation.
The court also set aside the FCC's flat-rate compensation mandate. Subsequently,
on October 9, 1997, the FCC issued a second Report and Order to address some of
the issues vacated by the court. In this second order, the FCC established a new
per-call rate of 28.4 cents for phase two compensation that all PSPs were
eligible to receive beginning October 9, 1997. The FCC tentatively concluded
that this per-call rate should also be used to calculate phase one compensation.
The Company has recorded approximately $14.3 million of payphone revenues
associated with the October 9, 1997 FCC order. It is likely that the phase one
compensation directive will be revisited in a subsequent order.
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<PAGE> 42
12. COMMITMENTS AND CONTINGENCIES
The Company has noncancelable leases covering certain buildings, office space
and equipment. Rental expense was $43.1 million, $40.9 million, and $30.6
million in 1997-1995, respectively. Minimum rental commitments for noncancelable
leases through 2002 do not exceed $13.5 million annually and aggregate $5.5
million thereafter.
The Company is subject to a number of proceedings arising out of the conduct of
its business, including those relating to regulatory actions, commercial
transactions and environmental, safety and health matters. Management believes
that the ultimate resolution of these matters will not have a material adverse
effect on the results of operations or the financial position of the Company.
Recent judicial and regulatory developments, as well as the pace of
technological change, have continued to influence industry trends, including
accelerating and expanding the level of competition. As a result, the Company's
operations face increasing competition in virtually all aspects of its business.
The Company supports greater competition in telecommunications, provided that,
overall, the actions to eliminate existing legal and regulatory barriers allow
an opportunity for all service providers to participate equally in a competitive
marketplace under comparable conditions.
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<PAGE> 43
13. QUARTERLY FINANCIAL DATA (UNAUDITED)
Summarized 1997 and 1996 quarterly financial data is as follows:
<TABLE>
<CAPTION>
Revenues Operating Net
and Sales Income Income
---------- ---------- ----------
(Thousands of Dollars)
<S> <C> <C> <C>
1997
First Quarter $ 781,082 $ 240,964 $ 128,297
Second Quarter 809,852 215,187 117,462
Third Quarter (a) 821,301 306,371 170,797
Fourth Quarter (a) 910,201 373,370 226,208
---------- ---------- ----------
Total $3,322,436 $1,135,892 $ 642,764
========== ========== ==========
1996
First Quarter $ 747,799 $ 181,079 $ 93,037
Second Quarter 778,746 192,137 97,415
Third Quarter 772,425 256,000 143,114
Fourth Quarter 842,196 313,398 182,272
---------- ---------- ----------
Total $3,141,166 $ 942,614 $ 515,838
========== ========== ==========
</TABLE>
(a) Third and fourth quarter 1997 operating income includes the effects of a
reduction to depreciation rates to reflect higher net salvage values related
to certain of its telephone plant and equipment.
41
<PAGE> 44
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Shareholders of
GTE California Incorporated:
We have audited the accompanying consolidated balance sheets of GTE California
Incorporated (a California corporation and wholly-owned subsidiary of GTE
Corporation) and subsidiary as of December 31, 1997 and 1996, and the related
consolidated statements of income, shareholders' equity and cash flows for each
of the three years in the period ended December 31, 1997, as set forth on pages
17 through 20 and Schedule II of this report. These financial statements and the
schedule and exhibit referred to below are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements and the schedule and exhibit 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 financial statements referred to above present fairly, in
all material respects, the financial position of GTE California Incorporated and
subsidiary as of December 31, 1997 and 1996, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 1997, in conformity with generally accepted accounting principles.
As discussed in Note 2 to the consolidated financial statements, in 1995, the
Company discontinued applying the provisions of Statement of Financial
Accounting Standards No. 71, "Accounting for the Effects of Certain Types of
Regulation."
Our audits were made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The supporting schedule and exhibit
listed under Item 14 are presented for purposes of complying with the Securities
and Exchange Commission's rules and are not a required part of the basic
financial statements. The supporting schedule and exhibit have been subjected to
the auditing procedures applied in the audits of the basic financial statements
and, in our opinion, fairly state in all material respects the financial data
required to be set forth therein in relation to the basic financial statements
taken as a whole.
Dallas, Texas ARTHUR ANDERSEN LLP
January 26, 1998
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<PAGE> 45
MANAGEMENT REPORT
To Our Shareholders:
The management of the Company is responsible for the integrity and objectivity
of the financial and operating information contained in this Annual Report on
Form 10-K, including the consolidated financial statements covered by the Report
of Independent Public Accountants. These statements were prepared in conformity
with generally accepted accounting principles and include amounts that are based
on the best estimates and judgments of management.
The Company has a system of internal accounting controls which provides
management with reasonable assurance that transactions are recorded and executed
in accordance with its authorizations, that assets are properly safeguarded and
accounted for, and that financial records are maintained so as to permit
preparation of financial statements in accordance with generally accepted
accounting principles. This system includes written policies and procedures, an
organizational structure that segregates duties, and a comprehensive program of
periodic audits by the internal auditors. The Company has also instituted
policies and guidelines which require employees to maintain the highest level of
ethical standards.
DAVID R. BOWMAN
President
GERALD K. DINSMORE
Senior Vice President - Finance and Planning
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<PAGE> 46
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
None.
44
<PAGE> 47
PART III
Item 10. Directors and Executive Officers of the Registrant
Reference is made to the Registrant's Proxy Statement covering the Annual
Meeting of Shareholders to be held April 8, 1998, pages 3 and 4, which is
incorporated herein by reference. A complete list of executive officers of the
Registrant as of March 1, 1998 is provided below.
There are no family relationships between any of the directors or executive
officers of the Company.
The Company's policies are established not only by the Company's executive
officers, but also by the executive officers of GTE Network Services.
Accordingly, the list below contains the names, ages and positions of the
executive officers of both the Company and GTE Network Services as of March 1,
1998.
45
<PAGE> 48
Identification of Executive Officers
<TABLE>
<CAPTION>
Year Assumed
Present Position
----------------------------
Network the
Name Age Services Company Position
- --------------------------- --------- ------------- ------------- ---------------------------------------------
<S> <C> <C> <C> <C> <C>
John C. Appel (1) 49 1997 -- President of GTE Network Services
-- 1995 Executive Vice President - Network
Operations of the Company
Mary Beth Bardin 43 -- 1995 Vice President - Public Affairs of the
Company
David R. Bowman (2) 54 -- 1997 President of the Company
Gerald K. Dinsmore 48 -- 1993 Senior Vice President - Finance and
Planning of the Company
William M. Edwards, III 49 -- 1993 Vice President - Controller of the Company
Gregory D. Jacobson 46 -- 1994 Treasurer of the Company
Mateland L. Keith, Jr. (3) 55 1997 -- Senior Vice President - Regional Operations
of GTE Network Services
Brad M. Krall 56 1993 1995 Vice President - Centralized Operations of
GTE Network Services and the Company
Robert G. McCoy (4) 53 1997 1997 President - Retail Markets of GTE Network
Services and Vice President - Retail
Markets of the Company
William G. Mundy (5) 48 1997 1998 Vice President and General Counsel of GTE
Network Services and the Company
Barry W. Paulson 46 1996 1996 Vice President - Network Operations
Planning and Support of GTE Network
Services and the Company
Richard L. Schaulin 55 1989 1995 Vice President - Human Resources of GTE
Network Services and the Company
Charles J. Somes 51 -- 1994 Secretary of the Company
Larry J. Sparrow (6) 54 1997 -- President - Wholesale Markets of GTE
Network Services
-- 1995 Vice President - Carrier Markets of the
Company
</TABLE>
(1) John C. Appel was appointed President of GTE Network Services in June 1997
replacing Thomas W. White, who was appointed Senior Executive Vice
President - Market Operations of GTE Service Corporation.
(2) David R. Bowman was appointed President of the Company in July 1997
replacing Mateland L. Keith, Jr.
(3) Mateland L. Keith, Jr. was appointed Senior Vice President - Regional
Operations of GTE Network Services in June 1997, replacing John C. Appel.
(4) Robert G. McCoy was appointed President - Retail Markets of GTE Network
Services and elected Vice President - Retail Markets of the Company in
October 1997 replacing C.F. Bercher, who was appointed and elected
President of GTE Communications Corporation.
(5) William G. Mundy was appointed Vice President and General Counsel of GTE
Network Services in October 1997 and elected Vice President - General
Counsel of the Company in January 1998. Mr. Mundy replaced Richard M.
Cahill, who was appointed Vice President and Associate General Counsel of
GTE Service Corporation.
(6) Larry J. Sparrow was appointed President - Wholesale Markets of GTE Network
Services in June 1997.
Each of these executive officers has been an employee of the Company or an
affiliated company for the last five years. Except for duly elected officers and
directors, no other employees had a significant role in decision making. All
officers are appointed for a term of one year.
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<PAGE> 49
Item 11. Executive Compensation
Reference is made to the Registrant's Proxy Statement covering the Annual
Meeting of Shareholders to be held April 8, 1998, pages 4 to 17, which is
incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Reference is made to the Registrant's Proxy Statement covering the Annual
Meeting of Shareholders to be held April 8, 1998, page 17, which is incorporated
herein by reference.
Item 13. Certain Relationships and Related Transactions
Reference is made to the Registrant's Proxy Statement covering the Annual
Meeting of Shareholders to be held April 8, 1998, pages 3, 4, 17 and 18, which
is incorporated herein by reference.
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<PAGE> 50
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) (1) Financial Statements - See GTE California Incorporated's consolidated
financial statements and report of independent accountants thereon in
the Financial Statements section included elsewhere herein.
(2) Financial Statement Schedules - Schedules supporting the consolidated
financial statements for the years ended December 31, 1997-1995 (as
required):
II - Valuation and Qualifying Accounts
Note: Schedules other than the one listed above are omitted as not
applicable, not required, or the information is included in the
consolidated financial statements or notes thereto.
(3) Exhibits - Included in this report or incorporated by reference.
2.1* Agreement of Merger, dated September 10, 1992 between GTE
California Incorporated and Contel of California, Inc.
(Exhibit 2.1 of the 1993 Form 10-K, File No. 1-6417)
3.1* Articles of Incorporation and Bylaws (Exhibit 3 of the 1988
Form 10-K, File No. 1-6417)
3.2 Certificate of Amendment of the Articles of Incorporation
dated March 28, 1998
4.1* Indenture dated as of December 1, 1993 between GTE California
Incorporated and Bank of America National Trust and Savings
Association, as Trustee, dated as of December 1, 1993 (Exhibit
4.1 of the Company's Registration Statement on Form S-3, File
No. 33-51541, filed with the Securities and Exchange
Commission on December 17, 1993)
4.2* First Supplemental Indenture dated as of April 15, 1996
between GTE California Incorporated and First Trust of
California, National Association, as Trustee (as successor
trustee to Bank of America National Trust and Savings
Association) (Exhibit 4.3 of the Company's Report on Form 8-K,
dated April 23, 1996)
10.1* Material Contracts - Agreements between GTE and Certain
Executive Officers (Exhibit 10 of the 1995 Form 10-K, File No.
1-6417)
10.2 Material Contracts - Separation Agreement between GTE and
Richard M. Cahill
12 Statements re: Calculation of the Consolidated Ratio of
Earnings to Fixed Charges
23 Consent of Independent Public Accountants
26* Revised Form of Invitation for Bids pertaining to Registration
Statements on Form S-3 (Exhibit 26.1 of the Company's
Registration Statement on Form S-3, File No. 333-46677)
27 Financial Data Schedule
(b) Reports on Form 8-K
No reports on Form 8-K were filed during the fourth quarter of 1997.
* Denotes exhibits incorporated herein by reference to previous filings with
the Securities and Exchange Commission as designated.
48
<PAGE> 51
GTE California Incorporated and Subsidiary
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
Years Ended December 31, 1997, 1996 and 1995
(Thousands of Dollars)
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------------
Column A Column B Column C Column D Column E
- ------------------------------------------------------------------------------------------------------------------
Additions
--------------------------------
Charged Deductions
Balance at Charged (Credited) to from Balance at
Description Beginning to Other Reserves Close of
of Year Income Accounts (Note 1) Year
- ------------------------------------------------------------------------------------------------------------------
Allowance for uncollectible accounts
for the years ended:
<S> <C> <C> <C> <C> <C> <C>
December 31, 1997 $ 72,010 $ 71,263 $ 70,655 (2) $ 148,759 $ 65,169
=========== =========== =========== =========== ===========
December 31, 1996 $ 61,705 $ 69,439 $ 73,951 (2) $ 133,085 $ 72,010
=========== =========== =========== =========== ===========
December 31, 1995 $ 42,060 $ 84,365 $ 87,127 (2) $ 151,847 $ 61,705
=========== =========== =========== =========== ===========
</TABLE>
Accrued restructuring costs for the years ended:
<TABLE>
<CAPTION>
<S> <C> <C> <C> <C> <C> <C>
December 31, 1996 $ 224,885 $ -- $ (54,899)(3) $ 169,986 $ --
=========== =========== =========== =========== ===========
December 31, 1995 $ 354,088 $ -- $ -- $ 129,203 $ 224,885
=========== =========== =========== =========== ===========
</TABLE>
NOTES:
(1) Charges for which reserve was created.
(2) Recoveries of previously written-off amounts.
(3) Represents amounts necessary to satisfy commitments related to the
re-engineering program that have been reclassified to accounts payable and
accrued expenses.
49
<PAGE> 52
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.
GTE CALIFORNIA INCORPORATED
--------------------------------------------
(Registrant)
Date March 27, 1998
----------------- By /s/ David R. Bowman
--------------------------------------------
David R. Bowman
President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
is signed below by the following persons on behalf of the registrant and in the
capacities and on the dates indicated.
<TABLE>
<CAPTION>
<S> <C> <C>
/s/ David R. Bowman President March 27, 1998
- ---------------------------- (Principal Executive Officer)
David R. Bowman
/s/ Gerald K. Dinsmore Senior Vice President - Finance and Planning March 27, 1998
- ---------------------------- (Principal Financial Officer)
Gerald K. Dinsmore
/s/ William M. Edwards, III Vice President - Controller March 27, 1998
- ---------------------------- (Principal Accounting Officer)
William M. Edwards, III
/s/ John C. Appel Director March 27, 1998
- ----------------------------
John C. Appel
/s/ Mateland L. Keith, Jr. Director March 27, 1998
- ----------------------------
Mateland L. Keith, Jr.
/s/ Lawrence R. Whitman Director March 27, 1998
- ----------------------------
Lawrence R. Whitman
/s/ William G. Mundy Director March 27, 1998
- ----------------------------
William G. Mundy
</TABLE>
50
<PAGE> 53
EXHIBIT INDEX
<TABLE>
<CAPTION>
Exhibit
Number Description
<S> <C>
3.2 Certificate of Amendment of the Articles of
Incorporation dated March 28, 1998
10.2 Material Contracts - Separation Agreement between GTE
and Richard M. Cahill
12 Statements re: Calculation of the Consolidated Ratio of
Earnings to Fixed Charges
23 Consent of Independent Public Accountants
27 Financial Data Schedule
</TABLE>
<PAGE> 1
EXHIBIT 3.2
CERTIFICATE OF AMENDMENT OF
ARTICLES OF INCORPORATION
OF
GTE CALIFORNIA INCORPORATED
William G. Mundy and Charles J. Somes certify that:
1. They are the Vice President-General Counsel and the Secretary,
respectively, of GTE California Incorporated, a California corporation.
2. The Board of Directors of GTE California Incorporated has approved a
resolution providing that the Articles of Incorporation of GTE California
Incorporated shall be amended by deleting the provisions contained in Article
FIFTH and inserting in lieu thereof the following:
FIFTH: The corporation elects to be governed by the
Corporation Code as amended by the Act of the California Legislature
1975-1976 Regular Session, effective January 1, 1977.
3. The foregoing amendment was approved by the Board of Directors
acting alone pursuant to Section 2302 of the California General Corporation Law.
Each of the undersigned declares under penalty of perjury that the
statements contained in the foregoing Certificate of Amendment of Articles of
Incorporation are true of their own knowledge. Executed at Irving, Dallas
County, Texas, on March 23, 1998.
------------------------------
William G. Mundy
Vice President-General Counsel
------------------------------
Charles J. Somes
Secretary
<PAGE> 2
STATE OF TEXAS )
)ss.:
COUNTY OF DALLAS )
William G. Mundy and Charles J. Somes being by me duly sworn, depose
and say: That they are a Vice President and the Secretary, respectively, of GTE
California Incorporated, a California corporation, and that they have read the
foregoing certificate entitled "CERTIFICATE OF AMENDMENT OF ARTICLES OF
INCORPORATION OF GTE CALIFORNIA INCORPORATED" and know the contents thereof and
that the same is true of their own knowledge.
------------------------------
------------------------------
Subscribed and sworn to before me
this 23rd day of March, 1998.
Notary Public in and for said State
<PAGE> 1
Exhibit 10-2
[AS AMENDED JANUARY 23, 1998]
December 24, 1997
Mr. Richard M. Cahill
1158 Hidden Ridge
Apartment 2311
Irving, Texas 75038
Dear Dick:
As we discussed, I want to provide you with an appropriate
transition arrangement prior to your scheduled separation and to enter into a
consulting arrangement with you in accordance with the terms set forth below.
This agreement ("Letter Agreement") supersedes any other agreements you may have
with GTE (as defined below) or may have received from GTE with regard to the
subject matter contained herein, including but not limited to the letter dated
August 13, 1997. The terms of this Letter Agreement are as follows:
A. RESIGNATION FROM EMPLOYMENT
1. RESIGNATION - Effective July 31, 1997, you irrevocably
resign from your position as Vice President and General Counsel - GTE Telephone
Operations. Effective no later than December 31, 1997, you also irrevocably
resign from any officer, director, or other positions you hold for GTE
Corporation or any affiliate of GTE Corporation (collectively referred to in
this Letter Agreement as "GTE") and from any internal or external Boards where
you represent GTE effective as of that date.
2. SPECIAL ASSIGNMENT - From August 1, 1997 through June 30,
1998 ("Special Assignment Period"), you will continue on the GTE Service
Corporation (the "Company") payroll as an active employee in your new special
assignment as Vice President and Associate General Counsel, reporting to me or
my successor or designee. During the Special Assignment Period, you will work on
special projects as assigned by me or my successor or designee. In addition,
during the Special Assignment Period, you will continue to receive your base
salary as in effect on July 31, 1997 and will receive all benefits that active
employees receive, except that your EIP and LTIP participation will be governed
by the terms of this Letter Agreement. Except as otherwise expressly provided
herein, all perquisites provided by the Company will cease at the end of the
Special Assignment Period. In the event the Company offers any new employee
plans, any new, enhanced, or supplemental executive plans, or, except as
expressly provided herein, any new grants, awards, or benefits under existing
executive plans on or after July 31, 1997, you will not participate in such
plans or receive such grants, awards, or benefits. You irrevocably resign from
employment with GTE and the position of Vice President and Associate General
Counsel effective June 30, 1998. During and after the Special Assignment Period,
you will not seek reinstatement, recall, or future or other employment with GTE.
3. SEPARATION BENEFITS - At the conclusion of the Special
Assignment Period, you will separate from employment with the Company and you
will be eligible for separation benefits pursuant to the Company's Involuntary
Separation Program ("ISEP") or its equivalent as then in effect, subject to any
applicable release requirements.
4. EIP AWARDS - You will participate in the Executive
Incentive Plan ("EIP") at a Salary Grade Level 20 for the full 1997 Plan Year
and one half (1/2) of the 1998 Plan Year in accordance
<PAGE> 2
Mr. Richard M. Cahill
December 24, 1997
Page 2
with the terms of the EIP. Your 1997 EIP award and pro-rated 1998 EIP award will
be the same as the average EIP rating for the Company's Legal Department for
each such year. You will not participate in EIP for the 1999 Plan Year or
thereafter. All EIP awards will be subject to approval by the GTE Corporation
Executive Compensation and Organizational Structure Committee ("ECC"). The EIP
awards will be payable at the same time EIP awards are payable to other EIP
participants. You will be eligible to defer, and thus receive a match pursuant
to the Equity Participation Program ("EPP"), only those of your EIP awards
payable while you are still employed by GTE (in this case, only the 1997 Plan
Year award). Note that the ECC reserves the right not to approve EIP awards in
1997 and/or 1998, and, if so, you will be treated in the same manner as other
executives at your salary level.
5. LTIP - Subject to ECC approval, in the spring of 1998, you
will be eligible for a standard grant of Stock Options, and you also will be
eligible for a Performance Bonus Award for the 1998-2000 award cycle under the
GTE Long-Term Incentive Plan ("LTIP"). You will not receive grants of Stock
Options or Performance Bonus Awards under LTIP after the initial spring of 1998
grants. Your outstanding Stock Options will vest immediately upon your
separation at the end of the Special Assignment Period (subject to applicable
release requirements), and you will have until the earlier of: (i) five years
from your date of separation or (ii) the expiration date of the Option to
exercise those Stock Options ("Special Exercise Period"). The Special Assignment
Period will be counted for prorating your existing Performance Bonus Awards. As
such, your participation in LTIP Performance Bonus Cycles will be as follows:
1995-1997 (Full Participation), 1996-1998 Cycle (30/36 Participation), 1997-99
(18/36 Participation), and 1998-2000 (6/36 Participation). You will not receive
any Performance Bonus Award in 1999 or thereafter. Achievement of targets,
determination of the amount of Performance Bonus Awards, and determination of
the number of shares covered by your grant of Stock Options will be established
in the sole discretion of the ECC. Each Performance Bonus Award will be payable
at the same time LTIP awards are payable to other LTIP participants. You will be
eligible to defer, and thus receive a match pursuant to the EPP, only those of
your LTIP Performance Bonus Awards payable while you are still employed by GTE
(in this case, only the 1995-97 Performance Bonus Award). For purposes of this
Letter Agreement, your 1998 Stock Option and Performance Bonus Award grants are
collectively referred to as "LTIP Grants." Note that the ECC reserves the right
not to make Stock Option or Performance Bonus Awards in 1998, and, if so, you
will be treated in the same manner as other executives at your salary level.
6. RELEASE - In order to receive full Separation Benefits
(including but not limited to full ISEP and the Special Exercise Period
described in paragraph 5 above) and the 1998 EIP Award, and in order for your
participation in the LTIP Performance Bonus Award Cycles to be as described in
paragraph 5 above, you will be required to sign a release upon the expiration of
the Special Assignment Period.
7. VACATION - At the end of the Special Assignment Period, you
may elect to take the remainder of your banked/accrued but unused vacation in a
lump sum. In the alternative, you may elect to use your banked/accrued but
unused vacation to extend your last day as an active employee on payroll;
provided that any such extension shall not affect the payment or pro-ration of
your EIP and LTIP awards as set forth in paragraphs 4 and 5 above.
8. MISCELLANEOUS BENEFITS - During the Special Assignment
Period, you will be entitled to the same level of executive perquisites as other
similarly situated executives in Dallas are accorded, and you will also be
entitled to office space at a location to be determined by GTE in its sole
discretion. After the end of the Special Assignment Period, the Company will pay
for tax preparation services for you for the 1998 calendar year, which would be
paid in 1999, up to a maximum of $3,000. The benefits
<PAGE> 3
Mr. Richard M. Cahill
December 24, 1997
Page 3
described in this paragraph A.8 are collectively referred to in this Letter
Agreement as miscellaneous benefits ("Miscellaneous Benefits").
9. CIRCUMSTANCES WHEN ABOVE PAYMENTS/BENEFITS WILL NOT BE PAID
- - In the event any of the following occur prior to the expiration of the Special
Assignment Period (or if applicable after the expiration of the Special
Assignment Period), you will cease to receive any further salary, the Special
Exercise Period will not apply, you will not receive any EIP Payments, LTIP
Grants, payment of Performance Bonus Awards, Separation Benefits (including but
not limited to ISEP), Miscellaneous Benefits, or any other benefits or payments,
and you will not be required to perform, and will not be paid for, any
consulting services:
o you voluntarily terminate your employment for any reason;
o your employment is terminated for cause as determined by me or
my successor or designee; or
o you violate any of the terms of the attached Separation
Agreement and General Release (including but not limited to
the provisions regarding confidentiality and
non-embarrassment) or the non-compete provisions of paragraphs
A.10 and B.7 of this Letter Agreement.
In the event that you die or become disabled (within the
meaning of GTE's Long-Term Disability Plan) during the Special Assignment
Period, all further salary will cease, your eligibility for the Miscellaneous
Benefits will cease, your EIP Payments and Performance Bonus Awards will be
pro-rated to the date of your death or disability (but will not be paid until
the date they otherwise would have been paid had you not died or become
disabled), the Special Exercise Period will not apply, your Separation Benefits
(including but not limited to ISEP) will be treated in accordance with the terms
of the relevant plans or policies, your eligibility for the LTIP Grants will be
determined in accordance with the relevant plan provisions, and you will not be
required to perform, and will not be paid for, any consulting services.
10. MISCELLANEOUS - Since you will remain a GTE employee until
the end of the Special Assignment Period, you will remain subject to all GTE
policies, including but not limited to GTE's policies relating to
non-competition and disclosure of confidential information. You shall be
responsible for the payment of all applicable taxes relating to the benefits
described in Paragraph A of this Letter Agreement, including but not limited to
taxes as a result of ISEP or any ISEP equivalent payment.
B. CONSULTING ARRANGEMENT
1. CONSULTING PERIOD. You will serve as a non-employee
consultant for the period July 1, 1998 through June 30, 2000 (the "Consulting
Period"). During the Consulting Period and thereafter, you will not be entitled
to any benefits provided by GTE to its active employees and, by signing below,
you acknowledge and agree that you shall not be entitled to any such benefits
and effectively waive participation in any such benefits.
2. CONSULTING SERVICES. During the Consulting Period, you will
perform special projects as assigned by me or my successor or designee. All
required services will be performed by you. You will be free at all times to
arrange the time and manner of performance of the consulting services to be
rendered hereunder and will not be expected to maintain or observe a schedule of
duties or assignments. You will not report to the Company on any regular basis,
but will work as you may independently decide. You will not be required to
provide consulting services to
<PAGE> 4
Mr. Richard M. Cahill
December 24, 1997
Page 4
the Company for more than 30% of the regularly scheduled working days in any
calendar year during the term of this Letter Agreement. The Company is entering
into this arrangement with the understanding that the performance of your
services will be subject to the non-compete provisions of paragraph B.7 below.
During the Consulting Period and thereafter, you may, in your discretion,
provide services to others without being constrained by your obligations under
this Letter Agreement, provided only that such services do not prevent you from
providing the consulting services required under this Letter Agreement, and
provided further that such services to others do not cause you to violate your
obligations regarding non-competition, confidentiality, and intellectual
property rights as described in this Letter Agreement and the attached
Separation Agreement and General Release.
3. COMPANY CONTACT. I or my successor or designee will be your
contact at the Company during the Consulting Period and will be responsible for
coordinating your assignments. All services must be performed to my satisfaction
or to the satisfaction of my successor or designee.
4. CONSULTING FEES. You will be paid $164,000 per year for
your consulting services during the Consulting Period, payable in equal
quarterly installments of $41,000 in arrears. You also will be entitled to be
reimbursed for reasonable travel expenses you incur in the performance of
consulting services for the Company as approved by me or my successor or
designee. Please submit quarterly invoices to me or to my successor or designee
for payment. You will be paid the full amount of your annual consulting fees
during the Consulting Period whether or not you actually perform consulting
services for the Company.
5. PERFORMANCE OF CONSULTING SERVICES. As a non-employee
consultant, the Company does not retain or exercise the right to direct,
control, or supervise you as to the details and means by which the consulting
services contracted for are accomplished. You and the Company agree that, as a
non-employee consultant, you will serve as an independent contractor in the
performance of your duties under this Letter Agreement. As a result, you will be
responsible for payment of all taxes and expenses incurred arising out of the
payments under the Letter Agreement for your activities as a non-employee
consultant in accordance with this Letter Agreement, including but not limited
to, federal and state income taxes, social security taxes, unemployment
insurance taxes, and any other taxes or business license fees as required.
Moreover, you agree that, except as authorized by the Company, you will not
represent directly or indirectly that you are an agent or legal representative
of the Company, nor will you incur any liabilities or obligations of any kind in
the name of or on behalf of the Company, other than those specifically made or
approved as part of this Letter Agreement.
6. OFFICE SPACE. You are responsible for securing your own
office space, office equipment, and clerical support services during the
Consulting Period, but visiting office space and appropriate office equipment
will be provided to you if you are meeting with individuals at GTE's offices.
7. NON-COMPETE PROVISIONS. As a non-employee consultant, you
agree that, among other policies and guidelines, the GTE Conflict of Interest
Guidelines and the Business and Scientific Information Policy or replacement
policies will apply to you. In addition, you agree not to engage directly or
indirectly in a Competitive Business during the Consulting Period, unless the
Company approves such an arrangement in writing in advance. For purposes of this
paragraph B.7, a
<PAGE> 5
Mr. Richard M. Cahill
December 24, 1997
Page 5
"Competitive Business" is any inter-exchange carrier (such as MCI Communications
Corporation, Sprint Corporation, AT&T Corp., WorldCom, Inc., LCI International,
Inc., and Cable & Wireless PLC) and its Affiliates, any local exchange carrier
(such as any Regional Bell Operating Company ("RBOC") and British
Telecommunications PLC) and its Affiliates, or any of the following companies
and their Affiliates: Digex, Incorporated, Qwest Communications International
Inc., Netscape Communications Corporation, Cisco Systems, Inc., Ascend
Communications, Inc., Airtouch Communications, Inc., NEXTEL Communications,
Inc., and Teleport Communications Group, Inc. An Affiliate for purposes of this
paragraph B.7 shall mean any entity, whether or not incorporated, (i) in which a
Competitive Business has equity ownership of 10% or more, or (ii) which provides
goods or services (including but not limited to software, processing, switching,
marketing, or consulting) to a Competitive Business to materially compete with
GTE.
You acknowledge that the obligations imposed on you pursuant
to this paragraph B.7 are reasonable in their nature, scope and duration and
will not deprive you of the opportunity to earn a livelihood. During and after
the Consulting Period, you also will remain subject to those GTE policies which
apply following termination of service.
Subject to paragraph B.8, in consideration of your compliance
with the provisions of this paragraph B.7, the Company will pay to you $25,000
per quarter payable in arrears, commencing with the quarter beginning July 1998
and ending with the quarter ending June 2000 (or such later date as the parties
may agree in writing). If you fail to comply with the provisions of this
paragraph B.7, you will forfeit your right to receive the payments described in
this paragraph B.7.
8. EARLY TERMINATION OF CONSULTING SERVICES. In the event any
of the following occurs during the Consulting Period, this Letter Agreement will
terminate immediately, and, except as provided in the immediately succeeding
sentence, you will not be entitled to any further payments under paragraphs B.4
or B.7: you violate any of the provisions of this Letter Agreement or the
Separation and General Release referred to below; you die; you become disabled;
or you fail to provide services under this Letter Agreement to the satisfaction
of the Company. Of course you will be entitled to payment of amounts due
pursuant to paragraphs B.4 and B.7 with respect to that portion of the quarter
prior to the termination of your consulting services in an amount equal to the
payment due for the quarter multiplied by a fraction, the numerator of which is
the number of days in the quarter prior to the termination of your consulting
services and the denominator of which is 90.
C. GENERAL PROVISIONS
1. CONFIDENTIALITY. You agree that any information you receive
or acquire during the performance of your obligations in accordance with this
Letter Agreement or have received or acquired from your prior employment with
GTE will be treated by you in the strictest confidence and will not be disclosed
to or used for the benefit of any persons, firms or organizations. This
provision will survive the termination of this Letter Agreement.
2. GTE AS EXCLUSIVE OWNER OF WORK PRODUCT. You agree that GTE
will be the exclusive owner of all works conceived or first produced by you
within the scope of your prior employment with GTE or pursuant to or related to
this Letter Agreement and your services as a consultant, including that GTE will
be the exclusive owner of all copyrights and other intellectual property rights
in or based upon such works. With regard to such copyrightable works, you agree
<PAGE> 6
Mr. Richard M. Cahill
December 24, 1997
Page 6
that GTE will be the "person for whom the work is prepared" and that GTE will be
the exclusive work-for-hire author under the copyright laws of the United
States. In addition, you agree to and to hereby assign exclusively to GTE such
works, copyrights and other intellectual property rights. This provision will
survive the termination of this Letter Agreement.
The arrangements described above are contingent upon your
executing the attached Separation Agreement and General Release (the "Release").
As you know, you were given a version of this Letter Agreement dated October 16,
1997 and, therefore, you have been given twenty-one days to sign the Release
(with a seven-day period to revoke) as required by law. Although not legally
required, we have determined to give you an additional twenty-one day period
commencing as of December 24, 1997 (with a seven-day period to revoke) to sign
the Release. Since the December 24, 1997 version of this Letter Agreement has
been modified based on requests you have made, you continue to have twenty-one
days from December 24, 1997 to sign the Release (with a seven-day period to
revoke). If you fail to sign the Release or if you sign and revoke the Release
within seven days of signing it, this Letter Agreement shall be void, and you
will not receive any of the benefits described in this Letter Agreement.
Dick, your past contributions to GTE are appreciated by me and
the entire GTE management team.
Sincerely,
William P. Barr
Executive Vice President -
Government and Regulatory Advocacy,
General Counsel
I have read, understand, and agree to the terms of this Letter Agreement
including the attached Separation Agreement and General Release.
- ---------------------- ---------------
Richard M. Cahill Date
<PAGE> 7
SEPARATION AGREEMENT AND GENERAL RELEASE
This Agreement is by and between GTE Service Corporation (the
"Company") and Richard M. Cahill ("Cahill").
PART I
In consideration of the provisions in Part II, the Company agrees as
follows:
1. The Company will provide Cahill with the benefits described in
William P. Barr's letter dated December 24, 1997, as amended January 9, 1998
(the "December 24, 1997 Letter"). (The December 24, 1997 Letter and this
Separation Agreement and General Release are collectively referred to as the
"Agreement").
2. By making this Agreement, the Company does not admit that it has
done anything wrong, and the Company specifically states that it has not
committed any tort, breach of contract, or violation of any federal, state, or
local statute or ordinance.
PART II
In consideration of the provisions in Part I, Cahill agrees as follows:
1. Effective July 31, 1997, Cahill irrevocably resigns from his
position as Vice President and General Counsel - GTE Telephone Operations, from
any officer, director, or other positions he holds for GTE Corporation or any of
its affiliates, and from any internal or external Boards where he represents GTE
(as described in paragraph 3 below), at which time Cahill will commence the
Special Assignment described in the December 24, 1997 Letter. Cahill irrevocably
resigns from employment with GTE effective at the end of the Special Assignment
Period described in the December 24, 1997 Letter. Cahill agrees not to seek
reinstatement, recall, or future employment with GTE after the end of the
Special Assignment Period.
Cahill agrees that GTE retains the right to make future organizational changes,
including but not limited to the right to combine, create, and/or fill
positions.
2. Cahill agrees and understands that the payments and the benefits
described in Part I, paragraph 1 above are more than any payments or benefits
due to him under the Company's policies or practices. Cahill waives and forever
discharges GTE (as described in paragraph 3 below) from any liability to provide
any notice of termination, including but not limited to any notice under the
Worker Adjustment and Retraining Notification Act, or to pay any additional
salary continuance, separation pay, severance pay, retention bonus or pay,
retirement incentive, or payments or benefits arising under any other plan,
policy, practice, or program (offered on a qualified or non-qualified or
voluntary or involuntary basis) which may have been payable as a result of the
termination of his employment, except as provided in paragraph 3 below. Cahill
agrees that, should the Company offer any retirement incentive, early
retirement, or voluntary separation program on or after July 31, 1997, Cahill
shall not be eligible to participate. In addition, Cahill has not relied on any
statement, agreement, or promise of eligibility for any benefits, other than
those set forth in this Agreement.
3. Cahill agrees to release GTE Corporation and any related or
affiliated companies, and any and all current and former directors, employees,
officers, agents, and contractors of these companies, and any and all employee
pension or welfare benefit plans of these companies, including current and
former
<PAGE> 8
trustees and administrators of these plans, (hereinafter GTE Corporation, the
Company, and the other entities and persons referenced above are collectively
referred to in this Separation Agreement and General Release as "GTE") from all
known and unknown claims, charges, or demands Cahill may have based on his
employment with GTE, including a release of any rights or claims Cahill may have
under the Age Discrimination in Employment Act ("ADEA"), which prohibits age
discrimination in employment; Title VII of the Civil Rights Act of 1964, and the
Civil Rights Act of 1991, which prohibit discrimination in employment based on
race, color, sex, religion, and national origin; the Americans with Disabilities
Act, which prohibits discrimination based upon disability; Section 1981 of the
Civil Rights Act of 1866, which prohibits discrimination based on race; the
Employee Retirement Income Security Act, which governs employee benefits; any
state laws against discrimination; or any other federal, state, or local statute
or common law relating to employment. This includes a release by Cahill of any
claims for wrongful discharge, breach of contract, employment-related torts, or
any other claims in any way related to Cahill's employment with GTE.
This release does not include, however, a waiver of any right to vested benefits
under any pension or savings plan, any right to Worker's Compensation, any right
to receive pay for banked and accrued, but unused, vacation, or any right to
unemployment compensation that Cahill may have.
4. Cahill has not filed and promises not to file, or permit to be filed
on his behalf, any lawsuit or complaint against GTE regarding the claims
released in Part II, paragraph 3 above. Cahill also promises to opt out of and
to take such other steps as he has the power to take to disassociate himself
from any class seeking relief against GTE regarding any claims released in Part
II, paragraph 3. If a court, administrative agency, arbitrator, or any other
decision maker with authority awards Cahill money damages or other relief, with
respect to claims released in Part II, paragraph 3, Cahill hereby assigns to the
Company all rights and interest in such money damages and other relief.
5. Cahill agrees not to disclose the terms of this Agreement, that this
Agreement exists, or that he received any payments from the Company to anyone
except his attorney, his financial planner, or his immediate family (spouse,
children, siblings, parents). If he does disclose the terms of this Agreement to
his immediate family, his financial planner, or his attorney, he will advise
them that they must not disclose the terms of this Agreement.
6. Cahill acknowledges that, during the period he has served as an
in-house attorney with GTE, he has had access to confidential information
relating to GTE. Consistent with the Rules of Professional Conduct, Cahill will
not use or disclose any such confidential information without first obtaining
the consent of the Company.
Cahill agrees to comply with the provisions of GTE H.R. Policy 412 (Attachment
I) provided that, in the event of a conflict between Policy 412 and this
Agreement, the terms of this Agreement shall take precedence. Contemporaneously
with the execution of this Agreement, if Cahill has not executed a copy of the
Business and Scientific Information Agreement, Cahill shall do so (Policy
Attachment A). Upon his termination, Cahill shall execute Policy Attachment D.
Cahill further agrees to take no action that would cause GTE (including its
employees, directors, and shareholders) embarrassment or humiliation or
otherwise cause or contribute to GTE (including its employees, directors, and
shareholders) being held in disrepute by the general public or GTE's clients,
shareholders, customers, federal or state regulatory agencies, employees,
agents, officers, or directors.
<PAGE> 9
Cahill will cooperate and make all reasonable efforts to assist the Company in
any investigation of matters involving GTE. Cahill also agrees to testify as a
witness and be available for interviews and to assist GTE in preparation for any
legal proceedings involving GTE in which Cahill has direct knowledge or specific
expertise. Cahill will be compensated appropriately and reimbursed for
reasonable expenses.
Nothing in this Agreement shall be construed to prevent Cahill from giving
compelled truthful testimony before any federal or state agency or in any
judicial proceeding; provided that, in order to permit GTE to seek an injunction
or other judicial relief, he will timely notify GTE in advance of any such
proceeding in which he expects to be called to testify or for which he has
received a subpoena.
7. Cahill acknowledges and agrees that he has not been discriminated
against in any way during his employment with GTE or with regard to his
separation from employment with the Company.
8. Cahill agrees that GTE will be entitled to recover liquidated
damages in the amount of $75,000 if he breaks his promises in Part II,
paragraphs 1-6 of this Agreement. These liquidated damages are based upon the
parties' recognition that damages to GTE due to Cahill's breaking of these
promises are not capable of measurement with any degree of certainty. The amount
specified is not to be considered a penalty, but solely as liquidated damages.
If Cahill breaks his promise in Part II, paragraph 4 and files a lawsuit or
complaint regarding claims Cahill has released, in addition to the liquidated
damages described above, Cahill will pay for all costs incurred by GTE,
including reasonable attorneys' fees, in defending against his claim.
9. Cahill understands that he has been given 21 days to review and
consider this Agreement before signing it. Cahill further understands that he
may use as much of this 21-day period as he wishes prior to signing this
Agreement.
10. Cahill may revoke this Agreement within seven days after he signs
it. If Cahill wishes to revoke this Agreement within this seven-day period,
written notice of revocation should be delivered to the office of Thomas W.
Green, Senior Head of Stamford Transition Team, by the close of business seven
days after Cahill signs the Agreement. This Agreement will not become effective
or enforceable until seven days after Cahill signs it. If Cahill revokes this
Agreement, it will not be effective or enforceable, and he will not receive the
benefits described in Part I, paragraph 1.
11. Cahill agrees that the Company advised Cahill to consult with an
attorney before signing this Agreement.
12. The parties participated jointly in the negotiation of this
Agreement, and each party had the opportunity to obtain the advice of legal
counsel and to review, comment upon, and redraft this Agreement. Accordingly, it
is agreed that no rule of construction shall apply against any party or in favor
of any party, and any uncertainty or ambiguity shall not be interpreted against
any one party and in favor of the other.
13. Cahill and the Company hereby consent that any disputes relating to
this Agreement will be governed by Connecticut law.
<PAGE> 10
14. In the event that any one or more of the provisions contained in
this Agreement shall, for any reason, be held to be invalid, illegal, or
unenforceable in any respect, such invalidity, illegality, or unenforceability
shall not affect any other provision of this Agreement.
15. This Separation Agreement and General Release and the December 24,
1997 Letter constitute the entire Agreement between Cahill and the Company and
shall be binding upon the heirs, successors, and assigns of Cahill and the
Company. No other promises or agreements have been made to Cahill other than
those in this Agreement. Cahill is not relying on any statement, representation,
or warranty that is not contained in this Agreement. Cahill acknowledges that he
has read this Agreement carefully, fully understands the meaning of the terms of
this Agreement, and is signing this Agreement knowingly and voluntarily.
Subscribed and sworn to before -------------------
me this____day of____, 1998. Richard M. Cahill
- ------------------------- -------------------
Notary Public Date
Subscribed and sworn to before
me this____day of____, 1998.
GTE Service Corporation
- ------------------------- -------------------
Notary Public By:
Title:
--------------------
Date
<PAGE> 1
Exhibit 12
GTE California Incorporated and Subsidiary
STATEMENTS OF THE CONSOLIDATED RATIO OF EARNINGS TO FIXED CHARGES
(Thousands of Dollars)
<TABLE>
<CAPTION>
Years Ended December 31,
-------------------------------------------------------------------------------------
1997 1996 1995 1994 1993(a) 1993
---------- ---------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C>
Net earnings available for fixed charges:
Income before extraordinary charges $ 642,764 $ 515,838 $ 342,861 $ 500,286 $ 476,088 $ 148,688
Add - Income tax expense 390,548 329,326 235,534 339,585 312,432 107,932
- Fixed charges 124,303 119,737 133,635 131,761 144,729 144,729
---------- ---------- ---------- ---------- ---------- ----------
Adjusted earnings $1,157,615 $ 964,901 $ 712,030 $ 971,632 $ 933,249 $ 401,349
========== ========== ========== ========== ========== ==========
Fixed charges:
Interest expense $ 109,953 $ 106,112 $ 120,010 $ 115,012 $ 133,214 $ 133,214
Portion of rent expense
representing interest 14,350 13,625 13,625 16,749 11,515 11,515
---------- ---------- ---------- ---------- ---------- ----------
Adjusted fixed charges $ 124,303 $ 119,737 $ 133,635 $ 131,761 $ 144,729 $ 144,729
========== ========== ========== ========== ========== ==========
RATIO OF EARNINGS TO FIXED
CHARGES 9.31 8.06 5.33 7.37 6.45 2.77
</TABLE>
(a) Results for 1993 exclude an after-tax restructuring charge of approximately
$304.4 million for the implementation of a re-engineering plan and a
one-time after-tax charge of approximately $23 million related to the
enhanced early retirement and voluntary separation programs offered to
eligible employees in 1993.
<PAGE> 1
EXHIBIT 23
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
As independent public accountants, we hereby consent to the incorporation of
our report, dated January 26, 1998, on the consolidated financial statements and
supporting schedule of GTE California Incorporated and subsidiary included in
this Form 10-K, into the Registration Statements previously filed on Form S-3
(File Nos. 333-46677 and 333-01001).
ARTHUR ANDERSEN LLP
Dallas, Texas
March 27, 1998
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> DEC-31-1997
<CASH> 9,871
<SECURITIES> 0
<RECEIVABLES> 764,207
<ALLOWANCES> 65,169
<INVENTORY> 51,050
<CURRENT-ASSETS> 795,358
<PP&E> 10,077,872
<DEPRECIATION> 6,278,551
<TOTAL-ASSETS> 5,320,330
<CURRENT-LIABILITIES> 1,164,886
<BONDS> 1,466,679
0
49,984
<COMMON> 1,400,000
<OTHER-SE> 345,825
<TOTAL-LIABILITY-AND-EQUITY> 5,320,330
<SALES> 3,322,436
<TOTAL-REVENUES> 3,322,436
<CGS> 1,056,431
<TOTAL-COSTS> 2,186,544
<OTHER-EXPENSES> 670
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 101,910
<INCOME-PRETAX> 1,033,312
<INCOME-TAX> 390,548
<INCOME-CONTINUING> 642,764
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 642,764
<EPS-PRIMARY> 0
<EPS-DILUTED> 0
</TABLE>
