<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 September 30, 1996
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 October 31, 1996, 428,321,498 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 Cash Flows ................ 6
Notes to Condensed Consolidated Financial Statements ........... 8
Item 2. Management's Discussion and Analysis of Results of
Operations and Financial Condition ......................... 14
PART II. OTHER INFORMATION
- ---------------------------
Item 4. Submission of Matters to a Vote of Security Holders......... 32
Item 5. Proposed Merger With SBC Communications Inc................. 32
Item 6. Exhibits and Reports on Form 8-K............................ 35
SIGNATURE............................................................ 36
<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 (the "Corporation") as of September 30,
1996 and the related condensed consolidated statements of income for the
three- and nine-month periods ended September 30, 1996 and 1995, and the
condensed consolidated statements of cash flows for the nine-month periods
ended September 30, 1996 and 1995. 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.
The Corporation's Pacific Bell subsidiary discontinued application of
Statement of Financial Accounting Standards No. 71 effective third quarter
1995.
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, 1995, 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 22, 1996, 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, 1995, 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
November 13, 1996
1
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
For the 3 Months Ended For the 9 Months Ended
September 30, September 30,
(Dollars in millions, ---------------------- ---------------------
except per share amounts) 1996 1995 1996 1995
- ---------------------------------------------------------------------------
OPERATING REVENUES
Local service ................... $1,026 $ 963 $3,020 $2,858
Network access:
Interstate .................... 462 427 1,381 1,297
Intrastate .................... 177 180 543 525
Toll service .................... 330 311 969 926
Other service revenues .......... 423 394 1,232 1,154
------ ------ ------ -----
TOTAL OPERATING REVENUES......... 2,418 2,275 7,145 6,760
------ ------ ------ -----
OPERATING EXPENSES
Cost of products and services ... 455 403 1,300 1,329
Customer operations and
selling expenses .............. 507 477 1,445 1,352
General, administrative, and
other expenses ................ 365 348 1,101 990
Property and other taxes......... 48 46 138 146
Depreciation and amortization ... 473 471 1,401 1,405
------ ------ ------ -----
TOTAL OPERATING EXPENSES......... 1,848 1,745 5,385 5,222
------ ------ ------ -----
OPERATING INCOME................. 570 530 1,760 1,538
Interest expense................. 78 117 265 350
Other income(expense)-net........ (17) 21 (38) 65
------ ------ ------ -----
INCOME BEFORE INCOME TAXES AND
EXTRAORDINARY ITEM.............. 475 434 1,457 1,253
Income taxes..................... 189 159 592 436
------ ------ ------ -----
INCOME BEFORE EXTRAORDINARY ITEM. 286 275 865 817
Extraordinary item, net of tax... - (3,360) - (3,360)
------ ------ ------ -----
NET INCOME (LOSS)................ $ 286 $(3,085) $ 865 $(2,543)
====== ====== ====== ======
(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 Ended For the 9 Months Ended
September 30, September 30,
(Dollars in millions, ---------------------- ---------------------
except per share amounts) 1996 1995 1996 1995
- ---------------------------------------------------------------------------
Earnings (loss) per share:
Income before
extraordinary item............. $ 0.67 $ 0.64 $ 2.02 $ 1.92
Extraordinary item.............. - (7.86) - (7.90)
------ ------ ------ -----
Net income (loss)............... $ 0.67 $(7.22) $ 2.02 $(5.98)
====== ====== ====== ======
Dividends per share ............. $0.315 $0.545 $1.175 $1.635
Average shares outstanding
(thousands) .................. 428,362 427,421 428,411 425,184
===========================================================================
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
September 30, December 31,
(Dollars in millions) 1996 1995
- ---------------------------------------------------------------------------
ASSETS: (Unaudited)
Cash and cash equivalents........................ $ 81 $ 76
Accounts receivable - (net of allowances for
uncollectibles of $157 and $132 in 1996
and 1995, respectively)........................ 1,598 1,505
Prepaid expenses and other current assets........ 1,004 1,002
------- ------
Total current assets............................. 2,683 2,583
------- ------
Property, plant, and equipment - at cost......... 28,414 27,222
Less: accumulated depreciation................ (16,754) (15,837)
------- ------
Property, plant, and equipment - net............. 11,660 11,385
------- ------
Other noncurrent and intangible assets........... 1,882 1,873
------- ------
TOTAL ASSETS..................................... $16,225 $15,841
======= =======
LIABILITIES AND SHAREOWNERS' EQUITY:
Accounts payable and accrued liabilities......... $ 2,053 $2,203
Debt maturing within one year.................... 484 1,530
Other current liabilities........................ 731 908
------- ------
Total current liabilities........................ 3,268 4,641
------- ------
Long-term obligations............................ 5,424 4,737
------- ------
Other noncurrent liabilities and
deferred credits............................... 3,910 4,273
------- ------
(Continued on next page)
4
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Continued)
September 30, December 31,
(Dollars in millions) 1996 1995
- ---------------------------------------------------------------------------
(Unaudited)
LIABILITIES AND SHAREOWNERS' EQUITY (Continued):
Commitments and contingencies (Note B)
Corporation-obligated mandatorily redeemable
preferred securities of subsidiary trusts*
(Note C)....................................... 1,000 -
------- ------
Common stock ($0.10 par value; 432,827,595
shares issued; 428,324,798 and 428,434,672
shares outstanding)............................ 43 43
Additional paid-in capital....................... 3,502 3,498
Accumulated deficit.............................. (619) (982)
Treasury stock (4,502,797 and 4,392,923 shares).. (131) (127)
Deferred compensation - LESOP trust.............. (172) (242)
------- ------
Total shareowners' equity........................ 2,623 2,190
------- ------
TOTAL LIABILITIES AND SHAREOWNERS' EQUITY........ $16,225 $15,841
======= =======
===========================================================================
* The trusts contain an asset of $1,030 million in principal amount of the
Subordinated Debentures of Pacific Telesis Group.
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 9 Months Ended
September 30,
----------------------
(Dollars in millions) 1996 1995
- ---------------------------------------------------------------------------
CASH FROM (USED FOR) OPERATING ACTIVITIES:
Net income (loss).................................... $ 865 $(2,543)
Adjustments to reconcile net income (loss) to cash
from operating activities:
Extraordinary item................................. - 3,360
Depreciation and amortization...................... 1,401 1,405
Change in deferred income taxes.................... 184 50
Changes in operating assets and liabilities:
Accounts receivable.............................. (93) 43
Prepaid expenses and other current assets........ (51) (46)
Other noncurrent and intangible assets........... (79) 135
Accounts payable and accrued liabilities......... (139) 4
Other current liabilities........................ (80) 23
Noncurrent liabilities and deferred credits...... (327) (438)
Other adjustments, net............................. 93 (11)
------- ------
Cash from operating activities....................... 1,774 1,982
------- ------
CASH USED FOR INVESTING ACTIVITIES:
Additions to property, plant, and equipment.......... (1,680) (1,308)
Investment in PCS licenses........................... (72) (656)
Other investing activities, net...................... (95) (13)
------- ------
Cash used for investing activities................... (1,847) (1,977)
------- ------
CASH FROM (USED FOR) FINANCING ACTIVITIES:
Proceeds from issuance of common and treasury shares. 109 67
Proceeds from issuance of long-term debt............. 495 -
Retirements of long-term debt........................ (15) (261)
Proceeds from issuance of trust originated
preferred securities............................... 1,000 -
Proceeds from sale and leaseback transactions........ 211 -
Dividends paid....................................... (601) (693)
Increase (decrease) in short-term borrowings, net.... (1,045) 821
Other financing activities, net...................... (76) (2)
------- ------
Cash from (used for) financing activities............ 78 (68)
------- ------
(Continued on next page)
6
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(Continued)
For the 9 Months Ended
September 30,
----------------------
(Dollars in millions) 1996 1995
- ---------------------------------------------------------------------------
Increase (decrease) in cash and cash equivalents..... 5 (63)
Cash and cash equivalents at January 1............... 76 135
------- ------
Cash and cash equivalents at September 30............ $ 81 $ 72
======= ======
Cash payments for:
Interest........................................... $ 291 $ 382
Income taxes....................................... $ 366 $ 359
===========================================================================
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, and its telephone subsidiaries: Nevada Bell and Pacific Bell
(which when used herein includes its subsidiaries, Pacific Bell
Directory, Pacific Bell Information Services, Pacific Bell Mobile
Services, Pacific Bell Internet Services, Pacific Bell Network
Integration and others) hereinafter referred to as the Telephone
Companies. Other Pacific Telesis subsidiaries include Pacific Telesis
Enterprises, Pacific Bell Communications, and several other subsidiaries
that provide video, communications and other services. The Condensed
Consolidated Financial Statements reflect reclassifications made to
conform with the current year presentation. These reclassifications did
not affect net income or shareowners' equity.
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
1995 annual report on Form 10-K and its 1996 Proxy Statement that
includes the audited 1995 financial statements.
Effective third quarter 1995, for external financial reporting purposes,
Pacific Bell discontinued the application of Statement of Financial
Accounting Standards No. ("SFAS") 71, "Accounting for the Effects of
Certain Types of Regulation," an accounting standard for entities subject
to traditional regulation. As a result, during third quarter 1995 the
Corporation recorded a non-cash, extraordinary, after-tax charge of $3.4
billion, or $7.86 per share. Nevada Bell continues to apply SFAS 71
accounting.
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.
8
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
A. BASIS OF PRESENTATION (Continued)
Change In Estimates
In March 1996, management amended the salaried pension plan, which
changed from a final pay plan to a cash balance plan. As a result of the
approval of this plan amendment, in second quarter 1996 the Corporation
updated its actuarial assumptions to reflect changes in market interest
rates and recent experience, including a change in its assumption
concerning future ad hoc increases in pension benefits. These changes in
estimates increased net income by approximately $75 million, or $0.175
per share for the first nine months of 1996 in comparison to the same
period in 1995.
B. COMMITMENTS AND CONTINGENCIES
Merger Agreement
On April 1, 1996, SBC Communications Inc. ("SBC") and the Corporation
jointly announced a definitive agreement whereby the Corporation will
become a wholly-owned subsidiary of SBC. Under terms of the merger
agreement, each share of Pacific Telesis common stock will be exchanged
for 0.733 shares of SBC common stock, subject to adjustment. The
transaction is intended to be accounted for as a pooling of interests and
to be a tax-free reorganization. On July 31, 1996, the shareowners of the
Corporation and SBC approved the transaction, which previously had been
approved by the respective Board of Directors of each company. Pursuant
to the merger agreement, the Corporation's quarterly dividend per share
cannot exceed 0.733 of SBC's quarterly dividend per share. Accordingly,
the Corporation reduced its second and third quarter 1996 dividends to
$0.315 per share. On November 5, 1996, the U.S. Department of Justice
announced it had concluded that the merger does not violate the antitrust
laws and accordingly that it was closing its investigation into the
merger. The merger is subject to certain other conditions and regulatory
approvals. The California Public Utilities Commission ("CPUC") has
established a schedule for review of the transaction with final comments
from interested parties due in January 1997. On September 30, 1996, the
Office of Ratepayer Advocates ("ORA"), the consumer interest branch of
the CPUC, filed testimony in the merger proceeding recommending a $2.1
billion refund to customers payable over five years. Management does not
agree with the ORA's recommendation and believes no customer rebate
should be required in connection with the merger. The CPUC is expected
to make a final decision on the merger by the end of March 1997. In
Nevada, SBC and the Corporation entered into a stipulation with the staff
of the Public Service Commission of Nevada ("PSCN") and the Office of the
Consumer Advocate to refund to customers the greater of $4 million or 2.0
percent of the amount, if any, ordered by the CPUC to be refunded to
Pacific Bell customers. The refund is conditioned on approval of the
stipulation by the PSCN and closing of the merger. The PSCN has
scheduled hearings for November 25, 1996, and approval is expected in
December 1996. If all necessary approvals are granted, the transaction is
expected to close in the first quarter of 1997.
9
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
B. COMMITMENTS AND CONTINGENCIES (Continued)
Purchase Commitments
In November 1995, the Corporation announced an agreement to acquire 100
percent of the stock of Wireless Holdings, Inc. and Videotron Bay Area,
Inc., which hold licenses and rights to provide wireless video services.
Both are joint ventures between Transworld Telecommunications, Inc.
("TTI") and Le Groupe Videotron Ltee (collectively the "Sellers"). The
acquisition agreement provides for termination after November 9, 1996,
one year after execution of the agreement, by either the Sellers or the
Corporation under specified circumstances. Closing of the transaction was
subject to a number of conditions, which had not been met by November 9,
1996. The Corporation filed an arbitration complaint in September 1996
alleging that Sellers had breached the agreement. Sellers denied the
allegations and counterclaimed that the Corporation had breached its
obligations. On November 12, 1996, management notified Sellers that the
Corporation was exercising its right to terminate the agreement.
Management anticipates that the parties' arbitration claims and
counterclaims will be amended in view of the termination of the
agreement. The Corporation has some related investments in tangible and
intangible assets, and may incur additional expenses as part of
terminating this agreement. The assets may be reused, written-off or
sold. Pending further analysis, management does not expect any write-off
or additional expenses to be material.
In December 1994, Pacific Bell contracted for the purchase of up to
$2 billion of Advanced Communications 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. Management now expects the actual amount of these facilities
purchased in 1998 will be less than $700 million.
As of September 30, 1996, Pacific Bell had purchase commitments of about
$212 million remaining in connection with its previously announced
program for deploying an all-digital switching platform with ISDN and
SS-7 capabilities.
10
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
B. COMMITMENTS AND CONTINGENCIES (Continued)
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 management's opinion, the likelihood that
the Corporation will be required to pay principal or interest on this
debt under these guarantees is remote.
Revenues Subject to Refund
In 1992, the CPUC issued a decision adopting, with modification, SFAS
106, "Employers' Accounting for Postretirement Benefits Other than
Pensions," for regulatory accounting purposes. Annual price cap
decisions by the CPUC granted Pacific Bell approximately $100 million in
each of the years 1993-1996 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
plus interest. It is possible that the CPUC could decide this issue in
the near term, and that the decision could have a material adverse effect
on Pacific Bell. Related revenues subject to refund totaled about $197
million at September 30, 1996. Management believes postretirement
benefits costs are appropriately recoverable in Pacific Bell's price cap
filings.
11
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
B. COMMITMENTS AND CONTINGENCIES (Continued)
Property Tax Investigation
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 for a period of eight
years. 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 approximately $66 million as of
September 30, 1996, plus interest should be returned to customers.
Management believes that, under the CPUC's regulatory framework, any
property tax savings should be treated only as a component of the
calculation of shareable earnings not as an exogenous cost. 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 other than pensions decision discussed above. It
is possible that the CPUC could decide this issue in the near term, and
that the decision could have a material adverse effect on the
Corporation.
C. CORPORATION-OBLIGATED MANDATORILY REDEEMABLE PREFERRED SECURITIES OF
SUBSIDIARY TRUSTS
Pacific Telesis Financing I and II (the "Trusts") were formed for the
exclusive purpose of issuing preferred and common securities representing
undivided beneficial interests in the Trusts and investing the proceeds
from the sale of Trust Originated Preferred Securities ("TOPrS") in
unsecured subordinated debt securities of the Corporation. Under certain
circumstances, dividends on TOPrS could be deferred for up to a period of
five years. TOPrS are subject to a limited guarantee from the
Corporation. The Corporation sold $1 billion of TOPrS, $500 million at
7.56 percent in January 1996 through Pacific Telesis Financing I and $500
million at 8.5 percent in June 1996 through Pacific Telesis Financing II.
Both issues of TOPrS were priced at $25 per share, have an original 30-
year maturity that may be extended up to 49 years and are callable in
five years at par. The proceeds were used to retire short-term
indebtedness, primarily commercial paper.
As of September 30, 1996, Pacific Telesis Financing I and II contained
subordinated debt securities of the Corporation in principal amounts of
$515.5 and $514.5 million, respectively, with interest rates of 7.56 and
8.5 percent, respectively.
12
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PACIFIC TELESIS GROUP AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
D. DEBT ISSUANCES
Pacific Bell issued $500 million of debentures, $250 million in February
1996 at 5.875 percent due February 15, 2006, and $250 million in August
1996 at 6.875 percent due August 15, 2006. Neither issue may be redeemed
prior to maturity. The proceeds from the sale of the debentures were
used to reduce short-term debt incurred to retire Pacific Bell's
debentures totaling approximately $500 million called in December 1995.
Pacific Bell has remaining CPUC authority, which will expire December 31,
1996, to issue up to $750 million of long- and intermediate-term debt.
Pacific Bell plans to make an application to renew this authority. The
proceeds may be used only to redeem maturing debt and to refinance other
debt issues. Pacific Bell has remaining authority from the SEC to issue
up to $150 million of long- and intermediate-term debt through a shelf
registration filed in April 1993.
13
<PAGE>
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION
In addition to historical information contained herein, this quarterly report
on Form 10-Q contains certain forward-looking statements that involve
potential risks and uncertainties. Pacific Telesis Group's (the
"Corporation") future results could differ materially from those discussed
herein. Factors that could cause or contribute to such differences include,
but are not limited to, those discussed herein and those discussed in the
"Annual Financial Review" in the Corporation's 1996 Proxy Statement. Readers
are cautioned not to place undue reliance on these forward-looking statements
which speak only as of the date hereof. The Corporation undertakes no
obligation to revise or update these forward-looking statements to reflect
events or circumstances after the date hereof or to reflect the occurrence of
unanticipated events.
RESULTS OF OPERATIONS
The following discussions and data compare the results of operations of the
Corporation for the three- and nine-month periods ended September 30, 1996 to
the same periods in 1995. The Corporation's operations include Pacific Bell
and Nevada Bell (the "Telephone Companies"), along with several other units.
Results for the first nine months of 1996 may not be indicative of results for
the full year.
A summary of selected operating data is shown below:
For the 3 Months Ended For the 9 Months Ended
September 30, September 30,
---------------------- ----------------------
% %
Operating Statistics 1996 1995 Change 1996 1995 Change
- -----------------------------------------------------------------------------
Return on shareowners'
equity (%)................... 45.0 -246.3 - 47.9 -64.5 -
Capital expenditures ($mil).. 684 650 5.2 1,825 2,195 -16.9
Total employees at Sept. 30.. 48,427 49,976 -3.1 - - -
Telephone Companies' employees
at September 30*............. 44,309 46,643 -5.0 - - -
Telephone Companies' employees
per ten thousand access lines
at September 30*............. 27.1 29.8 -9.1 - - -
- -----------------------------------------------------------------------------
* Excludes Pacific Bell Directory and Pacific Bell Mobile Services employees.
14
<PAGE>
Earnings
- --------
The Corporation's quarterly earnings continue to reflect the year-to-date
revenue growth from increased customer demand for local telephone products
associated with marketing efforts and California's growing economy, offset by
expenses to prepare to enter new businesses and to comply with local
competition mandates. The Corporation reported net income of $286 million for
the third quarter 1996, a 4.0 percent increase over the $275 million before
extraordinary item reported for the same period last year. Earnings per share
for the third quarter 1996 was $0.67, up 4.7 percent from the $0.64 per share
before extraordinary item for the same period last year. The extraordinary
item was a one-time, non-cash, after-tax charge of $3.4 billion, or $7.86 per
share recorded in third quarter 1995. The extraordinary charge resulted from
the discontinued application by Pacific Bell of special accounting rules for
entities subject to traditional regulation and its change to the general
accounting rules used by competitive enterprises. (See "Extraordinary Item"
on page 22.)
For the first nine months of 1996, the Corporation reported net income of
$865 million, or $2.02 per share, compared to earnings before extraordinary
item of $817 million, or $1.92 per share for a year ago. For the first nine
months in 1995, pressure on earnings before extraordinary item 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.
The California Public Utilities Commission ("CPUC") authorized facilities-
based local services competition effective January 1996, and resale
competition effective March 1996. Certain issues remain open in the local
competition proceedings. (See "CPUC Local Services Competition" on page 30.)
As of September 30, 1996, such competition had not yet had a significant
effect on the Corporation's earnings. In August 1996, the Federal
Communications Commission ("FCC") released a decision establishing guidelines
to implement the 1996 Telecommunications Act, which sets additional rules for
opening local telecommunications markets to full competition. (See "FCC
Interconnection Order" on page 29.) Management is concerned that final terms
set by regulators could deprive the Corporation of the opportunity to earn a
fair return on investment.
15
<PAGE>
Volumes
- -------
For the 3 Months Ended For the 9 Months Ended
September 30, September 30,
---------------------- ----------------------
% %
Volume Indicators 1996 1995 Change 1996 1995 Change
- -----------------------------------------------------------------------------
Switched access lines in
service at September 30
(thousands).............. 16,320 15,630* 4.4 - - -
Residence.............. 10,172 9,804* 3.8 - - -
Business............... 5,933 5,615* 5.7 - - -
Other.................. 215 211* 1.9 - - -
ISDN access lines
(included in above access
lines)................ 92 44 109.1 - - -
Interexchange carrier access
minutes-of-use (millions). 16,353 15,037 8.8 48,274 44,083 9.5
Interstate.............. 9,411 8,252 14.1 26,827 24,505 9.5
Intrastate.............. 6,942 6,785 2.3 21,447 19,578 9.5
Toll messages (millions)... 1,333 1,238* 7.7 3,884 3,609* 7.6
Toll minutes-of-use
(millions)................ 3,909 3,701 5.6 11,565 10,870 6.4
Voice mailbox equivalents at
September 30 (thousands).. 1,666 1,374 21.3 - - -
Custom calling services at
September 30 (thousands).. 7,829 7,093 10.4 - - -
- -----------------------------------------------------------------------------
* Restated
The total number of access lines in service grew to 16.320 million, an
increase of 4.4 percent for the twelve months ended September 30, 1996. This
is an improvement over the 2.7 percent increase for the same period last year.
The residential access line growth rate increased to 3.8 percent for the
twelve months ended September 30, 1996, from 1.8 percent last year. Changes in
technology, telecommuting, Internet access and the Corporation's marketing
efforts continue to fuel increased demand for additional telephone lines in
the home. Second access lines in residences grew 14.2 percent from
1.742 million lines to 1.989 million lines for the twelve months ended
September 30, 1996. The growth rate in business access lines was 5.7 percent
for the twelve months ended September 30, 1996, up from 4.5 percent for the
same period last year. The number of ISDN lines in service for the
Corporation grew to 92 thousand, an increase of 109.1 percent for the twelve
months ended September 30, 1996, as customers increased telecommuting and
demanded faster data transmission and Internet access. Accelerated demand for
the Corporation's high-speed data transmission continued through the third
quarter due to the Corporation's intensified marketing efforts.
16
<PAGE>
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 nine months ended September 30, 1996 increased by 9.5 percent
over the same period last year. The increase in access minutes-of-use was
primarily attributable to the continued economic growth in California.
Toll messages and minutes-of-use are comprised of Message Telecommunications
Service and Optional Calling Plans ("local toll") as well as WATS and
terminating 800 services. For the nine months ended September 30, 1996, toll
minutes-of-use increased by 6.4 percent driven by the continued economic
growth in California.
High demand for the Corporation's voice mail products continued in 1996.
Voice mailbox equivalents in service increased 21.3 percent for the twelve
months ended September 30, 1996 to 1.666 million. Similarly, demand for
custom calling services, such as call waiting, grew 10.4 percent for the
twelve months ended September 30, 1996 due to California's growing economy and
the Corporation's focused customer retention efforts.
Operating Revenues
- ------------------
For the 3 Months Ended For the 9 Months Ended
September 30, September 30,
---------------------- -----------------------
($ millions) 1996 1995 Change 1996 1995 Change
- ----------------------------------------------------------------------------
Total operating revenues. $2,418 $2,275 $143 $7,145 $6,760 $385
6.3% 5.7%
- ----------------------------------------------------------------------------
Revenues for the three- and nine-months ended September 30, 1996 increased
from the same periods last year primarily due to increased customer demand for
the Corporation's telephone services driven by marketing efforts and
California's growing economy. Revenues for the nine-months ended September
30, 1996 were offset by a $55 million rate reduction due to FCC price cap
orders. Revenues for the six months ended June 30, 1996, decreased $60
million due to the FCC price cap filing for the twelve months ending June 30,
1996. For the 1996 annual access tariffs filings effective July 1, 1996,
revenues increased approximately $5 million for the three-month period ending
September 30, 1996. (See "FCC Annual Access Tariff Filing and Regulatory
Framework Review" on page 30.) The CPUC price cap order effective January 1,
1996, had a minimal effect on Pacific Bell revenues due to an order in
December 1995 suspending use of the "inflation minus productivity" component
of the price cap formula for 1996 through 1998. This action freezes the price
caps on most of Pacific Bell's regulated services through 1998 except for
adjustments due to exogenous costs or price changes approved through the
CPUC's application process. (See "CPUC Regulatory Framework Review" and
"Nevada Bell Rate Case" on page 31.)
17
<PAGE>
Factors affecting revenue changes are summarized in the following tables.
Third Quarter 1996 versus Third Quarter 1995
----------------------------------------------
Total
Price Change
Cap Customer From
($ millions) Orders Misc. Demand 1995
- ----------------------------------------------------------------------------
Local service........................ $- $ -2 $ 65 $ 63
Network access:
Interstate.......................... 5 -5 35 35
Intrastate.......................... - -7 4 -3
Toll service......................... - 3 16 19
Other service revenues............... - 1 28 29
----- ----- ----- ----
Total operating revenues............. $5 $-10 $148 $143
============================================================================
First 9 Months 1996 versus First 9 Months 1995
----------------------------------------------
Total
Price Change
Cap Customer From
($ millions) Orders Misc. Demand 1995
- ----------------------------------------------------------------------------
Local service........................ $ - $15 $147 $162
Network access:
Interstate.......................... -55 54 85 84
Intrastate.......................... - -18 36 18
Toll service......................... - -24 67 43
Other service revenues............... - 5 73 78
----- ----- ----- ----
Total operating revenues............. $-55 $32 $408 $385
============================================================================
The increases in revenue due to customer demand for the periods presented in
the above tables for local service revenues are the result of the 4.4 percent
growth in access lines and the 10.4 percent growth in custom calling services.
These increases were generated by the continuing growth in the California
economy and the Corporation's focused customer retention efforts. In
addition, Pacific Bell introduced a new feature, "Call Return," on a "pay-per-
use" basis in April 1996 that generated revenues of approximately $30 million
for 1996.
Increases in interstate network access revenues due to customer demand for the
periods presented in the above tables reflect increased interexchange carrier
access minutes-of-use, as well as increased access lines. Customer demand
increases in intrastate network access revenues also resulted from growth in
access minutes-of-use.
18
<PAGE>
Increases in toll service revenues due to customer demand for the periods
presented in the above tables were driven primarily by increased local toll
usage resulting from general economic growth. The customer demand-related
increase in local toll service revenues was partially offset by competitive
losses in WATS and 800 services. Interexchange carriers currently have the
competitive advantage of being able to offer WATS and 800 service both within
and between service areas.
The increases in other service revenues due to customer demand for the periods
presented in the above tables reflect the continuing success of the Telephone
Companies' voice mail products and directory operations. In addition,
customer demand-related revenues increased in the Corporation's network
integration and wireless cable services.
Operating Expenses
- ------------------
For the 3 Months Ended For the 9 Months Ended
September 30, September 30,
---------------------- ----------------------
($ millions) 1996 1995 Change 1996 1995 Change
- ---------------------------------------------------------------------------
Total operating expenses. $1,848 $1,745 $103 $5,385 $5,222 $163
5.9% 3.1%
- ---------------------------------------------------------------------------
Total operating expenses for the three- and nine-month periods ended September
30, 1996 increased when compared with 1995 reflecting costs for increased
demand for products and services, new business initiatives and costs incurred
to prepare for local competition. Increased expenses were partially offset by
cost reductions from the Corporation's ongoing efficiency efforts and savings
due to changes in employee benefit plans and benefit plan assumptions.
Primary factors affecting expense changes are summarized below.
19
<PAGE>
Third Quarter 1996 versus Third Quarter 1995
--------------------------------------------
Pacific Pacific Total
Bell* Bell* Pacific Other Change
Salaries Employee Bell* PTG** From
& Wages Benefits Misc. Entities 1995
- ----------------------------------------------------------------------------
Cost of products and services. $24 $-28 $54 $ 2 $52
Customer operations and
selling expenses............. 3 -14 3 38 30
General, administrative,
and other expenses........... 5 -18 55 -25 17
Property and other taxes...... - - 1 1 2
Depreciation and amortization. - - -1 3 2
--- ---- ---- --- ----
Total operating expenses...... $32 $-60 $112 $19 $103
============================================================================
* Excludes Pacific Bell subsidiaries.
** Includes Pacific Telesis Group and Pacific Bell subsidiaries.
First 9 Months 1996 versus First 9 Months 1995
----------------------------------------------
Pacific Pacific Total
Bell* Bell* Pacific Other Change
Salaries Employee Bell* PTG** From
& Wages Benefits Misc. Entities 1995
- ----------------------------------------------------------------------------
Cost of products and services. $6 $-94 $55 $4 $-29
Customer operations and
selling expenses............. 6 -49 29 107 93
General, administrative,
and other expenses........... 5 -12 112 6 111
Property and other taxes...... - - -9 1 -8
Depreciation and amortization. - - -15 11 -4
--- ----- ---- ---- ----
Total operating expenses...... $17 $-155 $172 $129 $163
============================================================================
* Excludes Pacific Bell subsidiaries.
** Includes Pacific Telesis Group and Pacific Bell subsidiaries.
At Pacific Bell, excluding subsidiaries, salary and wage expense for the three
and nine-month periods ended September 30, 1996 increased compared to the same
periods in 1995, primarily due to wage increases associated with new labor
agreements effective August 1995 and overtime in the second and third quarters
of 1996 due to increased business volumes. These increases were mostly offset
by force reduction programs. Decreased overtime in first quarter 1996 due to
milder weather when compared to 1995 also partially offset the increases.
20
<PAGE>
At Pacific Bell, excluding subsidiaries, employee benefits expense for the
three- and nine-month periods ended September 30, 1996, decreased compared to
the same periods in 1995 primarily due to changes in employee benefit plans
and a related remeasurement of benefit plan expense. The changes in employee
benefit plans and benefit plan assumptions will continue to produce savings
through year end and are expected to produce savings in future periods. (See
"Change In Estimates" under Note A on page 9.)
At Pacific Bell, excluding subsidiaries, miscellaneous cost of products and
services, and general, administrative, and other expenses increased for the
three- and nine-month periods ended September 30, 1996 compared to 1995
primarily due to costs incurred to prepare for local competition and contract
services associated with increased demand for products and services.
At Pacific Bell, excluding subsidiaries, miscellaneous property and other
taxes expense decreased for the nine-month period ended September 30, 1996
compared to 1995 primarily due to nonrecurring audit adjustments accrued in
1995.
At Pacific Bell, excluding subsidiaries, depreciation expense decreased for
the three- and nine-month periods ended September 30, 1996 compared to 1995
primarily due to the elimination of the amortization of certain regulatory
assets associated with the discontinued application of Statement of Financial
Accounting Standards No. ("SFAS") 71, "Accounting for the Effects of Certain
Types of Regulation." (See "Extraordinary Item" on page 22.) The effect of
this decrease was partially offset by higher telecommunications plant
balances.
The Corporation's other entities' customer operations and selling expenses
increased for the three- and nine-month periods ended September 30, 1996
compared to 1995 due to new business initiatives, such as Personal
Communications Services ("PCS"), Internet access and network integration.
The Corporation's other entities' general, administrative, and other expenses
decreased for the three-month period ended September 30, 1996 compared to 1995
primarily due to reduced software expenses.
Interest Expense
- ----------------
For the 3 Months Ended For the 9 Months Ended
September 30, September 30,
----------------------- -----------------------
($ millions) 1996 1995 Change 1996 1995 Change
- ----------------------------------------------------------------------------
Interest expense............. $78 $117 $-39 $265 $350 $-85
-33.3% -24.3%
- ----------------------------------------------------------------------------
Interest expense decreased for the three- and nine-month periods ended
September 30, 1996 compared to 1995. This decrease was due to a change in the
Corporation's debt structure, lower interest rates and a change in
classification of interest capitalized during construction from an item of
other income to a reduction in interest expense due to the discontinued
application of SFAS 71 at Pacific Bell. An adjustment to capitalized interest
in third quarter 1996 also contributed to the overall decrease.
21
<PAGE>
Other Income (Expense) - Net
- ----------------------------
For the 3 Months Ended For the 9 Months Ended
September 30, September 30,
----------------------- ----------------------
($ millions) 1996 1995 Change 1996 1995 Change
- ----------------------------------------------------------------------------
Other income (expense)-net $-17 $21 $-38 $-38 $65 $-103
-181.0% -158.5%
- ----------------------------------------------------------------------------
Other income (expense)-net decreased for the three- and nine-month periods
ended September 30, 1996 compared to 1995 due to a change in classification of
interest capitalized during construction from an item of other income to a
reduction of interest expense and dividends paid on Trust Originated Preferred
Securities ("TOPrS"). (See Note C - "Corporation-Obligated Mandatorily
Redeemable Preferred Securities of Subsidiary Trusts" on page 12.) Interest
income received on a tax refund in first quarter 1995 contributed to the
comparative decrease for the nine-month period ended September 30, 1996.
Income Taxes
- ------------
For the 3 Months Ended For the 9 Months Ended
September 30, September 30,
---------------------- ----------------------
($ millions) 1996 1995 Change 1996 1995 Change
- ----------------------------------------------------------------------------
Income taxes ............. $189 $159 $30 $592 $436 $156
18.9% 35.8%
- ----------------------------------------------------------------------------
Income tax expense increased for the three- and nine-month periods ended
September 30, 1996 compared to 1995 primarily due to higher pre-tax income,
tax adjustments and tax refunds received in first quarter 1995.
Extraordinary Item
- ------------------
Effective third quarter 1995, for external financial reporting purposes,
Pacific Bell discontinued the application of SFAS 71, an accounting standard
for entities subject to traditional regulation. As a result, during third
quarter 1995 the Corporation recorded a non-cash, extraordinary, after-tax
charge of $3.4 billion, or $7.86 per share.
22
<PAGE>
Status of Reserves
- ------------------
As previously reported, the Corporation 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. After new hires, net force reduction for Pacific Bell, excluding its
subsidiaries, was approximately 1,225 employees for the first nine months of
1996. A total of $144 million in cash outlays was charged to the reserve in
the first nine months of 1996. In 1995, Pacific Bell charged $219 million to
the restructuring reserve for the cost through 1997 of enhanced retirement
benefits negotiated in the 1995 union contracts. Based on its experience,
Pacific Bell this year revised its estimate of these retirement costs.
Consequently, $64 million of these 1995 noncash charges were reversed in
second quarter 1996. There was no effect on net income from either the 1995
charge or the 1996 change in estimate. As of September 30, 1996, $148 million
remained in the restructuring reserve.
Other reserves were recorded in 1993, 1992 and 1990 primarily related to the
Corporation's withdrawal from, or restructuring of, its real estate, cable,
and customer premises equipment businesses. As of September 30, 1996, $94
million remained in these reserves.
23
<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 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 September 30, 1996, the unused
lines of credit available totaled approximately $2.9 billion.
For longer-term borrowings, Pacific Bell has remaining CPUC authority, which
will expire December 31, 1996, to issue up to $750 million of long- and
intermediate-term debt. Pacific Bell plans to make an application to renew
this authority. The proceeds may be used only 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 $150 million of
long- and intermediate-term debt through a shelf registration filed in April
1993. The Corporation's PacTel Capital Resources ("PTCR") subsidiary may
issue up to $192 million of medium-term notes through a shelf registration on
file with the SEC.
In March 1996, Moody's Investors Services, Inc. ("Moody's"), placed the senior
long-term debt ratings of Pacific Bell and PTCR as well as the preferred
securities rating of Pacific Telesis Financing I and II under review for
possible downgrade. In August 1996, Moody's downgraded Pacific Bell's
debentures and notes to A1 from Aa3, PTCR's medium-term notes to A2 from A1,
Pacific Telesis Group's counterparty rating to A2 from A1 and Pacific Telesis
Financing I and II Trust Originated Preferred Securities to a2 from a1. In
addition, Moody's downgraded Pacific Bell's shelf registration of debt
securities to (P)A1 from (P)Aa3 and PTCR's shelf registration of debt
securities to (P)A2 from (P)A1. The downgrades were prompted by Moody's
concerns about the ability of Pacific Bell to continue to generate the same
level of highly predictable cash flows in an increasingly uncertain
competitive and regulatory environment.
In April 1996, reflecting the announcement of the merger agreement with SBC
Communications Inc. ("SBC"), Standard & Poor's Corporation revised the outlook
on Pacific Telesis Group's corporate credit ratings, including PTCR, to stable
from negative. (See "Merger Agreement" under Note B on page 9.) The outlook
for Pacific Bell remains negative. Also reflecting the merger agreement
announcement, Duff and Phelps, Inc. reaffirmed its ratings of Duff 1+ and
Double-A-Minus ("AA-") on Pacific Bell's commercial paper and debentures,
respectively.
24
<PAGE>
The following are commercial paper, bond, and TOPrS ratings for the
Corporation and its subsidiaries as of September 30, 1996:
Moody's Investors Standard & Duff and
Services, Inc. Poor's Corp. Phelps, Inc.
-----------------------------------------------
Commercial Paper:
- ------------------------
Pacific Telesis Group... Prime-1 A-1 -
Pacific Bell............ Prime-1 A-1+ Duff 1+
PacTel Capital Resources Prime-1 A-1 -
Long- and Intermediate-
Term Debt:
- ------------------------
Pacific Bell............ A1 AA- AA-
PacTel Capital Resources A2 A+ -
TOPrS:
- -------------------------
Pacific Telesis Financing
I and II................ a2 A -
The above ratings reflect the views of the rating agencies and are subject to
change. The ratings should be evaluated independently and are not
recommendations to buy, sell, or hold the securities of the Corporation.
The Corporation has entered into sale and leaseback arrangements to finance
equipment associated with the buildout of its PCS network. In accordance with
generally accepted accounting principles, these leases are being classified as
capital leases in property, plant, and equipment. As of September 30, 1996,
the financing obtained under the leases was $211 million. Management expects
the total financing to reach about $350 million, of which approximately one-
third will be repaid in Japanese yen. To hedge exposure to foreign currency
exchange fluctuations, the Corporation has entered into foreign currency
forward contracts to purchase yen in amounts equal to the current yen lease
obligations when they become due. Gains or losses due to foreign currency
rate fluctuations on these contracts and on the yen lease obligations offset
each other in results of operations. The Corporation does not expect to
realize any loss from counterparty nonperformance under these contracts.
25
<PAGE>
In November 1995, the Corporation announced an agreement to acquire 100
percent of the stock of Wireless Holdings, Inc. and Videotron Bay Area, Inc.,
which hold licenses and rights to provide wireless video services. Both are
joint ventures between Transworld Telecommunications, Inc. ("TTI") and Le
Groupe Videotron Ltee (collectively the "Sellers"). The acquisition agreement
provides for termination after November 9, 1996, one year after execution of
the agreement, by either the Sellers or the Corporation under specified
circumstances. Closing of the transaction was subject to a number of
conditions, which had not been met by November 9, 1996. The Corporation filed
an arbitration complaint in September 1996 alleging that Sellers had breached
the agreement. Sellers denied the allegations and counterclaimed that the
Corporation had breached its obligations. On November 12, 1996, management
notified Sellers that the Corporation was exercising its right to terminate
the agreement. Management anticipates that the parties' arbitration claims
and counterclaims will be amended in view of the termination of the agreement.
The Corporation has some related investments in tangible and intangible
assets, and may incur additional expenses as part of terminating this
agreement. The assets may be reused, written-off or sold. Pending further
analysis, management does not expect any write-off or additional expenses to
be material.
Cash from operating activities decreased $208 million for the nine months
ended September 30, 1996 compared to the same period in 1995. The decrease
was primarily due to timing differences in the payment and collection of
accounts payable and accounts receivable, respectively. A tax refund received
in 1996 of approximately $133 million was $19 million less than a tax refund
received in 1995.
Cash used for investing activities decreased $130 million for the nine months
ended September 30, 1996 compared to the same period in 1995. The decrease
was primarily due to payments of $656 million on the Corporation's PCS
licenses in 1995, offset by 1996 investments in the core telecommunications
network and the Pacific Bell Mobile Services' PCS network. Management
anticipates capital expenditures for 1996 to reach about the same level as in
1995.
26
<PAGE>
Cash from financing activities increased $146 million for the nine months
ended September 30, 1996 compared to the same period in 1995. The net
increase reflects the proceeds from TOPrS financing, long-term debt and
leasing arrangements substantially offset by the use of these funds to reduce
the level of short-term borrowings. Lower dividend payments also contributed
to the net increase. The Corporation sold $1 billion of TOPrS, $500 million at
7.56 percent in January 1996 through Pacific Telesis Financing I and $500
million at 8.5 percent in June 1996 through Pacific Telesis Financing II.
Under certain circumstances, dividends on TOPrS could be deferred for up to a
period of five years. (See Note C - "Corporation-Obligated Mandatorily
Redeemable Preferred Securities of Subsidiary Trusts" on page 12.) The
proceeds were used to retire outstanding short-term indebtedness, primarily
commercial paper. In February 1996, Pacific Bell issued $250 million of 5.875
percent debentures due February 15, 2006. In August 1996, Pacific Bell issued
$250 million of 6.875 percent debentures due August 15, 2006. Neither issue
may be redeemed prior to maturity. The proceeds from the sale of both
issuances of debentures were used to reduce short-term debt incurred to retire
Pacific Bell debentures totaling approximately $500 million called in December
1995. In addition during 1996, the Corporation financed $211 million through
its leasing arrangements for equipment purchases for the PCS network. The
Corporation reduced its second quarter 1996 dividend to $0.315 per share which
contributed to the overall increase in cash flow in third quarter 1996.
The Corporation's debt ratio improved to 62.0 percent at September 30, 1996
from 74.1 percent at December 31, 1995. This improvement was primarily due to
the use of the TOPrS proceeds to retire outstanding short-term indebtedness.
Pre-tax interest coverage was 6.6 times for the first nine months in 1996.
Pre-tax interest coverage for the same period in 1995 was negative due to the
Corporation's reported loss in third quarter 1995.
Pursuant to the terms of the merger agreement, the Corporation reduced its
second and third quarter dividends to $0.315 per share. These dividend
reductions will improve cash flow by approximately $195 million in 1996. (See
"Merger Agreement" under Note B on page 9.)
27
<PAGE>
MERGER AGREEMENT
On April 1, 1996, SBC and the Corporation jointly announced a definitive
agreement whereby the Corporation will become a wholly-owned subsidiary of
SBC. Under terms of the merger agreement, each share of Pacific Telesis
common stock will be exchanged for 0.733 shares of SBC common stock, subject
to adjustment. The transaction is intended to be accounted for as a pooling
of interests and to be a tax-free reorganization. On July 31, 1996, the
shareowners of the Corporation and SBC approved the transaction, which
previously had been approved by the respective Board of Directors of each
company. On November 5, 1996, the U.S. Department of Justice announced it had
concluded that the merger does not violate the antitrust laws and accordingly
that it was closing its investigation into the merger. The merger is subject
to certain other conditions and regulatory approvals. The California Public
Utilities Commission ("CPUC") has established a schedule for review of the
transaction with final comments from interested parties due in January 1997.
On September 30, 1996, the Office of Ratepayer Advocates ("ORA"), the consumer
interest branch of the CPUC, filed testimony in the merger proceeding
recommending a $2.1 billion refund to customers payable over five years.
Management does not agree with the ORA's recommendation and believes no
customer rebate should be required in connection with the merger. The CPUC is
expected to make a final decision on the merger by the end of March 1997. In
Nevada, SBC and the Corporation entered into a stipulation with the staff of
the Public Service Commission of Nevada ("PSCN") and the Office of the
Consumer Advocate to refund to customers the greater of $4 million or 2.0
percent of the amount, if any, ordered by the CPUC to be refunded to Pacific
Bell customers. The refund is conditioned on approval of the stipulation by
the PSCN and closing of the merger. The PSCN has scheduled hearings for
November 25, 1996, and approval is expected in December 1996. If all
necessary approvals are granted, the transaction is expected to close in the
first quarter of 1997.
PENDING REGULATORY ISSUES
Long Distance Service
- ---------------------
In February 1996, the 1996 Telecommunications Act was signed into law
establishing new procedures under which the Corporation can apply to offer
within its region long distance telephone service between service areas. To
compete effectively in this market, the Corporation formed Pacific Bell
Communications ("PBCOM"). In March and April of 1996, PBCOM filed
applications in California and Nevada to provide competitive long distance
telephone service between and within service areas and local exchange services
as a non-dominant carrier. The Corporation must comply with a competitive
checklist required by the 1996 Telecommunications Act before PBCOM can receive
FCC approval to offer in California and Nevada long distance service between
service areas. Both federal and state approvals are required before PBCOM may
enter these markets. Management expects to be able to provide these services
in the second half of 1997.
28
<PAGE>
FCC Recommendation on Universal Service
- ---------------------------------------
On November 7, 1996, the Joint Federal-State Board on Universal Service (the
"Board") issued a recommendation on how to implement sections of the 1996
Telecommunications Act regarding universal service. Generally the plan
creates a system that identifies cost subsidies in rural and high-cost areas.
However, the Board deferred a recommendation on how large the subsidy should
be. The Board also recommended creation of a $2.25 billion fund for providing
discounted services to schools and libraries. The FCC has until May 8, 1997
to issue a final decision on this matter.
FCC Interconnection Order
- -------------------------
In August 1996, the FCC released a decision (the "Interconnection Order")
establishing guidelines to implement the 1996 Telecommunications Act, which
sets rules for opening local telecommunications markets to full competition.
The Interconnection Order lays out how long-distance companies and other new
competitors may connect to local networks and sets guidelines and prices for
network components. Management believes that the Interconnection Order
undermines the intent of the 1996 Telecommunications Act by, among other
things, denying states a role in managing and setting prices for local
markets. Management is also concerned that the order requires local telephone
companies to offer wholesale network services at unrealistically low prices.
The Corporation, along with other local telephone companies, the National
Association of Regulatory Utility Commissioners and state PUCs including the
CPUC, appealed the Interconnection Order to a federal court. On October 15,
1996, the U.S. Court of Appeals for the Eighth Circuit (the "Court of
Appeals") issued a partial stay of the Interconnection Order that stays the
operation and effect of the pricing provisions and the "pick and choose" rule,
but allows the non-pricing elements of the order to go into effect. The U.S.
Supreme Court issued a memorandum decision on November 12, 1996 refusing to
overturn the stay imposed by the Court of Appeals.
The Interconnection Order also addressed the issue of wireless
interconnection, or the arrangements under which local exchange carriers
("LECs") are compensated for interconnecting with and terminating traffic for
commercial mobile radio service ("CMRS") providers (including cellular, PCS
and paging). The Interconnection Order ruled that CMRS providers are entitled
to reciprocal compensation arrangements for transport and termination of local
telecommunications traffic. On November 1, 1996 the Court of Appeals lifted a
part of the stay described above with respect to the non-price aspects of the
FCC's reciprocal compensation rules for CMRS providers. As a result of this
order, Pacific Bell is currently renegotiating its CMRS contracts.
29
<PAGE>
FCC Annual Access Tariff Filing and Regulatory Framework Review
- ---------------------------------------------------------------
The Telephone Companies filed their 1996 annual access tariffs with the FCC,
which will increase annual revenues by approximately $27 million, for the
twelve months beginning July 1, 1996. The revenue increases are under review
by the FCC.
The FCC adopted new interim price cap rules in 1995 that govern the prices
that the larger LECs, including the Telephone Companies, charge interexchange
carriers for access to local telephone networks. The interim rules require
the 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. As in 1995, the Telephone Companies again chose
the 5.3 percent productivity factor that will enable them to retain all of
their earnings effective July 1, 1996. The higher productivity factor was
chosen because management believes that it will be more than offset by
elimination of the sharing mechanism. An FCC ruling on permanent price cap
rules has been delayed until 1997 due to the implementation of the 1996
Telecommunications Act.
Management continues to believe that the FCC should adopt pure price cap
regulation and eliminate the productivity factor, sharing and earnings cap.
CPUC Local Services Competition
- -------------------------------
The CPUC authorized facilities-based local services competition effective
January 1996 and resale competition effective March 1996. Several issues
still need to be resolved in order to implement competition in all California
telecommunications markets. Issues to be finalized include final rates for
resale and number portability, LEC provisioning and pricing of essential
network functions to competitors and presubscription. The CPUC expects to
issue final rules on presubscription in early 1997 and final rates and rules
for all other issues in late 1997.
Management believes that all markets should be open to all competitors under
the same rules at the same time, and that a truly open competitive market, in
which the Corporation can compete without restrictions, offers long-term
opportunity to build the business.
CPUC Decision on Universal Service
- ----------------------------------
The CPUC issued its final decision on universal service on October 25, 1996,
establishing an annual California universal service fund of approximately $352
million. Customers of all telecommunications providers will contribute to the
preservation of affordable telephone service via a 2.87 percent surcharge on
all bills for telecommunications services provided in California. The new
program will go into effect February 1, 1997. Applications for rehearing are
due on December 4, 1996. Management is evaluating whether to seek rehearing.
30
<PAGE>
Management is concerned that the decision underestimates the true cost of
providing universal telephone service. While $305 million of the total $352
million is expected to be paid to Pacific Bell, this is far short of what
Pacific Bell estimates the true cost of providing universal service to be.
Pacific Bell developed a Cost Proxy Model to calculate the cost of service in
California. That model estimated the average cost of providing service to be
$27 per line per month. The CPUC uses the model for the new program, but has
determined that the average cost is only $20.30 per line per month.
In order to ensure revenue neutrality, Pacific Bell must offset its rates
dollar for dollar for any funds it receives from the newly created universal
service fund. This offset will initially be accomplished by means of an
across-the-board surcredit on all of Pacific Bell's products and services
except for residential basic exchange services.
The final decision also establishes a discount program for schools, libraries,
certain community-based organizations and municipal- and county-owned
hospitals and clinics. Carriers providing services at a discounted price will
be reimbursed from a newly created California Teleconnect Fund. This discount
program will be funded by a separate surcharge of 0.41 percent on the bills of
customers of all telecommunications carriers in California.
CPUC Regulatory Framework Review
- --------------------------------
As previously reported, in December 1995, the CPUC issued an order in its
review of the regulatory framework in California. The order suspended use of
the "inflation minus productivity" component of the price cap formula for 1996
through 1998. This action freezes the price caps on most of Pacific Bell's
regulated services for the years 1996 through 1998 except for adjustments due
to exogenous costs or price changes approved through the CPUC's application
process. In October 1996, Pacific Bell filed an application with the CPUC to
adjust its rates due to exogenous cost changes, proposing an annual revenue
reduction of approximately $65 million effective January 1, 1997. The CPUC is
expected to issue a decision before the end of 1996.
Nevada Bell Rate Case
- ---------------------
The Public Service Commission of Nevada ("PSCN") approved a "Plan of
Alternative Regulation" ("the Plan") in April 1995 redesigning
telecommunications regulation in the state of Nevada. The Plan 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 Plan is optional and required a rate case to determine
initial pricing. In March 1996, Nevada Bell filed a rate case to enter the
Plan. The PSCN approved the rate case in August 1996 that redesigned rates by
increasing the monthly residential flat rate service while reducing intra-
service area toll call services and business basic prices. The Plan will be
effective January 1, 1997 and is estimated to decrease annual revenue by
approximately $13 million. The PSCN also increased depreciation rates that
are estimated to increase annual depreciation expense by about $5 million
beginning in January 1997.
31
<PAGE>
PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders.
On July 31, 1996, the Corporation held a Special Meeting of Shareowners to
vote on a proposal to approve and adopt the Agreement and Plan of Merger among
the Corporation, SBC Communications Inc. and SBC Communications (NV) Inc.,
dated April 1, 1996. The proposal received the following number of votes:
Approve and Adopt the Agreement and Plan of Merger:
- ---------------------------------------------------
Broker
For Against Abstentions Nonvotes
- ----------- --------- ----------- --------
313,514,848 6,918,094 3,442,772 0
Item 5. Proposed Merger With SBC Communications Inc.
SBC Communications Inc. ("SBC") and Pacific Telesis have entered into the
Merger Agreement, pursuant to which Pacific Telesis would become a wholly-
owned subsidiary of SBC. Under terms of the Merger Agreement, each share of
Pacific Telesis Common Stock will be converted into 0.733 shares of common
stock, par value $1.00 per share, of SBC (the "SBC Common Stock"), subject to
adjustment, as described in the Merger Agreement. Under the Merger Agreement,
Pacific Telesis may not pay a dividend in excess of 73.3% of SBC's dividend.
The transaction, which has been approved by the Board of Directors and
shareholders of each company, will be accounted for as a pooling of interests
and be a tax-free reorganization. On November 5, 1996, the U.S. Department of
Justice announced it had concluded that the merger does not violate the
antitrust laws and accordingly that it was closing its investigation into the
merger. The Merger Agreement is subject to certain other conditions and
regulatory approvals. The California Public Utilities Commission has
established a schedule for review of the transaction with final comments from
interested parties due in January 1997. There can be no assurance that the
Merger will be consummated. Details of the proposed merger with SBC, including
certain financial information, appear in Pacific Telesis' Proxy Statement
dated June 3, 1996.
SBC is a holding company whose subsidiaries and affiliates operate
predominantly in the communications services industry. SBC's subsidiaries and
affiliates provide landline and wireless telecommunications services and
equipment, directory advertising, publishing and cable television services.
Southwestern Bell Telephone Company is SBC's largest subsidiary, providing
telecommunications services in Texas, Missouri, Oklahoma, Kansas and Arkansas.
32
<PAGE>
Item 5. Proposed Merger With SBC Communications Inc. (Continued)
SBC is subject to the informational reporting requirements of the Securities
Exchange Act of 1934, as amended, and in accordance therewith files reports,
including reports on Form 8-K which present proforma combined condensed
financial statements of SBC Communications Inc. and Pacific Telesis Group,
proxy statements and other information with the Securities and Exchange
Commission ("SEC"). Such reports, proxy statements and other information may
be inspected and copied at the public reference facilities maintained by the
SEC at Room 1024, Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C.
20549, and at the SEC's regional offices located at 7 World Trade Center, 13th
Floor, New York, New York 10019 and Northwestern Atrium Center, 500 West
Madison Street, Suite 1400, Chicago, Illinois 60661. Copies of such material
may be obtained by mail from the Public Reference Section of the SEC at
Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549, at prescribed
rates. The SEC maintains a World Wide Web site at http://www.sec.gov that
contains reports, proxy and information statements and other information
regarding entities that file electronically with the SEC, including SBC. In
addition, reports, proxy statements and other information concerning SBC may
be inspected at the offices of the following stock exchanges on which the
common stock of SBC is traded: the New York Stock Exchange, 20 Broad Street,
New York, New York 10005; the Chicago Stock Exchange, One Financial Place, 440
South La Salle Street, Chicago, Illinois 50504; and the Pacific Stock
Exchange, 301 Pine Street, San Francisco, California 94104. Pacific Telesis
does not assume any responsibility for the accuracy or completeness of the
information concerning SBC contained in such documents and does not warrant
that there have not occurred events not yet publicly disclosed by SBC which
would affect the accuracy or completeness of the information concerning SBC
included therein.
33
<PAGE>
Item 5. Proposed Merger With SBC Communications Inc. (Continued)
The following table sets forth for the fiscal periods indicated the high and
low reported sale prices for SBC's common stock on the New York Stock
Exchange.
REPORTED
SALE PRICE
----------------
HIGH LOW
-------- -------
1994
- ----
First Quarter.............................................$42.000 $36.750
Second Quarter............................................$44.375 $38.500
Third Quarter.............................................$44.250 $40.250
Fourth Quarter............................................$43.125 $39.250
1995
- ----
First Quarter.............................................$43.875 $39.625
Second Quarter............................................$47.875 $41.625
Third Quarter.............................................$55.125 $45.500
Fourth Quarter............................................$58.500 $53.125
1996
- ----
First Quarter.............................................$60.250 $49.750
Second Quarter............................................$50.750 $46.250
Third Quarter.............................................$51.000 $45.625
34
<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.
10a Agreement and Plan of Merger among Pacific Telesis Group, SBC
Communications Inc. and SBC Communications (NV) Inc., dated as of
April 1, 1996. (Exhibit (2) to Form 8-K, Date of Report April 1,
1996, File No. 1-8609.)
10qq Pacific Telesis Group 1996 Executive Deferred Compensation Plan, as
adopted effective December 1, 1995.
11 Computation of Earnings per common share.
15 Letter re unaudited interim financial information.
27 Article 5 FDS for 3rd Quarter 1996 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.
--------------------
None.
35
<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
Date: November 13, 1996
36
<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.
10a Agreement and Plan of Merger among Pacific Telesis Group, SBC
Communications Inc. and SBC Communications (NV) Inc., dated as of
April 1, 1996. (Exhibit (2) to Form 8-K, Date of Report April 1,
1996, File No. 1-8609.)
10qq Pacific Telesis Group 1996 Executive Deferred Compensation Plan, as
adopted effective December 1, 1995.
11 Computation of Earnings per common share.
15 Letter re unaudited interim financial information.
27 Article 5 FDS for 3rd Quarter 1996 Form 10-Q.
37
<PAGE>
EXHIBIT 11
----------
PACIFIC TELESIS GROUP AND SUBSIDIARIES
COMPUTATION OF EARNINGS (LOSS) PER SHARE
(Dollars in millions, except per share amounts; shares in thousands)
For the 3 Months Ended For the 9 Months Ended
September 30, September 30,
---------------------- -----------------------
1996 1995 1996 1995
---------------------- -----------------------
Net income (loss) $ 286 $ (3,085) $ 865 $ (2,543)
======== ======== ======= ========
Weighted average number
of common shares
outstanding ........... 428,362 427,421 428,411 425,184
Common stock equivalent
shares applicable to
stock options.......... 1,743 376 1,301 429
-------- -------- ------- --------
Total number of shares
for computing primary
earnings (loss) per share 430,105 427,797 429,712 425,613
Incremental shares for
computing fully diluted
earnings (loss) per share 4 202 446 149
-------- -------- ------- --------
Total number of shares
for computing fully
diluted earnings
(loss) per share......... 430,109 427,999 430,158 425,762
======== ======== ======== ========
Earnings (loss) per common
share (as reported)...... $ 0.67 $ (7.22) $ 2.02 $ (5.98)
Primary earnings (loss)
per share................ $ 0.66 $ (7.21) $ 2.01 $ (5.97)
Fully diluted earnings
(loss) per share......... $ 0.66 $ (7.21) $ 2.01 $ (5.97)
Earnings (loss) per share amounts for the three- and nine-month periods ended
September 30, 1996 and 1995, 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.
November 13, 1996
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 November 13, 1996 on our review of the
interim financial information of Pacific Telesis Group and Subsidiaries for
the three- and nine-month periods ended September 30, 1996 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-3: Pacific Telesis Group and Pacific Telesis Financing I, II
and III $1 billion of Trusts Preferred Securities and Other
Securities
Form S-3: 2,576,494 shares of Pacific Telesis Group Common Stock
Form S-3: SBC Communications, Inc. Dividend Reinvestment Plan
Form S-4: ABI American Businessphones, Inc. Merger
Form S-4: SBC Communications, Inc. Merger
Form S-4: 3,250,000 shares of Pacific Telesis Group Common Stock
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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<S> <C>
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> SEP-30-1996
<PERIOD-TYPE> 9-MOS
<CASH> 81
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<BONDS> 5,424
<COMMON> 43
0
0
<OTHER-SE> 2,580
<TOTAL-LIABILITY-AND-EQUITY> 16,225
<SALES> 0
<TOTAL-REVENUES> 7,145
<CGS> 0
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