<PAGE> 1
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended: SEPTEMBER 30, 1998
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from _______ to _______
Commission File Number 1-7077
GTE SOUTHWEST INCORPORATED
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 75-0573444
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)
1255 Corporate Drive, SVC04C08, Irving, Texas 75038
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
Registrant's telephone number, including area code 972-507-5000
600 Hidden Ridge, HQE04B12 - Irving, Texas 75038
(Former name, former address and former fiscal year,
if changed since last report)
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 [ ]
The Company had 6,500,000 shares of $100 par value common stock outstanding at
October 31, 1998. The Company's common stock is 100% owned by GTE Corporation.
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<PAGE> 2
PART I. FINANCIAL INFORMATION
GTE SOUTHWEST INCORPORATED
Condensed Statements of Income (Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------- --------------------------
1998 1997 1998 1997
---------- ---------- ---------- ----------
(Dollars in Millions)
<S> <C> <C> <C> <C>
REVENUES AND SALES
Local services $ 184.5 $ 167.4 $ 538.2 $ 480.8
Network access services 174.5 168.4 524.4 498.2
Toll services 20.1 37.2 66.8 113.3
Other services and sales 88.1 72.6 215.9 182.3
---------- ---------- ---------- ----------
Total revenues and sales 467.2 445.6 1,345.3 1,274.6
---------- ---------- ---------- ----------
OPERATING COSTS AND EXPENSES
Cost of services and sales 177.6 149.8 507.4 423.1
Selling, general and administrative 80.3 66.7 224.9 181.7
Depreciation and amortization 97.0 93.0 280.5 277.2
---------- ---------- ---------- ----------
Total operating costs and expenses 354.9 309.5 1,012.8 882.0
---------- ---------- ---------- ----------
OPERATING INCOME 112.3 136.1 332.5 392.6
OTHER (INCOME) EXPENSES
Interest - net 22.0 15.7 56.1 43.3
Other - net (0.2) -- (0.2) --
---------- ---------- ---------- ----------
INCOME BEFORE INCOME TAXES 90.5 120.4 276.6 349.3
Income taxes 31.8 41.0 95.6 118.7
---------- ---------- ---------- ----------
INCOME BEFORE EXTRAORDINARY CHARGE 58.7 79.4 181.0 230.6
Extraordinary charge -- -- (0.5) --
---------- ---------- ---------- ----------
NET INCOME $ 58.7 $ 79.4 $ 180.5 $ 230.6
========== ========== ========== ==========
</TABLE>
Per share data is omitted since the Company's common stock is 100% owned by GTE
Corporation.
The accompanying notes are an integral part of these statements.
1
<PAGE> 3
GTE SOUTHWEST INCORPORATED
Condensed Balance Sheets (Unaudited)
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
------------- ------------
(Dollars in Millions)
<S> <C> <C>
ASSETS
Current assets
Cash and cash equivalents $ 6.0 $ 24.3
Receivables, less allowances
of $28.0 and $21.2 294.3 300.1
Accounts receivable from affiliates 55.2 59.8
Inventories and supplies 17.0 24.0
Prepaid taxes -- 52.8
Prepaid insurance 15.0 1.6
Other 3.6 5.6
------------ ------------
Total current assets 391.1 468.2
------------ ------------
Property, plant and equipment, at cost 5,740.4 5,418.2
Accumulated depreciation (3,533.3) (3,317.2)
------------ ------------
Total property, plant and equipment, net 2,207.1 2,101.0
------------ ------------
Prepaid pension costs 168.1 145.2
Other assets 24.2 17.8
------------ ------------
Total assets $ 2,790.5 $ 2,732.2
============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
2
<PAGE> 4
GTE SOUTHWEST INCORPORATED
Condensed Balance Sheets (Unaudited) - Continued
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
------------- ------------
(Dollars in Millions)
<S> <C> <C>
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities
Note payable to affiliate $ 200.1 $ 42.8
Accounts payable 64.8 98.9
Affiliate payables and accruals 51.8 105.7
Advanced billings and customer deposits 46.6 40.0
Taxes payable 66.1 37.0
Accrued interest 18.0 10.1
Accrued payroll costs 41.7 33.3
Dividends payable 42.9 45.5
Deferred income taxes 18.7 11.3
Other 30.7 55.3
------------ ------------
Total current liabilities 581.4 479.9
------------ ------------
Long-term debt 942.8 985.0
Deferred income taxes 150.4 174.7
Deferred employee benefit obligations 213.7 212.5
Other liabilities 3.6 26.0
------------ ------------
Total liabilities 1,891.9 1,878.1
------------ ------------
Preferred stock, subject to mandatory redemption
-- 1.5
Shareholders' equity
Preferred stock 7.6 7.6
Common stock (6,500,000 shares issued) 650.0 650.0
Additional paid-in capital 48.8 48.8
Retained earnings 192.2 146.2
------------ ------------
Total shareholders' equity 898.6 852.6
------------ ------------
Total liabilities and shareholders' equity $ 2,790.5 $ 2,732.2
============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
3
<PAGE> 5
GTE SOUTHWEST INCORPORATED
Condensed Statements of Cash Flows (Unaudited)
<TABLE>
<CAPTION>
Nine Months Ended
September 30,
------------------------------
1998 1997
------------ ------------
(Dollars in Millions)
<S> <C> <C>
OPERATIONS
Income before extraordinary charge $ 181.0 $ 230.6
Adjustments to reconcile income before extraordinary
charge to net cash from operations:
Depreciation and amortization 280.5 277.2
Deferred income taxes (17.0) (5.7)
Provision for uncollectible accounts 30.4 23.1
Changes in current assets and current liabilities (46.4) (153.6)
Other - net (29.5) (11.0)
------------ ------------
Net cash from operations 399.0 360.6
------------ ------------
INVESTING
Capital expenditures (391.7) (361.1)
Other - net 0.2 --
------------ ------------
Cash used in investing (391.5) (361.1)
------------ ------------
FINANCING
Long-term debt issued 148.9 --
Long-term debt and preferred stock retired,
including premiums paid on early retirement (42.3) (38.5)
Dividends (137.0) (204.4)
Net change in affiliate notes 7.3 236.3
Other - net (2.7) --
------------ ------------
Net cash used in financing (25.8) (6.6)
------------ ------------
Decrease in cash and cash equivalents (18.3) (7.1)
Cash and cash equivalents:
Beginning of period 24.3 23.1
------------ ------------
End of period $ 6.0 $ 16.0
============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
4
<PAGE> 6
GTE SOUTHWEST INCORPORATED
Notes to Condensed Financial Statements (Unaudited)
NOTE 1. BASIS OF PRESENTATION
GTE Southwest Incorporated (the Company) is incorporated under the laws of the
State of Delaware and is a subsidiary of GTE Corporation (GTE).
The unaudited condensed financial statements included herein have been prepared
by the Company pursuant to the rules and regulations of the Securities and
Exchange Commission. Certain information and footnote disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted pursuant to such rules and
regulations. However, in the opinion of management of the Company, the condensed
financial statements include all adjustments, which consist only of normal
recurring accruals, necessary to present fairly the financial information for
such periods. These condensed financial statements should be read in conjunction
with the financial statements and the notes thereto included in the Company's
1997 Annual Report on Form 10-K.
Reclassifications of prior year data have been made, where appropriate, to
conform to the 1998 presentation.
NOTE 2. EXTRAORDINARY CHARGE
During the first quarter of 1998, the Company recorded an after-tax
extraordinary charge of $0.5 million, reflecting premiums paid on the redemption
of high-coupon debt prior to stated maturity.
NOTE 3. DEBT
In January 1998, the Company issued $150 million of 6.23% Series D Debentures,
due 2007. The net proceeds were applied toward the repayment of short-term
borrowings incurred for the purpose of financing the Company's construction
program and for general corporate purposes.
NOTE 4. RECENT ACCOUNTING PRONOUNCEMENTS
Employee Benefit Disclosures
In February 1998, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 132, "Employers'
Disclosures about Pensions and Other Postretirement Benefits." This new standard
does not change the measurement or recognition of costs for pension or other
postretirement plans. It standardizes disclosures and eliminates those that are
no longer useful. The Company will provide the new disclosures in the 1998
Annual Report on Form 10-K. The adoption of SFAS No. 132 will have no impact on
the results of operations or financial condition.
5
<PAGE> 7
GTE SOUTHWEST INCORPORATED
Notes to Condensed Financial Statements (Unaudited) - Continued
Computer Software
In March 1998, the American Institute of Certified Public Accountants (AICPA)
issued Statement of Position (SOP) 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use." SOP 98-1 defines internal-use
software and requires that the cost of such software be capitalized and
amortized over its useful life. Presently, the Company's practice is to
capitalize initial operating system and certain application software and expense
the cost of other software, including right-to-use fees. The Company is
currently assessing the impact of capitalizing and amortizing the cost of all
types of internal-use software as required by SOP 98-1, effective January 1,
1999.
Costs of Start-Up Activities
In April 1998, the AICPA also issued SOP 98-5, "Reporting on the Costs of
Start-Up Activities" to provide guidance to all non-governmental entities on
financial reporting of costs of start-up activities. SOP 98-5 must be adopted
not later than January 1, 1999, and requires that costs of start-up activities
be expensed as incurred instead of being capitalized and amortized. It applies
to start-up activities and costs of organization of both development stage and
established operating entities. Based on the Company's current policy for costs
of start-up activities, SOP 98-5 will not have an impact on the results of
operations or financial condition.
Derivative Instruments and Hedging Activities
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities." SFAS No. 133 establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities. The Company
is currently assessing the impact of adopting SFAS No. 133 and intends to
implement as of January 1, 2000.
NOTE 5. PROPERTY REPOSITIONING
In April 1998, GTE announced its intention to reposition non-strategic access
lines, including some access lines in the states served by the Company. These
lines generally exhibit slower growth characteristics and do not earn their cost
of capital. Many of these lines are in markets where the Company is facing
competitors who have regulatory advantages in the areas of access pricing and
Universal Service Fund subsidies. Specifically, access lines in the states of
Arkansas, New Mexico, Oklahoma and Texas have been identified for purchase or
trade. The identified assets constituted approximately 27% and 26%,
respectively, of the Company's total switched access lines and net plant at
December 31, 1997. These access lines generated approximately 23% of the
Company's 1997 revenues. The Company's goal is to reach the first definitive
agreement in the first quarter of 1999 and definitive agreements for all
properties by mid-year 1999. Transition of the properties to the buyers will
occur during the remainder of 1999 and into 2000.
6
<PAGE> 8
GTE SOUTHWEST INCORPORATED
Management's Discussion and Analysis of Financial Condition
And Results of Operations
RESULTS OF OPERATIONS
(Dollars in Millions)
<TABLE>
<CAPTION>
September 30,
--------------------------------- Increase Percent
Net income 1998 1997 (Decrease) Change
- ---------- -------------- --------------- ------------- -------------
<S> <C> <C> <C> <C>
Three months ended $ 58.7 $ 79.4 $ (20.7) (26)%
Nine months ended 180.5 230.6 (50.1) (22)%
</TABLE>
Year-to-date net income includes an extraordinary after-tax charge of $0.5
million related to the early retirement of debt. Excluding this charge,
year-to-date net income declined by 22% or $49.6 million during the period. The
decline is primarily due to lower toll revenues and higher operating expenses,
partially offset by increased local service and other revenues.
<TABLE>
<CAPTION>
REVENUES AND SALES
(Dollars in Millions) Three Months Ended
September 30,
-------------------------------- Increase Percent
1998 1997 (Decrease) Change
---------------- --------------- --------------- -------------
<S> <C> <C> <C> <C>
Local services $ 184.5 $ 167.4 $ 17.1 10%
Network access services 174.5 168.4 6.1 4%
Toll services 20.1 37.2 (17.1) (46)%
Other services and sales 88.1 72.6 15.5 21%
---------------- --------------- ---------------
Total revenues and sales $ 467.2 $ 445.6 $ 21.6 5%
================ =============== ===============
</TABLE>
<TABLE>
<CAPTION>
(Dollars in Millions) Nine Months Ended
September 30,
-------------------------------- Increase Percent
1998 1997 (Decrease) Change
---------------- --------------- --------------- -------------
<S> <C> <C> <C> <C>
Local services $ 538.2 $ 480.8 $ 57.4 12%
Network access services 524.4 498.2 26.2 5%
Toll services 66.8 113.3 (46.5) (41)%
Other services and sales 215.9 182.3 33.6 18%
---------------- --------------- ---------------
Total revenues and sales $ 1,345.3 $ 1,274.6 $ 70.7 6%
================ =============== ===============
</TABLE>
Local Services Revenues
Access lines were 6% higher for the three and nine months ended September 30,
1998 generating increased revenues of $6.1 million and $22.3 million from basic
local services, CentraNet(R), Integrated Services Digital Network and Digital
Channel Services for the three and nine month periods ended September 30, 1998,
respectively. Demand for enhanced custom calling features, such as SmartCall(R)
services, contributed $4.8 million and $14.6 million to the increase for the
three and nine month periods ended September 30, 1998, respectively.
7
<PAGE> 9
GTE SOUTHWEST INCORPORATED
Management's Discussion and Analysis of Financial Condition
And Results of Operations - Continued
Network Access Services Revenues
Demand for access services by interexchange carriers resulted in a 10% growth in
minutes of use for both the three and nine month periods ended September 30,
1998 which generated $10.2 million and $33.5 million in revenues for the three
and nine month periods, respectively. These increases were partially offset by
decreases resulting from the 1997 and 1998 Federal Communications Commission
(FCC) price cap of $3.1 million and $19.5 million for the three and nine month
periods ended September 30, 1998, respectively. Revenues were also reduced due
to FCC changes that altered the structure of access charges collected by the
Company. Year-to-date special access revenues, driven by growing demand for
increased bandwidth services by Internet Service Providers (ISPs) and other high
capacity users, increased by $18.3 million. The year-to-date results also
reflect a decrease of $7.3 million resulting from the 1996 and 1997 sharing
provisions of the FCC price cap. (For additional information on FCC actions see
section entitled "FEDERAL REGULATORY DEVELOPMENTS - Interstate Access
Revision.")
Toll Services Revenues
The decreases in toll service revenues were primarily due to lower toll volumes
resulting from intraLATA (local access transport area) toll competition,
including 10-10-XXX and 1+ presubscription.
Other Services and Sales Revenues
Other services and sales revenues increased primarily due to an increase of
$10.1 million for both the three and nine months ended September 30, 1998 in
equipment sales and $5.2 million and $8.7 million for the three and nine month
periods, respectively, in billing and collection service revenues. The results
also reflect an increase in revenues relating to the FCC's order increasing
payphone compensation from interexchange carriers. (For additional information
see "FEDERAL REGULATORY DEVELOPMENTS - Payphone Order.")
OPERATING COSTS AND EXPENSES
<TABLE>
<CAPTION>
(Dollars in Millions) Three Months Ended
September 30,
----------------------------- Increase Percent
1998 1997 (Decrease) Change
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Cost of services and sales $ 177.6 $ 149.8 $ 27.8 19%
Selling, general and administrative 80.3 66.7 13.6 20%
Depreciation and amortization 97.0 93.0 4.0 4%
------------ ------------ ------------
Total operating costs and expenses $ 354.9 $ 309.5 $ 45.4 15%
============ ============ ============
</TABLE>
8
<PAGE> 10
GTE SOUTHWEST INCORPORATED
Management's Discussion and Analysis of Financial Condition
And Results of Operations - Continued
<TABLE>
<CAPTION>
(Dollars in Millions) Nine Months Ended
September 30,
-------------------------------- Increase Percent
1998 1997 (Decrease) Change
-------------- -------------- ------------- -------------
<S> <C> <C> <C> <C>
Cost of services and sales $ 507.4 $ 423.1 $ 84.3 20%
Selling, general and administrative 224.9 181.7 43.2 24%
Depreciation and amortization 280.5 277.2 3.3 1%
-------------- -------------- -------------
Total operating costs and expenses $ 1,012.8 $ 882.0 $ 130.8 15%
============== ============== =============
</TABLE>
The increases in total operating costs and expenses are primarily attributable
to higher labor costs of $21.2 million and $65.0 million for the three and nine
month periods ended September 30, 1998 due to increased line growth and the
expansion of daily operating hours of the customer care centers and operator
services. Costs associated with increased equipment sales of $8.8 million and
$10.1 million for the three and nine month periods, respectively, and higher
operating taxes of $4.7 million and $11.5 million for the quarter and
year-to-date also contributed to the increases. Depreciation and amortization
increased for the three and nine months ended September 30, 1998 primarily due
to higher plant balances, partially offset by an adjustment of depreciation
rates in the fourth quarter of 1997.
OTHER INCOME STATEMENT ITEMS
Interest-net increased 40% or $6.3 million in the third quarter of 1998 and 30%
or $12.8 million year-to-date, compared to the same periods in 1997. The
increase is primarily due to an increase in interest expense resulting from
higher average long-term debt levels.
Income taxes decreased 22% or $9.2 million in the third quarter of 1998 and 19%
or $23.1 million year-to-date, compared to the same periods in 1997. These
decreases are primarily due to corresponding decreases in pretax income and
other tax adjustments.
During the first quarter of 1998, the Company recorded an after-tax
extraordinary charge of $0.5 million, reflecting premiums paid on the redemption
of high-coupon debt prior to stated maturity.
CAPITAL RESOURCES AND LIQUIDITY
Management believes that 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 financing can be obtained through borrowings
from GTE or GTE Funding Incorporated, an affiliate of the
9
<PAGE> 11
GTE SOUTHWEST INCORPORATED
Management's Discussion and Analysis of Financial Condition
And Results of Operations - Continued
Company. The Company participates with other affiliates in a $1.5 billion,
364-day syndicated revolving line of credit and has access to an additional $1.0
billion in short-term liquidity through GTE and GTE Funding Incorporated's
bi-lateral revolving lines of credit. The Company also has an existing shelf
registration statement for an additional $600.0 million of debentures.
The Company's primary source of funds during the first nine months of 1998 was
cash from operations of $399.0 million compared to $360.6 million for the same
period in 1997. The year-to-year increase in cash from operations primarily
reflects a decrease in the Company's working capital requirements, offset by a
decline in results from operations.
The Company's capital expenditures during the first nine months of 1998 were
$391.7 million compared to $361.1 million for the same period in 1997. The
majority of new investment is being made to meet the demands of growth,
modernize facilities and develop and install new software, all of which are
required to support new products and enhanced services. The overall anticipated
capital expenditures for 1998 are expected to be comparable to capital
expenditures incurred during 1997.
Cash used in financing activities was $25.8 million during the first nine months
of 1998 compared to $6.6 million for the same period in 1997. This included
dividend payments of $137.0 million during the first nine months of 1998
compared to $204.4 million for the same period in 1997. Short-term financing,
representing the net change in affiliate notes, increased $7.3 million for the
first nine months of 1998, compared to $236.3 million for the same period in
1997. During the first nine months of 1998, the Company paid a total of $42.3
million for the retirement of long-term debt and preferred stock compared to
$38.5 million in 1997. Retirements for 1998 included $0.5 million after-tax in
premiums on the retirement of long-term debt and preferred stock redeemed prior
to stated maturity. The Company issued $150.0 million of 6.23% Series D
debentures in January 1998. The proceeds were used to repay short-term
borrowings incurred for the purpose of financing a portion of the Company's
construction program and for general corporate purposes. The Company recognized
an interest rate hedge loss of approximately $2.7 million on the settlement of
forward contracts related to the January 1998 debt issuance. The loss is being
amortized over the life of the associated refinanced debt.
10
<PAGE> 12
GTE SOUTHWEST INCORPORATED
Management's Discussion and Analysis of Financial Condition
And Results of Operations - Continued
FEDERAL REGULATORY DEVELOPMENTS
Interstate Access Revision
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 $25.5 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 revenue reductions of approximately $3.1 million
annually. In May 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
access lines. In aggregate, new per-line charges and the charges paid by
end-user customers of $10.8 million annually offset the reductions in usage
sensitive access charges of $10.8 million paid by long-distance carriers.
Effective July 1, 1998, access charges were further reduced by $25.8 million
annually in compliance with FCC requirements to reflect the impacts of access
charge reform.
The FCC Access Reform Order 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. GTE and numerous other parties
challenged the FCC's decisions in this order before the Eighth Circuit Court of
Appeals 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 of 1996 (TA96), and that the FCC created additional
subsidy charges paid only by business and multi-line residential customers. In
August 1998, the Eighth Circuit announced its decision on the multiple appeals
of the FCC Access Reform Order. The opinion denies all of the petitions for
review of the access charge order. The Company is considering its options.
In October 1998, the FCC began a proceeding to "refresh the record" used in the
1997 access charge reform proceedings. The FCC will determine whether to
retain or modify its "market based" access charge reform approach, or to adopt
a "prescriptive" approach.
Universal Service
In May 1997, the FCC released a decision relating to implementation of the
TA96's provision on universal service. 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 TA96
to develop a sufficient, explicit and competitively neutral universal service
program. Oral argument is scheduled for December 1998. A final decision on the
appeal is expected to be issued by mid-1999.
11
<PAGE> 13
GTE SOUTHWEST INCORPORATED
Management's Discussion and Analysis of Financial Condition
And Results of Operations - Continued
In its Order on Reconsideration dated July 13, 1998, the FCC referred some key
issues back to the Federal-State Joint Board (the Board) on universal service.
The Board's recommendations are due in the fourth quarter of 1998. In its
October 22, 1998 Order, the FCC selected a "synthesis" model platform for
universal service and plans to select cost inputs by the first quarter of 1999
and a revenue benchmark by mid-1999. The implementation date of the new
universal service mechanism for non-rural carriers was moved to July 1999. The
Company is assessing the Order and its options.
The Eighth Circuit Court ruling on FCC access reform (see previous discussion of
"Interstate Access Revision") also impacts universal service. Specifically, the
FCC is not required to eliminate all implicit subsidies before the explicit
universal service mechanism is implemented in July 1999.
Payphone Orders
On June 4, 1996, the FCC issued its first Report and Order implementing the
payphone compensation provisions of the TA96. 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 credit card and toll-free calls for which PSPs were not previously
compensated.
Subsequently, on October 9, 1997, the FCC issued a second Report and Order to
address some of the issues vacated by the U.S. Court of Appeals in Washington,
D.C. concerning the FCC's first Order and Report mentioned above. In this second
order, the FCC established a new per-call rate of 28.4 cents for compensation
that all PSPs were eligible to receive beginning October 9, 1997.
On April 3, 1998, the FCC issued an order, which granted the IXCs a waiver of
the per-call compensation requirement so that they may pay per-phone instead of
per-call compensation for the payphones for which the FCC had granted technology
waivers. GTE will receive per-phone compensation under this waiver until the
technology is installed on those payphones that are not currently capable of
measuring per-call detail.
Price Cap
For the provision of interstate services, the Company operates under the terms
of the FCC's price cap incentive plan. This plan limits the rates a carrier may
charge rather than regulating on a traditional rate-of-return basis. The price
caps for a variety of service categories change annually using a price cap index
that is a function of inflation less a predetermined productivity offset. The
FCC's May 1997 Price Cap Order revised the price cap plan for incumbent price
cap LECs by adopting a productivity offset of 6.5%. This matter is before the
FCC as discussed above.
12
<PAGE> 14
GTE SOUTHWEST INCORPORATED
Management's Discussion and Analysis of Financial Condition
And Results of Operations - Continued
In June 1997, GTE and several other parties challenged the FCC's Price Cap Order
before the Court of Appeals for the District of Columbia Circuit. The issue
presented for review is whether, in computing its new 6.5% productivity offset,
the FCC arbitrarily manipulated the evidence to achieve a predetermined outcome.
Oral arguments are set for the first quarter of 1999 with a decision expected
later in the year. Associated with the FCC's current activity to "refresh the
record" for access reform discussed above, the FCC will decide whether the 6.5%
productivity offset should be changed.
STATE REGULATORY DEVELOPMENTS
Texas
The Public Utility Commission of Texas (TPUC) has set UNE rates and the resale
discount of 22.9% for wholesale services on an interim basis. These matters have
been appealed to Federal District Court. A docket is pending before the TPUC for
the establishment of permanent wholesale rates. The TPUC is also considering
cost models for USF purposes.
The Company has appealed on Order of the TPUC pertaining to the manner in which
the Company markets long distance service with GTE Long Distance, an affiliate
company. A hearing is scheduled for December 1998.
A lawsuit was filed previously against the Company for allegedly violating the
Texas Debt Collection Practices Act (the Act) by failing to include a "street
address" on the Company's disconnection notices. The Company's disconnection
notices provide a post office box for remittance of payment and a toll-free
number for inquiries, but do not provide a physical street address. In September
1995, an amendment to the Act became effective which provides that a post office
box, street address or telephone number on delinquency notices meets the
requirements of the Act. The state court granted the Company's motion to defer
the case to the Texas Public Utilities Commission; however, the plaintiff's
counsel challenged the constitutionality of the legislative amendment. In June
1998, the case was dismissed.
RECENT DEVELOPMENTS
Proposed GTE/Bell Atlantic Merger
On July 27, 1998, GTE and Bell Atlantic Corporation (Bell Atlantic) entered into
a merger agreement providing for the combination of the two companies in a
merger of equals transaction. Under terms of the definitive agreement, which was
unanimously approved by the board of directors of both companies, GTE
shareholders will receive 1.22 shares of Bell Atlantic stock for each GTE share
they own. The merger is expected to be accounted for as a pooling of interests,
is subject to shareholder and regulatory approval, and is expected to be
completed during the second half of 1999. For additional information regarding
the merger, refer to the Form 8-K filed by GTE dated July 27, 1998.
13
<PAGE> 15
GTE SOUTHWEST INCORPORATED
Management's Discussion and Analysis of Financial Condition
And Results of Operations - Continued
Property Repositioning
In April 1998, GTE announced a series of actions designed to further sharpen its
strategic focus and improve its competitive position by repositioning
non-strategic properties and reducing costs. GTE expects to generate after-tax
proceeds of $2 billion to $3 billion by selling non-strategic or
under-performing operations and plans to reduce annual costs by more than $500
million through improved efficiencies and productivity while it continues to
invest in new high-growth opportunities. The impact of this announcement is
under ongoing review. Specifically, access lines in the states of Arkansas, New
Mexico, Oklahoma and Texas have been identified for purchase or trade. The
identified assets constituted approximately 27% and 26%, respectively, of the
Company's total switched access lines and net plant at December 31, 1997. These
access lines generated approximately 23% of the Company's 1997 revenues. The
Company's goal is to reach the first definitive agreement in the first quarter
of 1999 and definitive agreements for all properties by mid-year 1999.
Transition of the properties to the buyers will occur during the remainder of
1999 and into 2000.
YEAR 2000 CONVERSION
General
The Year 2000 issue concerns the potential inability of information systems to
properly recognize and process date-sensitive information beyond January 1,
2000, and has industry-wide implications. GTE has had an active Year 2000
program in place since 1995. This program is necessary because the Year 2000
issue could impact the telecommunications networks, systems and business
processes at GTE. Although GTE maintains a significant portion of its own
systems and infrastructure, GTE also depends on certain, material external
supplier products that it must verify as Year 2000 compliant in their condition
of use. GTE's program methodology is very similar to the General Accounting
Office (GAO) methodology and in 1997 GTE's Year 2000 methodology and processes
were certified by the Information Technology Industry Association of America.
GTE presently expects that its core operations and essential functions will be
ready for the millennium transition.
State of Readiness
GTE's Year 2000 program is focused on both information technology (IT) and
non-IT systems, including: 1) telecommunications network elements that
constitute the portion of the public switched telephone network (PSTN) for which
GTE is responsible; 2) systems that directly support GTE's telecommunications
network operations and interactions with customers; 3) legacy software that
supports basic business operations, customer premise equipment and
interconnection with other telecommunications carriers; and 4) systems that
support GTE's physical infrastructure, financial operations and facilities.
14
<PAGE> 16
GTE SOUTHWEST INCORPORATED
Management's Discussion and Analysis of Financial Condition
and Results of Operations - Continued
Corporate-wide, essential remediation was approximately 63% complete as of
September 30, 1998. In addition to the essential remediation budget, GTE has set
aside funds equivalent to 12% of GTE's overall Year 2000 budget. These funds are
planned for program closeout and verification in the last six months of 1999 and
to address contingencies and millennium program operations and control through
March 2000. GTE's portion of the PSTN in the United States has been upgraded
substantially for Year 2000; 69% of GTE's digital access lines are already
operational using Year 2000 compliant central office switches. Additionally,
over 75% of GTE's legacy software has been remediated. Over the next nine months
GTE's focus will be the deployment of these systems throughout operations and
the testing of those systems under actual operating conditions.
Using the nomenclature of the GAO, GTE's Year 2000 program can be characterized
as follows: Management, including transition into the Year 2000, is 43%
complete, with a projected end date of March 2000; Awareness is approximately
60% complete and is expected to continue until June 1999; System Assessment is
approximately 62% complete and is expected to be completed by December 1998;
System Renovation, including supplier products, is approximately 76% complete,
with intended completion by December 1998 for essential functions; Validation,
including enterprise testing in operational environments, is 44% complete, with
an expected completion in June 1999; and Implementation, including regional
deployment, is 63% complete, with an expected completion in June 1999.
In summary, compliant product rollout (deployment) and enterprise testing of
GTE's telecommunications-related businesses, including national and
international interoperability and verification, are presently expected to be
complete by the end of June 1999. Due to its relatively recent acquisition of
BBN Corporation, GTE's data initiative is presently targeting completion of its
key infrastructure systems by the end of September 1999.
Successful conclusion of GTE's Year 2000 program depends upon timely delivery of
Year 2000-compliant products and services from external suppliers. Approximately
1,450 of third-party products used by GTE have been determined to be "vital"
products, critical to GTE's business and operations. As of September 30, 1998,
Year 2000-compliant versions, or suitable alternatives, for 53% of these vital
supplier products have been provided. GTE presently expects that by December 31,
1998, Year 2000-compliant versions, or suitable alternatives, of third-party
supplier products for GTE's critical or major legacy and support systems will
have been delivered.
15
<PAGE> 17
GTE SOUTHWEST INCORPORATED
Management's Discussion and Analysis of Financial Condition
And Results of Operations - Continued
Use of Independent Verification and Validation
GTE's Year 2000 program management office has established a corporate-wide
quality oversight and control function that reviews and evaluates quality
reports on the Year 2000 issue. Each GTE business unit has access to an
independent quality team that evaluates the conversion and testing of legacy
applications and third-party supplier products. Separately, GTE's corporate
internal and external auditors conduct periodic reviews of each business unit's
Year 2000 activities and report significant findings, if any, to business unit
and corporate management.
Cost to Address Year 2000 Issues
The current estimate for the cost of GTE's Year 2000 Program is approximately
$370 million. Through September 30, 1998, expenditures totaled $177 million.
Year 2000 remediation costs are expensed in the year incurred. These
expenditures constitute approximately 6% of the 1998 IT budget and are projected
to be approximately 4% of the 1999 IT budget. The current estimate for the cost
of remediation for the Company is approximately $23.2 million. Through September
30, 1998 expenditures totaled $10.1 million. GTE has not elected to replace, or
to accelerate the schedule of a planned replacement of, systems due to the Year
2000 issue.
Currently supporting GTE's Year 2000 program worldwide are an estimated 1,000 to
1,200 full-time equivalent workers (both corporate employees and contractors).
Approximately 12% of these full-time equivalent workers are engaged in all
aspects of program management; 30% are engaged in legacy system conversion; 25%
are involved in external supplier management; 30% are involved in testing at all
levels; and 3% are addressing contingency planning and interoperability
operations both nationally and internationally. Approximately 78% of GTE's
program effort involves U.S. domestic operations of all types. Twenty-two
percent (22%) of the effort is dedicated to GTE's international operations.
Risks of Year 2000 Issues
GTE has begun to examine the risks associated with its "most reasonably likely
worst case Year 2000 scenarios." To date, GTE has no indication that any
specific function or system is so deficient in technical progress as to threaten
GTE's present schedule. GTE's program and plans currently indicate a compliant
network infrastructure to be deployed by the end of June 1999. A general,
unspecific, schedule shift that would erode progress beyond January 1, 2000,
cannot reasonably be calculated. If, however, there were a schedule delay
lasting no more than six months, such schedule erosion would likely affect only
nonessential systems due to the prioritization of work schedules.
16
<PAGE> 18
GTE SOUTHWEST INCORPORATED
Management's Discussion and Analysis of Financial Condition
And Results of Operations - Continued
Other scenarios might include a possible but presently unforeseen failure of key
supplier or customer business processes or systems. This situation could
conceivably persist for some months after the millennium transition and could
lead to possible revenue losses. GTE's present assessment of its key suppliers
and customers does not indicate that this scenario is likely.
To date, GTE has not encountered any conditions requiring tactical contingency
planning to its existing Year 2000 program; however, contingency planning for
business and network operations and customer contact during 1999 and 2000 is
ongoing.
GTE is bolstering its normal business continuity planning to address potential
Year 2000 interruptions. In addition, GTE's disaster preparedness recovery teams
are including procedures and activities for a "multi-regional" Year 2000
contingency, if it occurs. GTE is also developing its plans with respect to
possible occurrences immediately before, during, and after the millennium
transition. Under consideration are: "follow-the-sun" time-zone impact analysis;
coordination with other (non-PSTN) telecommunications providers; a Year 2000
"war room" operation to provide high priority recovery support, plans for key
personnel availability, command structures and contingency traffic routing; and
plans for round-the-clock, on-call repair teams.
CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS
Information contained in this Management's Discussion and Analysis with respect
to expected financial results and future events and trends is forward-looking,
based on the Company's estimates and assumptions and is subject to risks and
uncertainties. For those statements, the Company claims the protection of the
safe harbor for forward-looking statements contained in the Private Securities
Litigation Reform Act of 1995.
The following important factors could affect the future results of the Company
and could cause those results to differ materially from those expressed in the
forward-looking statements: (1) materially adverse changes in economic
conditions in the markets served by the Company; (2) material changes in
available technology; (3) the final resolution of pending and potential future
federal, state and local regulatory initiatives and proceedings, and judicial
review of those initiatives and proceedings pertaining to, among other matters,
the terms of interconnection, access charges, universal service, unbundled
network elements and resale rates; (4) the extent, timing, success and overall
effects of competition from others in the local telephone and intraLATA toll
service markets; (5) the success and expense of our remediation efforts and
those of our suppliers, customers and all interconnecting carriers in achieving
Year 2000 compliance; and (6) the success of new GTE products, services and
businesses such as bundled services
17
<PAGE> 19
GTE SOUTHWEST INCORPORATED
Management's Discussion and Analysis of Financial Condition
And Results of Operations - Continued
through marketing and sales initiatives.
18
<PAGE> 20
PART II. OTHER INFORMATION
GTE SOUTHWEST INCORPORATED
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits required by Item 601 of Regulation S-K.
12 Statement re: Calculation of the Ratio of Earnings to
Fixed Charges
27 Financial Data Schedule
(b) The Company filed no reports on Form 8-K during the third
quarter of 1998.
19
<PAGE> 21
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
GTE Southwest Incorporated
---------------------------------
(Registrant)
Date: November 12, 1998 /s/ Stephen L. Shore
------------------- ---------------------------------
Stephen L. Shore
Controller
(Principal Accounting Officer)
20
<PAGE> 22
EXHIBIT INDEX
<TABLE>
<CAPTION>
Exhibit
Number Description
---------- ----------------------------------------------------
<S> <C>
12 Statement re: Calculation of the Ratio of Earnings to
Fixed Charges
27 Financial Data Schedule
</TABLE>
<PAGE> 1
EXHIBIT 12
GTE SOUTHWEST INCORPORATED
Statement of the Ratio of Earnings to Fixed Charges
(Unaudited)
<TABLE>
<CAPTION>
(Dollars in Millions) Nine Months Ended
September 30, 1998
------------------
<S> <C>
Net earnings available for fixed charges:
Income before extraordinary charge $ 181.0
Add - Income taxes 95.6
- Fixed charges 64.9
------------------
Adjusted earnings $ 341.5
==================
Fixed charges:
Interest expense $ 59.1
Portion of rent expense
representing interest 5.8
------------------
Adjusted fixed charges $ 64.9
==================
RATIO OF EARNINGS TO FIXED CHARGES 5.26
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 6,000
<SECURITIES> 0
<RECEIVABLES> 377,500
<ALLOWANCES> 28,000
<INVENTORY> 17,000
<CURRENT-ASSETS> 391,100
<PP&E> 5,740,400
<DEPRECIATION> 3,533,300
<TOTAL-ASSETS> 2,790,500
<CURRENT-LIABILITIES> 581,400
<BONDS> 942,800
0
7,600
<COMMON> 650,000
<OTHER-SE> 241,000
<TOTAL-LIABILITY-AND-EQUITY> 2,790,500
<SALES> 1,345,300
<TOTAL-REVENUES> 1,345,300
<CGS> 507,400
<TOTAL-COSTS> 1,012,800
<OTHER-EXPENSES> 200
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 59,100
<INCOME-PRETAX> 276,600
<INCOME-TAX> 95,600
<INCOME-CONTINUING> 181,000
<DISCONTINUED> 0
<EXTRAORDINARY> 500
<CHANGES> 0
<NET-INCOME> 180,500
<EPS-PRIMARY> 0
<EPS-DILUTED> 0
</TABLE>
