<PAGE>
FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
(X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 1995
OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number 1-8609
PACIFIC TELESIS GROUP
I.R.S. Employer No. 94-2919931
A Nevada Corporation
130 Kearny Street, San Francisco, California 94108
Telephone - Area Code (415) 394-3000
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 .
--- ---
At July 31, 1995, 428,404,446 common shares were outstanding.
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
TABLE OF CONTENTS
Page
Number
------
PART I. FINANCIAL INFORMATION
------------------------------
Item 1. Financial Statements
Review Report of Independent Accountants .............. 1
Condensed Consolidated Statements of Income ........... 2
Condensed Consolidated Balance Sheets ................. 4
Condensed Consolidated Statements of
Shareowners' Equity ............................... 5
Condensed Consolidated Statements of Cash Flows ....... 6
Notes to Condensed Consolidated Financial Statements .. 8
Item 2. Management's Discussion and Analysis of Results of
Operations and Financial Condition .................... 15
PART II. OTHER INFORMATION
---------------------------
Item 4. Submission of Matters to a Vote of Security Holders ..... 36
Item 6. Exhibits and Reports on Form 8-K ........................ 38
SIGNATURE ........................................................ 39
---------
<PAGE>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
REVIEW REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareowners of Pacific Telesis Group:
We have reviewed the accompanying condensed consolidated balance sheet of
Pacific Telesis Group and Subsidiaries as of June 30, 1995 and the related
condensed consolidated statements of income for the three- and six-month
periods ended June 30, 1995 and 1994, and the condensed consolidated
statements of shareowners' equity and cash flows for the six-month periods
ended June 30, 1995 and 1994. These financial statements are the
responsibility of the Corporation's management.
We conducted our review in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures
to financial data and making inquiries of persons responsible for financial
and accounting matters. It is substantially less in scope than an audit
conducted in accordance with generally accepted auditing standards, the
objective of which is the expression of an opinion regarding the financial
statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that
should be made to the accompanying condensed consolidated financial statements
for them to be in conformity with generally accepted accounting principles.
We have previously audited, in accordance with generally accepted auditing
standards, the consolidated balance sheet of Pacific Telesis Group and
Subsidiaries as of December 31, 1994, and the related consolidated statements
of income, shareowners' equity, and cash flows for the year then ended (not
presented herein); and in our report dated February 23, 1995, we expressed an
unqualified opinion on those consolidated financial statements. In our
opinion, the information set forth in the accompanying condensed consolidated
balance sheet as of December 31, 1994, is fairly stated, in all material
respects, in relation to the consolidated balance sheet from which it has been
derived.
/s/Coopers & Lybrand L.L.P.
San Francisco, California
August 11, 1995
1
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
For the 3 Months For the 6 Months
Ended June 30, Ended June 30,
(Dollars in millions, ------------------ -------------------
except per share amounts) 1995 1994 1995 1994
----------------------------------------------------------------------
OPERATING REVENUES
Local service.................. $ 946 $ 845 $1,895 $1,701
Network access:
Interstate................... 428 400 870 809
Intrastate................... 178 167 345 342
Toll service................... 296 506 615 1,004
Other service revenues......... 383 338 760 694
------ ------ ------ ------
TOTAL OPERATING REVENUES....... 2,231 2,256 4,485 4,550
------ ------ ------ ------
OPERATING EXPENSES
Cost of products and services 425 475 926 951
Customer operations and
selling expenses............. 440 462 875 884
General, administrative, and
other expenses............... 328 282 642 642
Property and miscellaneous
taxes........................ 53 47 100 94
Depreciation and amortization.. 467 443 934 884
------ ------ ------ ------
TOTAL OPERATING EXPENSES....... 1,713 1,709 3,477 3,455
------ ------ ------ ------
OPERATING INCOME............... 518 547 1,008 1,095
Interest expense............... 116 121 233 229
Miscellaneous income........... 13 12 44 24
------ ------ ------ ------
INCOME FROM CONTINUING
OPERATIONS BEFORE
INCOME TAXES................. 415 438 819 890
Income taxes................... 155 160 277 330
------ ------ ------ ------
INCOME FROM CONTINUING
OPERATIONS................... 260 278 542 560
Income from spun-off
operations, net of tax
(Note B)..................... - - - 23
------ ------ ------ ------
NET INCOME..................... $ 260 $ 278 $ 542 $ 583
====== ====== ====== ======
(Continued on next page)
2
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
(Continued)
For the 3 Months For the 6 Months
Ended June 30, Ended June 30,
(Dollars in millions, ------------------ -------------------
except per share amounts) 1995 1994 1995 1994
----------------------------------------------------------------------
Earnings per share:
Income from continuing
operations................ $ 0.61 $ 0.65 $ 1.28 $ 1.32
Income from spun-off
operations................ - - - 0.06
------ ------ ------ ------
Net income................. $ 0.61 $ 0.65 $ 1.28 $ 1.38
====== ====== ====== ======
Dividends per share.......... $0.545 $0.545 $ 1.09 $ 1.09
Average shares outstanding
(thousands)................ 424,065 424,051 424,065 423,873
The accompanying Notes are an integral part of the Condensed Consolidated
Financial Statements.
3
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
June 30, December 31,
(Dollars in millions) 1995 1994
------------------------------------------------------------------------
ASSETS: (Unaudited)
Cash and cash equivalents................... $ 72 $ 135
Accounts receivable -(net of allowances for
uncollectibles of $134 and $134 in 1995 and
1994, respectively)....................... 1,386 1,557
Prepaid expenses and other current assets... 1,156 1,206
------- -------
Total current assets........................ 2,614 2,898
------- -------
Property, plant, and equipment - at cost.... 26,899 26,565
Less: accumulated depreciation........... (10,889) (10,451)
------- -------
Property, plant, and equipment - net........ 16,010 16,114
------- -------
Deferred charges and other noncurrent assets 1,675 1,127
------- -------
TOTAL ASSETS................................ $20,299 $20,139
======= =======
LIABILITIES AND SHAREOWNERS' EQUITY:
Accounts payable and accrued liabilities.... $ 1,792 $ 1,907
Debt maturing within one year............... 728 246
Other current liabilities................... 1,309 1,330
------- -------
Total current liabilities................... 3,829 3,483
------- -------
Long-term obligations....................... 4,887 4,897
------- -------
Deferred income taxes....................... 1,693 1,673
------- -------
Other noncurrent liabilities and
deferred credits.......................... 4,533 4,853
------- -------
Commitments and contingencies (Note C)......
Total shareowners' equity................... 5,357 5,233
------- -------
TOTAL LIABILITIES AND SHAREOWNERS' EQUITY... $20,299 $20,139
======= =======
The accompanying Notes are an integral part of the Condensed Consolidated
Financial Statements.
4
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF SHAREOWNERS' EQUITY
(Unaudited)
For the 6 Months Ended
June 30,
----------------------
(Dollars in millions) 1995 1994
---------------------------------------------------------------------------
COMMON STOCK
Balance at beginning of period...................... $ 43 $ 43
------ ------
Balance at end of period............................ 43 43
------ ------
ADDITIONAL PAID-IN CAPITAL
Balance at beginning of period...................... 3,493 6,372
Spin-off stock distribution (Note B)................ - (2,901)
Issuance of shares.................................. - 22
Other changes....................................... 9 2
------ ------
Balance at end of period............................ 3,502 3,495
------ ------
REINVESTED EARNINGS
Balance at beginning of period...................... 2,257 2,040
Net income.......................................... 542 583
Dividends declared.................................. (462) (462)
Other changes....................................... - (12)
------ ------
Balance at end of period............................ 2,337 2,149
------ ------
TREASURY STOCK
Balance at beginning of period...................... (254) (283)
Issuance of shares.................................. - 29
------ ------
Balance at end of period............................ (254) (254)
------ ------
DEFERRED COMPENSATION - LESOP TRUST
Balance at beginning of period...................... (306) (386)
Cost of trust shares allocated to employee accounts. 35 40
------ ------
Balance at end of period............................ (271) (346)
------ ------
TOTAL SHAREOWNERS' EQUITY ............................ $5,357 $5,087
====== ======
The accompanying Notes are an integral part of the Condensed Consolidated
Financial Statements.
5
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
For the 6 Months Ended
June 30,
-----------------------
(Dollars in millions) 1995 1994
----------------------------------------------------------------------
CASH FROM (USED FOR) OPERATING ACTIVITIES:
Net income........................................ $ 542 $ 583
Adjustments to net income:
(Income)from spun-off operations (Note B)....... - (23)
Depreciation and amortization................... 934 884
Deferred income taxes........................... 3 (46)
Changes in operating assets and liabilities:
Accounts receivable........................... 172 43
Prepaid expenses and other current assets..... (38) 5
Deferred charges and other noncurrent assets.. 152 17
Accounts payable and accrued liabilities...... (51) 110
Other current liabilities..................... (13) (3)
Noncurrent liabilities and deferred credits... (307) (3)
Other adjustments, net.......................... (37) (75)
------ ------
Cash from continuing operations................... 1,357 1,492
Cash from spun-off operations..................... - 18
------ ------
Cash from operating activities.................... 1,357 1,510
------ ------
CASH FROM (USED FOR) INVESTING ACTIVITIES:
Additions to property, plant, and equipment....... (832) (703)
Investment in PCS licenses........................ (640) -
Other investing activities, net................... (13) 39
------ ------
Cash used by continuing operations................ (1,485) (664)
Cash used by spun-off operations.................. - (332)
------ ------
Cash used for investing activities ............... (1,485) (996)
------ ------
(Continued on next page)
6
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(Continued)
For the 6 Months Ended
June 30,
-------------------------
(Dollars in millions) 1995 1994
-------------------------------------------------------------------------
CASH FROM (USED FOR) FINANCING ACTIVITIES:
Proceeds from issuance of common and treasury shares.. 62 118
Proceeds from issuance of long-term debt.............. - 10
Retirements of long-term debt......................... (202) (1)
Dividends paid........................................ (462) (445)
Increase (Decrease) in short-term borrowings, net..... 668 (516)
Other financing activities, net....................... (1) (15)
----- -----
Cash from (used by) continuing operations............. 65 (849)
Cash from spun-off operations......................... - 39
----- -----
Cash from (used for) financing activities............. 65 (810)
----- -----
Net cash used for all activities...................... (63) (296)
Less spun-off operations.............................. - (275)
----- -----
Decrease in cash and cash equivalents................. (63) (21)
Cash and cash equivalents at January 1................ 135 69
----- -----
Cash and cash equivalents at June 30.................. $ 72 $ 48
===== =====
Cash payments for:
Interest............................................ $ 238 $ 228
Income taxes........................................ $ 149 $ 244
-------------------------------------------------------------------------
The accompanying Notes are an integral part of the Condensed Consolidated
Financial Statements.
7
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
A. BASIS OF PRESENTATION
The Condensed Consolidated Financial Statements include the accounts of
Pacific Telesis Group (the "Corporation") and its wholly and majority
owned subsidiaries. The Corporation includes a holding company,
Pacific Telesis; its telephone subsidiaries: Pacific Bell (and its
subsidiaries, Pacific Bell Directory, Pacific Bell Information Services,
and Pacific Bell Mobile Services) and Nevada Bell (the "Telephone
Companies"); and several other units.
The Condensed Consolidated Financial Statements have been prepared in
accordance with the rules and regulations of the Securities and Exchange
Commission ("SEC") applicable to interim financial information. Certain
information and footnote disclosures included in financial statements
prepared in accordance with generally accepted accounting principles have
been condensed or omitted in these interim statements pursuant to such
SEC rules and regulations. Management recommends that these interim
financial statements be read in conjunction with both the Corporation's
1994 annual report on Form 10-K and its 1995 Proxy Statement that
includes the audited 1994 financial statements.
In management's opinion, the Condensed Consolidated Financial Statements
include all adjustments (consisting of only normal recurring adjustments)
necessary to present fairly the financial position and results of
operations for each interim period shown. The Condensed Consolidated
Financial Statements have been reviewed by Coopers & Lybrand L.L.P.,
independent accountants. Their report is on page 1.
The Corporation's previous interest in the operating results of wireless
operations which were spun off effective April 1, 1994 is reported
separately as "spun-off operations." (See Note B - "Spun-off Operations"
following.) These operations are excluded from the prior year amounts
reported for the Corporation's revenues and expenses which reflect
"continuing operations." The Corporation's prior year statement of cash
flows has been reclassified to include separately the cash flows of spun-
off operations to conform to the current presentation. Amounts presented
for spun-off operations have been prepared solely for the purpose of
reporting Pacific Telesis Group results.
8
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
A. BASIS OF PRESENTATION (CONTINUED)
Intangible Assets and Capitalized Interest
Included in deferred charges and other noncurrent assets is $696 million
representing the amounts paid for two Personal Communications Services
("PCS") licenses recorded at cost. Interest related to these licenses is
capitalized as part of their cost. In addition, costs to relocate
incumbent microwave users will be capitalized as part of the license
acquisition cost. These costs will be amortized once the PCS system is in
service. Management anticipates a widespread offering of PCS services in
early 1997.
Accounting Under Regulation
The Telephone Companies account for the economic effects of regulation
under Statement of Financial Accounting Standards No. 71 ("SFAS 71"),
"Accounting for the Effects of Certain Types of Regulation." SFAS 71
requires the Telephone Companies to reflect the rate actions of
regulators in their financial statements when appropriate. Regulators
sometimes include costs in allowable costs for ratemaking in a period
other than the period in which those costs would be charged to expense by
an unregulated enterprise. These timing differences can create
"regulatory assets" or "regulatory liabilities" recorded by the Telephone
Companies. The regulatory assets and liabilities included in the
Corporation's consolidated balance sheets are listed and discussed below:
June 30, December 31,
($ millions) 1995 1994
------------------------------------------------------------------------
Regulatory assets (liabilities) due to:
Deferred pension costs*..................... $442 $407
Unamortized debt redemption costs**......... 340 346
Deferred compensated absence costs*......... 209 213
Unamortized purchases of property, plant,
and equipment under $500................. 90 107
Deferred income taxes***.................... (174) (193)
Other...................................... 43 51
---- ----
Total........................................ $950 $931
========================================================================
* Included primarily in "deferred charges and other noncurrent
assets" in the Corporation's balance sheets.
** Reflected as a reduction of "long-term obligations."
*** Included in "other current liabilities" and "other noncurrent
liabilities and deferred credits."
9
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
A. BASIS OF PRESENTATION (CONTINUED)
Deferred pension costs above reflect an order by the California Public
Utilities Commission ("CPUC") requiring Pacific Bell to use the
"aggregate cost method" for its intrastate operations. These deferred
costs represent differences between Pacific Bell's intrastate pension
costs calculated using this actuarial method, subject to Internal Revenue
Service ("IRS") and other limitations, and costs determined under the
provisions of Statement of Financial Accounting Standards No. 87
("SFAS 87"), "Employers' Accounting for Pensions," and No. 88
("SFAS 88"), "Employers' Accounting for Settlements and Curtailments of
Defined Benefit Pension Plans and for Termination Benefits."
When debt is refinanced before maturity, Pacific Bell amortizes to
expense any difference between net book value and redemption price evenly
over the term of the replacing issue for its intrastate operations, in
accordance with the ratemaking treatment of such costs by the CPUC.
These costs are expensed as incurred for interstate operations.
In prior years, the CPUC and the Federal Communications Commission
("FCC") changed the required accounting for the costs of compensated
absences, such as vacation days, from a cash basis to an accrual basis. A
transition liability for earned, but unused, compensated absence days is
being amortized to expense over periods prescribed by each regulator.
However, the CPUC continues to require Pacific Bell to recognize certain
compensated absence costs on a cash basis for ratemaking. The above
regulatory asset for compensated absences reflects those costs which have
been deferred in accordance with ratemaking treatment.
In 1989 and 1990, respectively, the FCC and the CPUC increased the
threshold for directly expensing purchases of property, plant, and
equipment from $200 to $500. Purchases of less than $500 which were
previously capitalized are being amortized to expense over periods
prescribed by regulators.
Specific provisions of Statement of Financial Accounting Standards
No. 109, "Accounting for Income Taxes," require regulated companies to
record a regulatory asset or a regulatory liability when recognizing
deferred income taxes if it is probable that these deferred taxes will be
reflected in future rates.
10
<PAGE>
PACIFIC TELESIS GROUP AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
A. BASIS OF PRESENTATION (CONTINUED)
In addition to the regulatory assets and liabilities described above, the
carrying amount of property, plant, and equipment is also affected by the
actions of regulators. Property, plant, and equipment is carried at
cost. The cost of self-constructed plant includes employee wages and
benefits, materials, and other costs. Regulators allow the Telephone
Companies to accrue an allowance for funds used during construction,
which includes both debt and equity components, as a cost of constructing
certain plant and as an item of miscellaneous income. This income is not
realized in cash currently, but is expected to be realized over the
service lives of the related plant. When retired, the original cost of
depreciable telephone plant is charged to accumulated depreciation.
Expenditures in excess of $500 that increase the capacity, operating
efficiency, or useful life of an individual asset are capitalized.
Expenditures for maintenance and repairs are charged to expense. The
costs of computer software purchased or developed for internal use
generally are expensed as incurred. However, initial operating system
software costs are capitalized and amortized over the lives of the
associated hardware. Costs for subsequent additions or modifications to
operating system software are expensed as incurred.
Depreciation of telephone plant is computed essentially by straight-line
depreciation using depreciable lives prescribed periodically by state and
federal regulators. Regulators currently have prescribed the following
depreciable lives for Pacific Bell's property, plant, and equipment:
Depreciable Lives
-------------------------------------------------------------------------
(in years)
Buildings................................................. 30 to 57
Cable..................................................... 10 to 30
Central office equipment.................................. 9 to 16.5
Furniture, equipment, and other...........................5.5 to 20
=========================================================================
An unregulated enterprise may have selected shorter depreciable lives for
similar assets.
11
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
A. BASIS OF PRESENTATION (CONTINUED)
The CPUC recently issued initial rules opening Pacific Bell's local
services market to competition beginning January 1, 1996, further
increasing competition in Pacific Bell's markets. In connection with
this action, the CPUC is scheduling hearings to determine what changes,
if any, should be made to Pacific Bell's regulatory framework.
Management is evaluating the effects of recent and pending regulatory
actions to determine whether the application of SFAS 71 regulatory
accounting continues to be appropriate. If it becomes no longer
reasonable to assume the Telephone Companies will recover their costs of
providing regulated services through rates charged to customers, whether
resulting from the effects of increased competition or specific
regulatory actions, SFAS 71 will no longer apply.
Discontinuing the application of SFAS 71 would require the Telephone
Companies to eliminate their regulatory assets and liabilities and may
require a reduction of the carrying amount of their telephone plant.
Five other telephone regional holding companies ("RHCs") have
discontinued the application of SFAS 71 regulatory accounting and have
adopted shorter depreciable lives and reduced their telephone plant
balances. If Pacific Bell were to discontinue the application of SFAS 71
and compute the effect on its telephone plant in a manner similar to
these other five RHCs, the reduction in the carrying amount of the
Corporation's property, plant, and equipment would be between $3 and
$5 billion. In addition, the Corporation would write off Pacific Bell's
regulatory assets and liabilities at the time of discontinuance. At
June 30, 1995, Pacific Bell had net regulatory assets of $954 million.
B. SPUN-OFF OPERATIONS
Effective April 1, 1994, the Corporation spun off to shareowners its
domestic and international cellular, paging, and other wireless
operations in a one-for-one stock distribution of its 86 percent interest
in AirTouch Communications, Inc. A stock distribution payable was
recorded during first quarter 1994 as a stock dividend from paid-in
capital at the carrying amount of the net assets of spun-off operations.
As a result, the Corporation's shareowners' equity was reduced by
$2.9 billion in the first quarter of 1994. The stock distribution itself
was a noncash transaction which did not affect the Corporation's cash
flow statement.
12
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
C. COMMITMENTS AND CONTINGENCIES
Broadband Network
In December 1994, Pacific Bell contracted for the purchase of up to
$2 billion of broadband network facilities which will incorporate emerging
technologies. Pacific Bell is committed to purchase these facilities in
1998 if they meet certain quality and performance criteria.
Revenues Subject to Refund
In 1992, the CPUC issued a decision adopting, with modification, Statement
of Financial Accounting Standards No. 106 ("SFAS 106"), "Employers'
Accounting for Postretirement Benefits Other than Pensions," for regulatory
accounting purposes. Annual price cap decisions by the CPUC granted
Pacific Bell $100 million in each of the years 1995 and 1994 for partial
recovery of higher costs under SFAS 106. However, the CPUC in October 1994
reopened the proceeding to determine the criteria for exogenous cost
treatment and whether Pacific Bell should continue to recover these costs.
The CPUC's order held that related revenues collected after October 12,
1994 are subject to refund. Beginning August 1, 1995, approximately
$25 million of 1993-94 postretirement benefits costs are being recovered
subject to potential refund in the interstate jurisdiction. The FCC is
examining the appropriateness of this cost recovery in a new proceeding.
Management believes these costs are appropriately included in Pacific
Bell's price cap filings, but is unable to predict the outcome of the
CPUC's or FCC's proceedings.
Purchase Options
In June 1990, Prime Cable of Chicago, Inc. ("Prime Cable"), acquired
certain Chicago cable television properties from Group W. The Corporation,
through its PTCB subsidiary, holds options to purchase a 75 percent
interest in Prime Cable. TC Cable, Inc. ("TC Cable") now holds this
interest. PacTel Capital Funding, a wholly owned subsidiary of the
Corporation, has guaranteed bank financing used by TC Cable and its parent
corporation to acquire this interest. The guarantees cover initial loan
amounts of $60 million as well as interest accruing on the loans which will
be added to the outstanding loan balances up to an aggregate of
$136 million. In the Corporation's opinion, the likelihood that it will be
required to pay principal or interest on this debt under these guarantees
is remote.
13
<PAGE>
PACIFIC TELESIS GROUP AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
D. SUBSEQUENT EVENT
In July 1995, the Corporation acquired 100 percent of the stock of
Cross Country Wireless Inc. ("CCW") to provide wireless cable service in
southern California. The Corporation now has existing wireless cable
operations with over 40,000 video customers in Riverside, California and
holds licenses and rights to provide wireless video services in
Los Angeles, Orange County, and San Diego. The transaction involved the
exchange of approximately $120 million of Pacific Telesis Group treasury
stock, or about 4.3 million shares, for the outstanding stock of CCW, and
the assumption of approximately $55 million of CCW debt. By the end of
1996, the Corporation plans to offer more than 100 channels of digital
programming in the Los Angeles, Orange County, and San Diego areas which
can deliver high quality digital picture with CD-quality sound to
approximately five million households.
14
<PAGE>
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION
RESULTS OF OPERATIONS
The following discussions and data compare the results of operations of
Pacific Telesis Group (the "Corporation") for the three- and six-month periods
ended June 30, 1995 to the same periods in 1994. The Corporation's previous
interests in the operating results of wireless operations which were spun off
to shareowners on April 1, 1994 are classified separately as "spun-off
operations" in the accompanying financial statements. (See Note A - "Basis of
Presentation" on page 8.) The spun-off operations are excluded from the
reported amounts of the Corporation's revenues and expenses. The
Corporation's "continuing operations" include Pacific Bell and Nevada Bell
(the "Telephone Companies"), along with several other units. Results for the
first six months of 1995 may not be indicative of results for the full year.
A summary of selected operating data is shown below:
For the 3 Months Ended For the 6 Months Ended
June 30, June 30,
---------------------- ----------------------
% %
Selected Operating Data* 1995 1994 Change 1995 1994 Change
----------------------------------------------------------------------------
Return on shareowners'
equity (%)................. 19.2 21.7 - 20.2 22.0 -
Operating ratio (%).......... 76.8 75.8 - 77.5 75.9 -
Revenues per average employee
($ thousands).............. 44 42 4.8 88 84 4.8
Total employees at June 30... 50,871 53,532 -5.0 - - -
Telephone Company employees per
ten thousand access lines**
at June 30................. 30.8 33.4 -7.8 - - -
----------------------------------------------------------------------------
* continuing operations
** excludes Pacific Bell Directory and Pacific Bell Mobile Services
employees
15
<PAGE>
Earnings
--------
For second quarter 1995, the Corporation reported net income of $260 million,
or $0.61 per share, compared to earnings of $278 million, or $0.65 per share,
from continuing operations for a year ago. Earnings for the second quarter of
1995 declined primarily due to continuing revenue shortfalls resulting from a
California Public Utilities Commission ("CPUC")-ordered price rebalancing that
accompanied the official introduction of toll services competition on January
1, 1995. The revenue shortfalls occurred because the average 40 percent
reduction in toll prices did not stimulate demand growth to the extent
anticipated by the CPUC. Stimulation of demand fell far short of the amount
necessary to achieve revenue neutrality as intended by the price rebalancing
order. The CPUC price rebalancing order assumed that volume growth would be a
key source of new revenues to offset the price reductions. The decrease in
earnings from revenue shortfalls was partially offset by the Corporation's
ongoing cost-reduction efforts.
In 1994, second quarter net income was reduced about $29 million because of a
CPUC refund order which resulted from past problems with Pacific Bell's
payment processing system.
For the first six months of 1995, the Corporation reported net income of
$542 million, or $1.28 per share, compared to earnings of $560 million, or
$1.32 per share, from continuing operations for a year ago. Earnings declined
primarily due to revenue shortfalls resulting from the CPUC-ordered price
rebalancing. Additional pressure on earnings resulted from incremental labor
expense associated with the severe storms in early 1995. These earnings
decreases in 1995 were partially offset by the Corporation's ongoing cost-
reduction efforts and other items including the receipt of tax and related
interest refunds. Results to date strongly suggest that the CPUC's forecasted
growth in demand from price rebalancing will not be realized in 1995.
Management believes 1995 earnings could be about 10 percent less than 1994
primarily due to this revenue rebalancing shortfall.
16
<PAGE>
Volume Indicators
------------------
For the 3 Months Ended For the 6 Months Ended
June 30, June 30,
---------------------- ----------------------
% %
Volume Indicators 1995 1994 Change 1995 1994 Change
---------------------------------------------------------------------------
Customer switched access
lines in service at
June 30 (thousands)...... 15,488 15,056 2.9 - - -
Carrier access minutes-
of-use (millions)........ 14,665 *13,230 10.8 29,046 *26,414 10.0
Interstate............... 8,123 *7,839 3.6 16,253 *15,711 3.4
Intrastate............... 6,542 *5,391 21.4 12,793 *10,703 19.5
Toll messages (millions)... 1,214 1,122 8.2 2,396 2,218 8.0
---------------------------------------------------------------------------
*Restated
The total number of access lines in service grew to 15,488 thousand, an
increase of 2.9 percent for the twelve months ended June 30, 1995. This is an
improvement over the 2.5 percent increase for the same period last year. The
residential access line growth rate increased to 2.2 percent for the twelve
months ended June 30, 1995, from 1.5 percent last year. The growth rate in
business access lines was 4.1 percent this year, down from 4.3 percent last
year. Pacific Bell's business Centrex lines grew 10.9 percent during the same
period as businesses continued to link multiple locations and improve disaster
preparedness. The number of ISDN lines in service for the Telephone Companies
grew to 34,098, an increase of 108 percent for the twelve months ended June
30, 1995, as customers demanded faster data transmission and Internet access.
Access minutes-of-use represent the volume of traffic carried by interexchange
carriers over the Telephone Companies' local networks. Total access minutes-
of-use for the six months ended June 30, 1995 increased by 10.0 percent over
the same period last year. The increase in access minutes-of-use was
primarily attributable to economic growth. In California, the official
introduction of toll services competition in January 1995 also had the effect
of increasing intrastate access minutes-of-use. Pacific Bell provides access
service to other carriers who complete intra-service area toll calls over
Pacific Bell's local network.
17
<PAGE>
Toll messages are comprised of Message Telecommunications Service, Optional
Calling Plans, WATS and terminating 800 messages. For the six months ended
June 30, 1995, toll messages increased by 8.0 percent compared to an increase
of 4.7 percent for the corresponding period in 1994. The increase was driven
primarily by economic growth as well as lower prices. In California on
January 1, 1995, Pacific Bell lowered the price of its toll services by an
average of 40 percent. Pacific Bell also began offering new discount calling
plans. Residential customers receive an automatic 15 percent off toll charges
above five dollars per month while businesses receive an automatic 20 percent
off toll charges over $15 per month. High volume customers can receive even
larger discounts. Price decreases have stimulated demand slightly but the
increase falls far short of levels included in the CPUC's order. Since the
official introduction of competition in January 1995, management estimates
that Pacific Bell lost approximately six percent of the local toll services
market to other providers by the end of second quarter 1995. Based upon prior
studies, the Corporation previously estimated that Pacific Bell retains less
than 75 percent of Pacific Bell's former share of the business toll market.
Those studies have now been updated and broadened to include all segments of
the expanding business toll market. Management now estimates that, as a
result of official competition and unofficial competitive losses in prior
years, Pacific Bell currently serves less than 60 percent of that total
market. Changes contemplated by the CPUC and the effects of pending
legislation make it too early to predict when, or at what level, market share
loss will stabilize.
Operating Revenues
------------------
For the 3 Months Ended For the 6 Months Ended
June 30, June 30,
---------------------- ----------------------
($ millions) 1995 1994 Change 1995 1994 Change
----------------------------------------------------------------------------
Total operating revenues.. $2,231 $2,256 -1.1 $4,485 $4,550 -1.4
----------------------------------------------------------------------------
Revenues for the three- and six-months ended June 30, 1995 were reduced from
the same periods last year primarily because demand growth as a result of
lower prices was slower than assumed in the CPUC-ordered price rebalancing.
Revenues were also reduced because of price cap revenue reductions ordered by
the CPUC under incentive-based regulation and the effects of toll services
competition.
18
<PAGE>
Effective January 1, 1995 the CPUC allowed long-distance companies and others
to officially compete with Pacific Bell in providing intra-service area toll
call services in California. The decision rebalanced prices for most of
Pacific Bell's regulated services so that it could remain competitive in the
new environment. The CPUC intended this decision to be initially revenue
neutral. Revenue reductions due to lower prices were intended to be offset by
other price increases and by increased network usage because of lower prices.
Although Pacific Bell observed some increased usage during the three- and six-
months ended June 30, 1995, calling volumes were far below levels envisioned
by the CPUC as necessary to achieve revenue neutrality.
Overall, revenue decreases from price rebalancing and price cap orders for the
three- and six-months ended June 30, 1995 compared to 1994 were partially
offset by $64 million and $145 million, respectively, in revenues from
increased customer demand. The increase in customer demand resulted both from
general economic growth and the effect of price rebalancing. The revenue
decreases were also partially offset by a CPUC-ordered refund in the second
quarter of 1994 related to past problems with Pacific Bell's payment
processing system. Due to the 1994 refund, miscellaneous other service
revenues increased $27 million compared to last year. Factors affecting
revenue changes are summarized in the following tables.
Second Quarter 1995 versus Second Quarter 1994
----------------------------------------------
Total
Price Change
Price Cap Customer from
($ millions) Rebalancing Order Misc. Demand 1994
-----------------------------------------------------------------------------
Local service............. $107 -$31 $22 $ 3 $101
Network access
Interstate.............. 6 2 3 17 28
Intrastate.............. -62 -4 41 36 11
Toll service.............. -177 -13 -10 -10 -210
Other service revenues.... 4 23 18 45
----- ----- ----- ----- -----
Total operating revenues.. -$122 -$46 $79 $64 -$ 25
-----------------------------------------------------------------------------
19
<PAGE>
First 6 Months 1995 versus First 6 Months 1994
----------------------------------------------
Total
Price Change
Price Cap Customer from
($ millions) Rebalancing Order Misc. Demand 1994
-----------------------------------------------------------------------------
Local service............. $202 -$62 $37 $ 17 $194
Network access
Interstate.............. 13 13 35 61
Intrastate.............. -123 -9 28 107 3
Toll service.............. -300 -25 -13 -51 -389
Other service revenues.... 8 21 37 66
----- ----- ----- ----- -----
Total operating revenues.. -$200 -$96 $86 $145 -$ 65
------------------------------------------------------------------------------
The increases in revenue due to customer demand for the periods presented in
the above tables are the result of growth in key volume indicators. Increases
in local service revenues due to customer demand reflects access line growth
resulting from economic recovery.
Increases in interstate network access revenues due to customer demand
reflects increased interexchange carrier access minutes-of-use, as well as
increased access lines. Demand-related increases in intrastate network access
revenues also reflect growth in interexchange carrier access minutes-of-use.
At Pacific Bell, the official introduction of competition in the intra-service
area toll market in January 1995 had the effect of increasing access usage
revenues.
The decreases in customer demand-related toll service revenues primarily
results from competition. Since the official introduction of competition in
January 1995, management estimates that Pacific Bell lost approximately
six percent of the local toll services market to other providers by the end of
second quarter. In addition, Pacific Bell has lost and continues to lose WATS
and 800 service business to interexchange carriers who have the competitive
advantage of being able to offer these services both within and between
service areas. Partially offsetting these reductions for the three- and six-
month periods were increased usage revenues resulting from general economic
growth. Based upon prior studies, the Corporation previously estimated that
Pacific Bell retains less than 75 percent of Pacific Bell's former share of
the business toll market. Those studies have now been updated and broadened
to include all segments of the expanding business toll market. Management now
estimates that, as a result of official competition and unofficial competitive
losses in prior years, Pacific Bell currently serves less than 60 percent of
that total market.
20
<PAGE>
The demand-related increases in other service revenues reflects the continuing
success of the Telephone Companies' voice mail products as well as directory
operations.
Operating Expenses
------------------
For the 3 Months Ended For the 6 Months Ended
June 30, June 30,
---------------------- ----------------------
($ millions) 1995 1994 Change 1995 1994 Change
----------------------------------------------------------------------------
Total operating expenses.. $1,713 $1,709 $4 $3,477 $3,455 $22
0.2% 0.6%
----------------------------------------------------------------------------
Total operating expenses for the three- and six-months ended June 30, 1995
increased slightly when compared with 1994 reflecting this year's increased
depreciation expense and the costs resulting from severe storm damage in early
1995. These expenses were partially offset by the Corporation's continuing
cost reduction efforts as displayed in the tables below.
Second Quarter 1995 versus Second Quarter 1994
-----------------------------------------------
Pacific Bell Expenses
(excluding subsidiaries)
--------------------------------- Total
Other Change
Salaries Employee Settle- PTG From
($ millions) & Wages Benefits ments Misc. Entities 1994
---------------------------------------------------------------------------
Cost of products &
services............... -$7 -$ 9 -$27 -$ 5 -$2 -$50
Customer operations &
selling expenses....... 4 -9 - -22 5 -22
General, admin. & other
expenses............... -3 4 - 41 4 46
Property & misc. taxes... - - - 6 - 6
Depreciation &
amortization........... - - - 24 - 24
----- ----- ----- ----- ----- -----
Total operating expenses. -$6 -$14 -$27 $44 $7 $ 4
===========================================================================
21
<PAGE>
First 6 Months 1995 versus First 6 Months 1994
----------------------------------------------
Pacific Bell Expenses
(excluding subsidiaries)
--------------------------------- Total
Other Change
Salaries Employee Settle- PTG From
($ millions) & Wages Benefits ments Misc. Entities 1994
---------------------------------------------------------------------------
Cost of products &
services............... $18 -$ 7 -$35 -$ 5 $ 4 -$25
Customer operations &
selling expenses....... -1 -13 - -5 10 -9
General, admin. & other
expenses............... -16 3 - 5 8 -
Property & misc. taxes... - - - 5 1 6
Depreciation &
amortization........... - - - 49 1 50
----- ----- ----- ----- ----- -----
Total operating expenses. $ 1 -$17 -$35 $49 $24 $22
===========================================================================
Pacific Bell's salary and wage expense for the three- and six-month periods in
1995 were relatively flat compared to 1994. Higher overtime costs were offset
by force reduction savings. For the first six months of 1995 compared to 1994,
Pacific Bell achieved a $62 million decrease in salary and wage expense
related to force reduction. However, higher overtime expense for storm and
flood repairs offset this decrease. Pacific Bell's lower employee benefits
expense for the three- and six-month periods in 1995 compared to 1994 was
primarily due to the Corporation's ongoing health care cost-reduction efforts.
Pacific Bell's settlements expense for the three- and six-month periods in
1995 compared to 1994 decreased primarily due to the CPUC-ordered price
rebalancing which lowered reimbursements to other local exchange carriers for
calls terminating in their territories.
Pacific Bell's miscellaneous general and administrative expense increased in
the second quarter of 1995 compared to the same quarter last year primarily
due to increased contract services for programmers of $18 million.
Pacific Bell's depreciation expense increased for the three- and six-month
periods in 1995 compared to 1994 primarily due to higher depreciation rates
ordered by the CPUC effective January 1, 1995 and higher telephone plant
balances.
22
<PAGE>
Interest Expense
----------------
For the 3 Months Ended For the 6 Months Ended
June 30, June 30,
---------------------- ----------------------
($ millions) 1995 1994 Change 1995 1994 Change
----------------------------------------------------------------------------
Interest expense.......... $116 $121 -$5 $233 $229 $4
-4.1% 1.7%
----------------------------------------------------------------------------
Second quarter 1995 interest expense decreased slightly compared to 1994
primarily due to last year's interest expense associated with the CPUC's late
payment charges decision. Interest expense for the first half of 1995
remained relatively flat.
Miscellaneous Income
--------------------
For the 3 Months Ended For the 6 Months Ended
June 30, June 30,
---------------------- ----------------------
($ millions) 1995 1994 Change 1995 1994 Change
----------------------------------------------------------------------------
Miscellaneous Income..... $13 $12 $1 $44 $24 $20
8.3% 83.3%
----------------------------------------------------------------------------
While miscellaneous income increased only slightly for second quarter 1995,
the increase for the first six months of 1995 was primarily due to interest
income of $25 million from a tax refund received in first quarter 1995 related
to prior years.
Income Taxes
------------
For the 3 Months Ended For the 6 Months Ended
June 30, June 30,
---------------------- ----------------------
($ millions) 1995 1994 Change 1995 1994 Change
----------------------------------------------------------------------------
Income Taxes............. $155 $160 -$5 $277 $330 -$53
-3.1% -16.1%
-----------------------------------------------------------------------------
The decrease in income tax expense for second quarter and first half of 1995
was primarily due to lower pre-tax income and a tax refund received in first
quarter 1995.
23
<PAGE>
Status of Reserves
------------------
As previously reported, Pacific Bell established a restructuring reserve at
the end of 1993 to provide for the incremental cost of force reductions and
other related costs to restructure its internal business processes through
1997. A total of 2,100 employees left Pacific Bell (excluding subsidiaries)
during the first six months of 1995. After new hires, net force loss for
Pacific Bell (excluding subsidiaries) was approximately 700. A total of $107
million was charged to the reserve in the first half of 1995 primarily for
reengineering projects. The majority of this year's projected costs is
expected to be incurred during the second half of the year. As of June 30,
1995, a balance of $727 million remained in the restructuring reserve.
During second quarter, Pacific Bell announced that it will further consolidate
its network operations centers to two by first quarter 1996, rather than four
centers as previously announced. This move is expected to result in
investment savings of $20 million during 1995 without affecting customer
service.
In December 1994, the Corporation's real estate subsidiary sold substantially
all of its assets for approximately $160 million which included $43 million in
notes secured by four of the properties. In March and April of 1995, defaults
on the secured notes resulted in the return of the four properties to the
Corporation. Management believes the $46 million reserve balance at June 30,
1995 is adequate to cover potential losses on the disposal of the remaining
assets.
24
<PAGE>
LIQUIDITY AND FINANCIAL CONDITION
The Corporation defines liquidity as its ability to generate resources to
finance business expansion, construct capital assets, pay its current
obligations, and pay dividends. The Corporation has been meeting most of its
liquidity needs from internally generated funds. The Corporation expects to
continue to meet the majority of its liquidity needs from internally generated
funds, but can also obtain external financing through the issuance of common
stock and short- and long-term debt, if needed.
Short-term borrowings are available under a commercial paper program and
through uncommitted unused lines of credit. These lines of credit are subject
to continued review by the lending banks. At June 30, 1995, the unused lines
of credit available totaled approximately $2.6 billion.
For longer term borrowings, Pacific Bell has remaining authority from the CPUC
to issue up to $1.25 billion of long- and intermediate-term debt. The
proceeds may be used to redeem maturing debt and to refinance other debt
issues. Pacific Bell has remaining authority from the Securities and Exchange
Commission ("SEC") to issue up to $650 million of long- and intermediate-term
debt through a shelf registration filed in April 1993. In addition, the
Corporation's PacTel Capital Resources subsidiary may issue up to $192 million
of medium-term notes through a shelf registration on file with the SEC.
In July 1995, the Corporation acquired 100 percent of the stock of
Cross Country Wireless Inc. ("CCW") to provide wireless cable service in
Southern California. The Corporation now has existing wireless cable
operations with over 40,000 video customers in Riverside, California and holds
licenses and rights to provide wireless video services in Los Angeles,
Orange County, and San Diego. The transaction involved the exchange of
approximately $120 million of Pacific Telesis Group treasury stock, or about
4.3 million shares, for the outstanding stock of CCW, and the assumption of
approximately $55 million of CCW debt. By the end of 1996, the Corporation
plans to offer more than 100 channels of digital programming in the
Los Angeles, Orange County, and San Diego areas which can deliver high quality
digital picture with CD-quality sound to approximately five million
households.
In June 1995, the Corporation paid the remaining $557 million balance for the
two licenses it had acquired to offer personal communications services ("PCS")
in California and Nevada. The licenses totaled $696 million of which
20 percent had been paid by March 1995 including a $56 million deposit made in
1994. These payments were made from a combination of internally generated
funds and external financing. The Corporation anticipates financing the
build-out of the PCS network including a five year, $300 million agreement
with Ericsson for network equipment from a combination of internally generated
funds and external financing.
25
<PAGE>
In May 1995, Duff and Phelps, Inc. lowered the rating of Pacific Bell's bonds
from Double-A ("AA") to Double-A-Minus ("AA-"). At June 30, 1995,
Pacific Bell had approximately $5 billion of long- and intermediate-term debt
outstanding. The rating action reflected price cap revenue reductions, toll
services competition, and proposed interim rules on local services
competition. The rating action also reflected the expected financing
requirements of the Corporation's broadband and PCS networks. Standard &
Poor's Corporation has placed bond and commercial paper ratings of the
Corporation, PacTel Capital Resources, and Pacific Bell on "CreditWatch," with
negative implications, following the release by the CPUC of its proposed
interim rules on local services competition. In addition, Moody's Investors
Services, Inc. has changed its outlook on the long-term debt of Pacific Bell
to "negative" from "stable," citing concerns about risks associated with
deployment of the broadband network and potential pressure on the financial
profile and performance of Pacific Bell.
Cash from continuing operations for operating activities decreased
$135 million for the six months ended June 30, 1995 compared to the same
period in 1994. The decrease was primarily due to timing differences in the
payment of accounts payable partially offset by decreased accounts receivable.
The decrease in cash flow was also partially offset by tax refunds of $152
million received in 1995.
Cash used by continuing operations for investing activities increased
$821 million for the six months ended June 30, 1995 compared to the same
period in 1994. The increase was primarily due to payments of $640 million on
the PCS licenses in 1995. In addition, the increase also reflects the
Corporation's 1995 investments in the TELE-TV joint venture with Bell Atlantic
and NYNEX and the LA Times joint venture.
Cash used by continuing operations for financing activities decreased
$914 million for the six months ended June 30, 1995 compared to the same
period in 1994. The decrease primarily reflects reduced payments of short-
term borrowings in 1995 and the increase in short-term borrowings of
approximately $480 million in June 1995. During the first six months of 1994,
the Corporation substantially repaid its short-term borrowings.
The Corporation's debt ratio changed to 51.2 percent at June 30, 1995 from
49.6 percent at December 31, 1994 primarily due to the increase in short-term
borrowings of approximately $480 million in June 1995. Pre-tax interest
coverage was 4.5 times for the first six months in 1995 compared to 4.9 times
for the same period in 1994. This decrease was due primarily to lower pre-tax
income.
For second quarter 1995, the Pacific Telesis Group Board of Directors
maintained the Corporation's dividend at $0.545 per share.
26
<PAGE>
LABOR NEGOTIATIONS
On August 8, 1995, the Telephone Companies reached a tentative three-year
agreement with the Communications Workers of America which represents about
34,000 employees. The previous union contract expired on August 5, 1995. The
new tentative agreement features a 10.5 percent wage increase over three
years, a 14 percent pension increase, a $16 million training and retraining
program, a new voluntary early retirement option, continued employment
security and improved health benefits. Agreements were also reached with two
other unions. Management estimates that the tentative agreements would result
in increased costs of approximately $550 million over three years. This
estimate does not include savings which may result from future force
reductions. The tentative agreements must be ratified by employees before
they become effective. The ratification results are expected by the end of
September 1995.
PENDING REGULATORY ISSUES
Telecommunications Legislation
------------------------------
In June 1995, the U.S. Senate approved a telecommunications bill which would
ease certain restrictions imposed by the Communications Act of 1934, the
1982 Consent Decree and the 1984 Cable Act. Among the provisions, the bill
would allow telephone companies and cable television companies to compete in
each others' markets. In August 1995, similar legislation was passed by the
House of Representatives. The bills now go to conference to reconcile the
differences. Management believes that the telecommunications reform
legislation passed by Congress, after reconciliation and if enacted, will be a
balanced plan that would begin to offer consumers the benefits of real
competition.
Calling Party Identification
----------------------------
In May 1995, the Federal Communications Commission ("FCC") established
national rules affecting how telephone companies, including the Telephone
Companies, may offer calling party identification services ("Caller ID").
Caller ID displays the telephone number of the calling party on a device that
attaches to a customer's telephone unless it is blocked by the calling party.
Caller ID is already available in most other states but has not been offered
in California due to CPUC blocking requirements that make the service
uneconomic to provide. The FCC ruling preempts the CPUC's restrictions which
made providing Caller ID uneconomic. In June 1995, the CPUC appealed the
FCC's ruling to the U.S. Court of Appeals for the Ninth Circuit. Subject to
CPUC approval, management believes that Caller ID could be an important new
revenue source.
27
<PAGE>
FCC Regulatory Framework Review
--------------------------------
In March 1995, the FCC adopted new interim price cap rules that govern the
prices that the larger local exchange carriers ("LECs"), including the
Telephone Companies, charge interexchange carriers ("IECs") for access to
local telephone networks.
The interim rules require LECs to adjust their maximum prices for changes in
inflation, productivity and certain costs beyond the control of the LEC.
Under the interim plan, LECs may choose from three productivity factors: 4.0,
4.7, or 5.3 percent. Election of the 5.3 percent productivity factor permits
the LEC to retain all of its earnings whereas the other lower productivity
factors require earnings to be shared with customers. In adopting the interim
plan, the FCC required LECs to prospectively reduce their price caps by
0.7 percent for each year the LEC elected the lower 3.3 percent productivity
factor during 1991-94. For Pacific Bell this resulted in a 2.1 percent
reduction. Likewise, Nevada Bell will have a 1.4 percent reduction due to
selecting the 3.3 percent productivity factor in two prior years. The
Telephone Companies have formally contested these reductions as well as other
adjustments associated with the interim plan in the U.S. Court of Appeals for
the District of Columbia (the "Court"). In August 1995, the Court agreed to
expedite review of these adjustments.
The FCC plans to adopt permanent rules in 1996 following a rulemaking
proceeding. Management continues to believe that the FCC should adopt pure
price cap regulation and eliminate the productivity factor, sharing, and
earnings caps.
The Telephone Companies' 1995 annual access filings implementing the interim
rules took effect August 1, 1995. As a result, the Telephone Companies'
revenues will be reduced approximately $126 million through June 30, 1996. Of
this amount, $72 million was reflected in the Corporation's 1994 financials.
The Telephone Companies chose the 5.3 percent productivity factor that will
enable them to retain all of their earnings after July 1, 1995. The higher
productivity factor was chosen because management believes that it will be
more than offset by elimination of the sharing mechanism.
28
<PAGE>
Video Dialtone Applications Approval
------------------------------------
In July 1995, the FCC approved Pacific Bell's applications for authority to
offer video dialtone services in specific locations in four of its service
areas. The approval allows Pacific Bell to begin installing the video-
specific components of its advanced communications network in the
San Francisco Bay Area, Los Angeles, Orange County and San Diego.
Construction of the video-specific elements of the network will give customers
access to such interactive services as movies and television shows on demand,
interactive news, tele-education, home shopping, video games, community
information listings, high-speed Internet access and broadcast programming.
Construction of the telephone portion of the network began in May 1994.
Pacific Bell's approved video dialtone applications, filed in late
December 1993, cover approximately 1.3 million homes throughout California.
With this approval, Pacific Bell is on track to be the first company in the
United States to offer a single full service network, supporting telephony,
data, and video. Technology trials will be conducted during the second half
of 1995 in the South San Francisco Bay Area, with paying customers connected
early next year. Interactive services will be offered to consumers beginning
mid-1996.
Pacific Bell has selected the state-of-the-art hybrid fiber/coaxial cable
architecture. The technology is cost effective to deploy and operate, and
allows Pacific Bell to achieve significant operational savings. Furthermore,
the architecture is flexible enough to meet customer needs today while network
capacity can be expanded easily as demand grows.
There are still critical regulatory issues to resolve before Pacific Bell can
deliver the full benefits of the "communications superhighway". The FCC must
still resolve the issue of whether video dialtone providers will be regulated
under cable television rules or common carrier rules. While a closed cable
television system allows the owner sole discretion to determine programming, a
video dialtone provider is a common carrier open to all. Management believes
that telephone companies providing video dialtone should be regulated solely
as common carriers.
29
<PAGE>
CPUC Regulatory Framework Review
--------------------------------
In June 1995, Pacific Bell filed an emergency petition with the CPUC
requesting an expeditious review of its current regulatory framework. In
July 1995, the CPUC granted Pacific Bell's request and announced the first
phase of the review which will address three issues.
1. Should the price cap formula be modified or eliminated?
2. Should the price cap formula be applied to non-competitive and partially
competitive services or only to non-competitive services?
3. Should any modifications to the regulatory framework be ordered in
stages?
Management believes that the productivity factor of the price cap formula is
excessive. As Pacific Bell operates under an increasingly competitive
environment, competition itself replaces the need for formula based
adjustments to rates.
Depreciation Filing
-------------------
The CPUC evaluates and prescribes depreciation rates each year. In June 1995,
Pacific Bell filed an application for changes to its depreciation rates to be
effective January 1, 1996. Pacific Bell requested technical changes which
would result in a $34 million decrease in annual depreciation expense.
Local Services Competition
--------------------------
In July 1995, the CPUC issued initial rules opening the local exchange market
to competition. Facilities-based competitive local carriers ("CLCs") are
authorized to begin providing local phone service beginning January 1, 1996.
Those companies leasing lines for resale will be able to offer phone service
by March 1, 1996. No CLC may begin operating until all certification
requirements are satisfied and the CPUC grants a certificate of public
convenience and necessity. The CPUC expects to resolve remaining issues and
issue final rules for implementing full competition in all California
telecommunications markets by January 1, 1997.
The CPUC will take additional comments and hold evidentiary hearings beginning
later this year on specific unresolved issues related to local competition.
These issues include the application of customer number rating areas used by
Pacific Bell for billing the CLCs, the removal of resale restrictions, the
economic effects of permitting resale competition, and the appropriate
wholesale rates for local phone services.
30
<PAGE>
Although management commends the CPUC decision expanding local telephone
competition, it is concerned that under the initial rules competitors will be
able to package and resell local phone service together with long-distance
service, while Pacific Bell will still not be able to offer customers the same
array of services. Management believes that the CPUC should accelerate its
efforts to resolve universal service issues in a competitive environment.
Management intends to file an Application for Rehearing of the decision on
certain limited grounds, including the need for evidentiary hearings on resale
and interconnection issues. (See "Universal Service" discussion below.)
Universal Service
-----------------
In July 1995, in connection with its local services competition decision, the
CPUC affirmed its commitment to universal service and proposed rules to assure
the continuation of affordable, high quality service in the coming competitive
local phone services market. Universal service issues are fundamental to the
ongoing CPUC proceeding to allow local and long-distance companies to compete
in providing basic local phone services, just as they already compete in
providing local toll services.
The CPUC has stated that companies that want to compete in the local phone
services market will have the opportunities as well as the obligations
associated with universal service. Hearings will be held to seek public
comment on the proposed universal funding mechanism for high-cost areas
service rules. The CPUC intends to implement a universal service funding
mechanism for high-cost areas only after local competition, unbundling, and
presubscription are in place. Management believes that universal service
issues should be resolved before local competition is authorized. Local
competition is currently scheduled to begin January 1, 1996.
31
<PAGE>
Public Service Commission of Nevada ("PSCN") Regulatory Review
--------------------------------------------------------------
On April 24, 1995, the PSCN issued a rule redesigning telecommunications
regulation in the state of Nevada. This rule includes many reforms initiated
by an industry coalition which includes Nevada Bell, Nevada IECs and other
Nevada LECs. The rule includes compromises reached with other parties,
including the cable industry and the state Office of Consumer Advocate. The
new rule will remove barriers to toll and local competition in Nevada but will
also allow Nevada Bell to keep any productivity gains by eliminating the
current customer sharing provision. The new plan is optional and will require
a rate case to determine initial pricing. After adoption, pricing flexibility
is based on the nature and competitive environment of the service. Prices for
basic service are capped during a three or five year period based on the
company's election. The plan does not prohibit or require presubscription and
allows interconnection where technologically feasible. Nevada Bell
anticipates a complete rate redesign as part of a rate case which it will file
in first quarter of 1996, for rates effective in the latter part of 1996 when
the current plan expires. Nevada Bell cannot predict the outcome of the
proceeding but believes that competition and increased productivity will
result in price reductions for customers.
Property Taxes
--------------
In 1992, a settlement agreement was reached between the State Board of
Equalization, all California counties, the State Attorney General, and
28 utilities, including Pacific Bell, on a specific methodology for valuing
utility property for property tax purposes. The CPUC opened an investigation
to determine if any resulting property tax savings should be returned to
customers. Intervenors have asserted that as much as $20 million of annual
property tax savings should be treated as an exogenous cost reduction in
Pacific Bell's annual price cap filings. These intervenors have also asserted
that past property tax savings totaling as much as $60 million plus interest
as of June 30, 1995 should be returned to customers. Management believes that
under the CPUC's regulatory framework, any property tax savings should only be
treated as a component of the calculation of shareable earnings. In an
Interim Opinion issued in June 1995, the CPUC decided to defer a final
decision on this matter pending resolution of the criteria for exogenous cost
treatment under its regulatory framework. The criteria are being considered
in a separate proceeding initiated for rehearing of the CPUC's postretirement
benefits decision. (See "Revenues Subject to Refund" under Note C on
page 13.)
32
<PAGE>
DISPOSITION OF BELLCORE
In April 1995, Bellcore announced a decision by its owners to pursue the
disposition of their interests in Bellcore. Bellcore is a leading provider of
communications software and consulting services. It is owned by Pacific Bell
and six other affiliates of the telephone regional holding companies formed at
the divestiture of AT&T Corp. in 1984. A final decision regarding the
disposition of interests and the structure of such a transaction has yet to be
determined. Any transaction will be subject to necessary approvals.
COMPETITIVE RISK
Regulatory, legislative and judicial actions, as well as advances in
technology, have expanded the types of available communications products and
services and the number of companies offering such services. Various forms of
competition are growing steadily and are already having an effect on the
Corporation's earnings. An increasing amount of this competition is from
large companies with substantial capital, technological, and marketing
resources. Currently, competitors primarily consist of interexchange
carriers, competitive access providers and wireless companies. Soon the
Corporation will also face competition from cable television companies and
others.
Effective January 1, 1995, the CPUC authorized toll services competition.
Toll service revenues represented approximately 14 percent of Pacific Bell's
total operating revenues for the first six months of 1995. Since the official
introduction of competition in January 1995, management estimates that Pacific
Bell lost approximately six percent of the local toll services market to other
providers by the end of second quarter. Based upon prior studies, the
Corporation previously estimated that Pacific Bell retains less than
75 percent of Pacific Bell's former share of the business toll market. Those
studies have now been updated and broadened to include all segments of the
expanding business toll market. Management now estimates that, as a result of
official competition and unofficial competitive losses in prior years,
Pacific Bell currently serves less than 60 percent of that total market.
Changes contemplated by the CPUC and the effects of pending legislation make
it too early to predict when, or at what level, market share loss will
stabilize. In May 1995, the CPUC issued a decision that requires Pacific Bell
to permit Centrex customers who purchase certain optional routing features to
route intra-service area calls to the toll carrier of their choice. In
addition, the CPUC has issued initial rules to open the local exchange market
to competition beginning January 1, 1996. (See "Local Services Competition"
on page 30.) Local service revenues represented approximately 42 percent of
Pacific Bell's total operating revenues for the first six months of 1995.
33
<PAGE>
Because of the unique characteristics of the California market, Pacific Bell
is vulnerable to competition. Pacific Bell's business and residence revenues
and profitability are highly concentrated among a portion of its customer base
and geographic areas. Competitors need only serve portions of our service
area to compete for the majority of Pacific Bell's business and residence
usage revenues. High-margin customers are clustered in high density areas
such as Los Angeles and Orange County, the San Francisco Bay Area, San Diego
and Sacramento.
Competitors can be expected to target the high-usage, high-profit customers
and can do this by targeting only a small part of our geographic area and a
small part of our customer base. Large and well-capitalized long-distance
carriers, wireless companies, competitive access providers and cable
television companies are preparing to compete in major local exchange markets.
In some cases they are already deploying switches and other facilities. In
California, cable television companies currently pass more than 90 percent of
Pacific Bell's residential customers. Cable television companies have already
announced plans for major build-outs to compete in the local exchange market.
All of Pacific Bell's customers have already chosen a long-distance company,
and there is more advertising from long-distance companies than from
traditional local exchange companies including Pacific Bell.
Market research has shown that a substantial majority of residence customers
prefer using one company for all telecommunications services. This is a
significant competitive disadvantage to Pacific Bell since it is prohibited by
the 1982 Consent Decree from providing long-distance service between service
areas. Similar market research shows that a substantial majority of business
customers would select one of the major long-distance companies over a
combination of Pacific Bell and a long-distance company because using one
carrier would permit them to apply all of their traffic toward volume discount
plans offered by the long-distance companies.
For these reasons, management believes that implementation of local exchange
competition prior to the Telephone Companies being allowed to enter the long-
distance market would provide already strong competitors an unfair advantage.
Management also believes that a truly open competitive market would allow for
the simultaneous entry of all telecommunications competitors into each others'
markets on an equal footing. Although the Telephone Companies are facing
increasing competition for all of their services, management believes that a
truly open competitive market, in which the Telephone Companies can compete
without restrictions, offers long-term opportunity to grow the business.
34
<PAGE>
APPLICABILITY OF REGULATORY ACCOUNTING
The Telephone Companies currently account for the economic effects of
regulation under Statement of Financial Accounting Standards No. 71
("SFAS 71"), "Accounting for the Effects of Certain Types of Regulation." The
CPUC recently issued initial rules opening Pacific Bell's local services
market to competition beginning January 1, 1996, further increasing
competition in Pacific Bell's markets. In connection with this action, the
CPUC is scheduling hearings to determine what changes, if any, should be made
to Pacific Bell's regulatory framework. Management is evaluating the effects
of recent and pending regulatory actions to determine whether the application
of SFAS 71 regulatory accounting continues to be appropriate. If it becomes
no longer reasonable to assume the Telephone Companies will recover their
costs of providing regulated services through rates charged to customers,
whether resulting from the effects of increased competition or specific
regulatory actions, SFAS 71 will no longer apply. (See "Pending Regulatory
Issues" and "Competitive Risk" beginning on page 27.)
Discontinuing the application of SFAS 71 would require the Telephone Companies
to eliminate their regulatory assets and liabilities and may require a
reduction of the carrying amount of their telephone plant. (See "Accounting
Under Regulation" in Note A on page 9.) Five other telephone regional
holding companies ("RHCs") have discontinued the application of SFAS 71
regulatory accounting and have adopted shorter depreciable lives and reduced
their telephone plant balances. If Pacific Bell were to discontinue the
application of SFAS 71 and compute the effect on its telephone plant in a
manner similar to these other five RHCs, the reduction in carrying amount of
the Corporation's property, plant, and equipment would be between $3 and
$5 billion. In addition, the Corporation would write off Pacific Bell's
regulatory assets and liabilities at the time of discontinuance. At June 30,
1995, Pacific Bell had net regulatory assets of $954 million.
35
<PAGE>
PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders.
On May 3, 1995, the Corporation held its 1995 Annual Meeting of Shareowners.
Shareowners voted in favor of the election of four directors to serve a three-
year term, the ratification of Coopers & Lybrand as the Corporation's
independent auditors, the approval of the amendment and restatement of the
Senior Management Long Term Incentive Plan and Short Term Incentive Plan and
the amendment of the 1994 Stock Incentive Plan and against three shareowner
proposals. Each matter presented at the Annual Meeting of Shareowners
received the following number of votes:
Broker
Nominees For Withheld Abstentions Nonvotes
-------- ----------- --------- ----------- --------
William P. Clark 344,559,492 9,045,712 N/A N/A
Ivan J. Houston 344,454,483 9,150,721 N/A N/A
Mary S. Metz 344,624,406 8,980,798 N/A N/A
Richard M. Rosenberg 344,580,927 9,024,277 N/A N/A
Directors Whose Term of Office Continued After the Annual Meeting:
------------------------------------------------------------------
Herman E. Gallegos, Donald E. Guinn, Frank C. Herringer, Lewis E. Platt,
Philip J. Quigley, Toni Rembe, and S. Donley Ritchey.
Ratification of Auditors:
-------------------------
Broker
For Against Abstentions Nonvotes
------------- ----------- --------- ----------
345,864,340 4,151,660 3,589,204 N/A
Amend and Restate Senior Management Long Term Incentive Plan:
-------------------------------------------------------------
Broker
For Against Abstentions Nonvotes
------------- ---------- ----------- ---------
294,410,947 49,437,385 9,756,871 1
Amend and Restate Short Term Incentive Plan:
--------------------------------------------
Broker
For Against Abstentions Nonvotes
------------- ----------- ----------- -----------
297,948,617 45,817,862 9,838,724 0
36
<PAGE>
Item 4. (Continued)
Amend 1994 Stock Incentive Plan:
--------------------------------
Broker
For Against Abstentions Nonvotes
----------- ----------- ----------- -----------
284,468,536 58,709,452 10,427,216 0
Shareowner Proposal to Eliminate Pensions for New Nonemployee Directors:
------------------------------------------------------------------------
Broker
For Against Abstentions Nonvotes
----------- ----------- ----------- -----------
92,372,115 213,547,100 10,646,145 37,039,843
Shareowner Proposal to Compensate Directors Solely in Stock:
------------------------------------------------------------
Broker
For Against Abstentions Nonvotes
----------- ----------- ----------- -----------
45,290,013 260,447,780 10,827,570 37,039,841
Shareowner Proposal to Suspend Paper Contract:
----------------------------------------------
Broker
For Against Abstentions Nonvotes
----------- ----------- ----------- -----------
43,241 353,551,218 10,745 0
37
<PAGE>
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits.
Exhibits identified as on file with the SEC are incorporated herein
by reference as exhibits hereto.
Exhibit
Number Description
------- -----------
4a Rights Agreement, dated as of September 22, 1989, between
Pacific Telesis Group and The First National Bank of Boston, as
successor Rights Agent, which includes as Exhibit B thereto the form
of Rights Certificate (Exhibits 1 and 2 to Form SE filed
September 25, 1989 as part of Form 8-A, File No. 1-8609).
4b No instrument which defines the rights of holders of long- and
intermediate-term debt of Pacific Telesis Group or its subsidiaries
is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A).
Pursuant to this regulation, Pacific Telesis Group hereby agrees to
furnish a copy of any such instrument to the SEC upon request.
11 Computation of Earnings per common share.
15 Letter re unaudited interim financial information.
27 Article 5 FDS for 2nd Quarter 1995 Form 10-Q.
The Corporation will furnish to a security holder upon request a copy of any
exhibit at cost.
(b) Reports on Form 8-K.
--------------------
Form 8-K, Date of Report April 19, 1995, was filed with the SEC,
under Item 5, in connection with a Pacific Bell competitive
vulnerability filing with the CPUC.
38
<PAGE>
FORM 10-Q
SIGNATURE
---------
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Pacific Telesis Group
BY /s/ W. E. Downing
--------------------------
W. E. Downing
Executive Vice President -
Chief Financial Officer & Treasurer
August 11, 1995
39
<PAGE>
EXHIBIT INDEX
Exhibits identified as on file with the SEC are incorporated herein by
reference as exhibits hereto. All other exhibits are provided as part of the
electronic transmission.
Exhibit
Number Description
------- -----------
4a Rights Agreement, dated as of September 22, 1989, between
Pacific Telesis Group and The First National Bank of Boston, as
successor Rights Agent, which includes as Exhibit B thereto the form
of Rights Certificate (Exhibits 1 and 2 to Form SE filed
September 25, 1989 as part of Form 8-A, File No. 1-8609).
4b No instrument which defines the rights of holders of long- and
intermediate-term debt of Pacific Telesis Group or its subsidiaries
is filed herewith pursuant to Regulation S-K, Item
601(b)(4)(iii)(A). Pursuant to this regulation, Pacific Telesis
Group hereby agrees to furnish a copy of any such instrument to the
SEC upon request.
11 Computation of Earnings per common share.
15 Letter re unaudited interim financial information.
27 Article 5 FDS for 2nd Quarter 1995 Form 10-Q.
40
<PAGE>
Exhibit 11
----------
PACIFIC TELESIS GROUP AND SUBSIDIARIES
COMPUTATION OF EARNINGS PER SHARE
(Dollars in millions, except per share amounts; shares in thousands)
For the 3 Months Ended For the 6 Months Ended
June 30, June 30,
---------------------- -----------------------
1995 1994 1995 1994
---------------------- -----------------------
Net income............... $ 260 $ 278 $ 542 $ 583
======== ======== ======= ========
Weighted average number
of common shares
outstanding ........... 424,065 424,051 424,065 423,873
Common stock equivalent
shares applicable to
stock options.......... 449 1,163 502 1,313
-------- -------- ------- --------
Total number of shares
for computing primary
earnings per share..... 424,514 425,214 424,567 425,186
Incremental shares for
computing fully diluted
earnings per share..... 0 0 0 0
-------- -------- ------- --------
Total number of shares
for computing fully
diluted earnings
per share.............. 424,514 425,214 424,567 425,186
======== ======== ======== ========
Earnings per common
share (as reported).... $ 0.61 $ 0.65 $ 1.28 $ 1.38
Primary earnings
per share.............. $ 0.61 $ 0.65 $ 1.28 $ 1.37
Fully diluted earnings
per share.............. $ 0.61 $ 0.65 $ 1.28 $ 1.37
Earnings per share amounts for the three- and six-month periods ended June 30,
1995 and June 30, 1994, as reported in the Condensed Consolidated Statements
of Income, were based on the weighted average number of common shares
outstanding for the respective periods. Primary and fully diluted earnings
per share amounts were not shown in the Condensed Consolidated Statements of
Income, as they differ from the reported earnings per share amounts by less
than three percent.
<PAGE>
Exhibit 15
----------
COOPERS & LYBRAND L.L.P.
August 11, 1995
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Ladies and Gentlemen:
Re: Pacific Telesis Group
Registrations on Forms S-3, Form S-4, and Forms S-8
---------------------------------------------------
We are aware that our report dated August 11, 1995 on our review of the
interim financial information of Pacific Telesis Group and Subsidiaries for
the three- and six-month periods ended June 30, 1995 and included in this
Form 10-Q is incorporated by reference in the Corporation's registration
statements as follows:
Form S-3: PacTel Capital Resources $500,000,000 Debt Securities and
Guarantee thereof by Pacific Telesis Group
Form S-3: Secondary Offering of 137,504 shares of Pacific Telesis Group
Common Stock
Form S-3: Shareowner Dividend Reinvestment and Stock Purchase Plan
Form S-4: ABI American Businessphones, Inc. Merger
Form S-8: Nonemployee Director Stock Option Plan
Form S-8: Supplemental Retirement and Savings Plan for Salaried
Employees
Form S-8: Supplemental Retirement and Savings Plan for Nonsalaried
Employees
Form S-8: Stock Option and Stock Appreciation Rights Plan
Form S-8: Stock Incentive Plan
Pursuant to Rule 436(c) under the Securities Act of 1933, this report should
not be considered a part of the registration statements prepared or certified
by us within the meaning of Sections 7 and 11 of that Act.
Very truly yours,
/s/ Coopers & Lybrand L.L.P.
<TABLE> <S> <C>
<PAGE>
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<MULTIPLIER> 1,000,000
<S> <C>
<FISCAL-YEAR-END> DEC-31-1995
<PERIOD-START> JAN-01-1995
<PERIOD-END> JUN-30-1995
<PERIOD-TYPE> 6-MOS
<CASH> 72
<SECURITIES> 0
<RECEIVABLES> 1,520
<ALLOWANCES> 134
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<CURRENT-ASSETS> 2,614
<PP&E> 26,899
<DEPRECIATION> 10,889
<TOTAL-ASSETS> 20,299
<CURRENT-LIABILITIES> 3,829
<BONDS> 0
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0
0
<OTHER-SE> 5,314
<TOTAL-LIABILITY-AND-EQUITY> 20,299
<SALES> 0
<TOTAL-REVENUES> 4,485
<CGS> 0
<TOTAL-COSTS> 3,477
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<INCOME-PRETAX> 819
<INCOME-TAX> 277
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