<PAGE>
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
Form 8-K
CURRENT REPORT
PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Date of Report: March 13, 1997
PACIFIC TELESIS GROUP
A Nevada Commission File I.R.S. Employer
Corporation No. 1-8609 No. 94-2919931
130 Kearny Street, San Francisco, California 94108
Telephone Number (415) 394-3000
<PAGE>
Form 8-K Pacific Telesis Group
March 13, 1997
Item 7. Exhibits
- -----------------
Exhibit
Number Description
------- -----------
23 Consent of Independent Accountants
99.1 1996 Unaudited Management's Discussion and Analysis of
Financial Condition and Results of Operations for Pacific
Telesis Group and Subsidiaries; and Audited Consolidated
Balance Sheets of Pacific Telesis Group and Subsidiaries
as of December 31, 1996 and 1995, and the related
Consolidated Statements of Income, Shareowners' Equity,
and Cash Flows for each of the three years in the period
ended December 31, 1996.
2
<PAGE>
Form 8-K Pacific Telesis Group
March 13, 1997
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/ William E. Downing
-------------------------
William E. Downing
Executive Vice President,
Chief Financial Officer, and Treasurer
March 13, 1997
3
<PAGE>
EXHIBIT INDEX
Exhibit
Number Description
------- -----------
23 Consent of Independent Accountants
99.1 1996 Unaudited Management's Discussion and Analysis of
Financial Condition and Results of Operations for Pacific
Telesis Group and Subsidiaries; and Audited Consolidated
Balance Sheets of Pacific Telesis Group and Subsidiaries
as of December 31, 1996 and 1995, and the related
Consolidated Statements of Income, Shareowners' Equity,
and Cash Flows for each of the three years in the period
ended December 31, 1996.
4
<PAGE>
EXHIBIT 23
----------
CONSENT OF INDEPENDENT ACCOUNTANTS
We consent to the incorporation by reference of our reports dated February 27,
1997 on our audits of the consolidated financial statements of Pacific Telesis
Group and Subsidiaries as of December 31, 1996 and 1995 and for each of the
three years in the period ended December 31, 1996, which reports are included,
or incorporated by reference, in the Pacific Telesis Group Form 8-K dated
March 13, 1997 and 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-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
/s/ COOPERS & LYBRAND L.L.P.
San Francisco, California
March 13, 1997
<PAGE>
EXHIBIT 99.1
------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
When used in the "Management's Discussion and Analysis of Financial Condition
and Results of Operations" ("MD&A") below, the words "expects", "anticipates",
"estimates", "believes" and words of similar import may constitute "forward-
looking statements" within the meaning of Section 17A of the Securities Act of
1933, as amended. Such statements, which include projections of revenue
growth and statements of management's objectives and expectations as to levels
of expenditures, are subject to risks and uncertainties that could cause
actual results to differ materially from those projected. These forward-
looking statements speak only as of the date of this MD&A. Pacific Telesis(R)
Group (the "Corporation") expressly disclaims any obligation or undertaking to
publicly release any updates or revisions to any forward-looking statements
contained herein to reflect any change in the Corporation's expectations with
regard thereto or any change in events, conditions or circumstances on which
any such statement is based.
OVERVIEW
The Corporation includes a holding company, Pacific Telesis, and its telephone
subsidiaries: Nevada Bell and Pacific Bell(R) (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 Telephone Companies
provide local exchange services, network access, local toll services,
directory advertising, Internet access, Personal Communications Services
("PCS") and selected information services in California and Nevada.
The Corporation's primary financial goal is to build long-term value for its
shareowners. Management's business strategies of expanding and strengthening
the core telecommunications business, developing new markets and promoting
public policy reform have returned the Corporation to solid growth and
continue to build value not only for its shareowners, but also for its
customers and employees.
To further enhance shareowner, customer and employee value, and to meet the
challenges of our dramatically changing industry, the Board of Directors
announced a plan on April 1, 1996 to merge with SBC Communications Inc.
("SBC").
PLANNED MERGER
The decision to merge with SBC was based on a comprehensive evaluation of the
economic, financial, regulatory and technological factors in the
telecommunications industry. Management believes that the combined financial
resources, access to national and international markets, and technologies of
the combined companies will better enable them to take full advantage of the
growth opportunities provided by the Telecommunications Act of 1996. This
1
<PAGE>
combination will better position the Corporation in today's competitive
telecommunications environment. The merger is based on growth opportunities
which will bring at least 1,000 new jobs to the combined companies in
California, as well as the headquarters of four of the combined companies'
operations.
The merger has been approved by the shareowners of the Corporation and SBC,
the Federal Communications Commission ("FCC") and the Public Service
Commission of Nevada ("PSCN"). The U.S. Department of Justice concluded that
the merger does not violate the antitrust laws. In addition, the California
State Attorney General has told the California Public Utilities Commission
("CPUC") that the merger will not hurt competition in California and is
consistent with emerging trends. On February 21, 1997, two California
administrative law judges issued a proposed decision approving the merger but
with a number of conditions, including payment of up to $750 million.
Management does not agree with the level of payment or the restrictive
conditions and intends to work towards their reduction or elimination. A
proposed decision by the administrative law judges is not binding. The CPUC
is expected to review the full case and the proposed decision and issue a
final decision by March 31, 1997. Depending on the final CPUC decision, the
merger could close in early second quarter. (See "Merger Agreement" under Note
O on page 70.)
Management believes the merger will broaden investors' options by creating one
of the nation's largest national and international telecommunications
businesses. The merger will enhance competition in the communications
industry and position the combined companies to continue to grow and pursue
new opportunities in these increasingly competitive markets.
KEY STRATEGIES
With increasing competition for existing services, the opening of local and
toll services competition in California, and the enactment of the
Telecommunications Act of 1996, the Corporation faces an increasingly
competitive marketplace. Management's key strategies provided a strong
response to the competitive challenge, as reflected by the Corporation's
strong growth in revenues for 1996. The business strategies of expanding and
strengthening the core telecommunications business, developing new markets and
promoting public policy reform further the Corporation's goal of being the
customers' first choice for their telecommunications needs.
Strengthen Core Business
- ------------------------
A strong core business provides the essential foundation to pursue future-
oriented opportunities. To strengthen the core telecommunications business,
management will continue to upgrade network and systems capability, improve
customer service and efficiency, and retain and expand existing markets
through product and channel innovation.
Upgrade Network and Systems Capabilities
In order to offer the products and services customers want, now and in the
future, the Telephone Companies continue to invest heavily in improvements to
the core telecommunications networks. The Telephone Companies spent a total of
$2.5 billion primarily on the telecommunications networks during 1996. The
2
<PAGE>
focus of these investments has been in the advanced digital technologies
discussed below. These technologies enable the Telephone Companies to provide
new products and services, increase network quality and reliability, increase
transmission speed, and reduce costs.
December 31
-----------
Technology Deployment 1996 1995
- ------------------------------------------------------------------------
Access lines served by digital switches...................... 80% 73%
Access lines with SS-7 capability............................ 98% 98%
Access lines with ISDN accessibility......................... 90% 85%
Miles of installed optical fiber (thousands)................. 541 482
- ------------------------------------------------------------------------
Digital switches and optical fiber, a technology using thin filaments of glass
or other transparent materials to transmit coded light pulses, increase the
capacity and reliability of transmitted data while reducing maintenance costs.
Signaling System 7 ("SS-7") permits faster call setup and custom calling
services. Integrated Services Digital Network ("ISDN") allows simultaneous
transmission of voice, data, and video over a single telephone line. In
addition, the Telephone Companies are deploying Synchronous Optical Network
("SONET") interfaces within the fiber infrastructure. SONET is an
international standard for high-speed fiber optics transmission.
In December 1994, Pacific Bell contracted for the purchase of up to $2 billion
of Advanced Communications Network ("ACN") facilities, which incorporated new
technologies. During 1995, the ability to deploy the facilities outstripped
the ACN vendors' ability to deliver necessary products and software.
Accordingly, management decided to suspend construction at certain sites,
which reduced the expected cost to less than $700 million. If ACN facilities
meet certain quality and performance criteria (the "Network Test"), Pacific
Bell is committed to purchase the ACN facilities in 1998. If ACN facilities
fail the Network Test, Pacific Bell will not be committed to buy the ACN
facilities but might be liable to reimburse the principal ACN vendor for some
construction costs up to $300 million. If competition or other factors affect
Pacific Bell's ability to recover its investment in these facilities, the
value of the ACN facilities could be materially impaired.
Improve Customer Service and Efficiency
The Corporation also has invested in its networks to enhance service quality,
key to winning and keeping customers in a competitive market. According to a
1996 telecommunications study performed by J. D. Power and Associates, the
Corporation ranked second in customer satisfaction for local residential
telephone service. The Corporation is in a service industry and the quality
of service provided is still the most essential part of what the Corporation
sells.
In April 1996, the Corporation introduced a Pacific Bell Awards program,
designed to reward customers for continuing to choose Pacific Bell. The
program offers rewards from more than 20 partners that include airlines,
computer companies and restaurants. The Pacific Bell Awards program helps
promote brand name and also encourages customers to subscribe to the
Corporation's new products and services such as wireless PCS and Digital TV.
3
<PAGE>
Recognizing the diversity of our customers, the Corporation provides service
in multiple languages to many bilingual or non-English speaking customers in
California, particularly those linked to the Pacific Rim and to Central and
South America. The number of customers whose service was provided in other
languages has grown by 129 percent since 1990, contributing to the
Corporation's revenues. Strong brand name recognition and an excellent
reputation in many ethnic market segments will enhance opportunity for the
Corporation when it enters the long distance business.
Superior service is delivered by employees in the Corporation's workforce
whose capabilities and cultures match the diversity and demands of the market.
In 1996, the U.S. Department of Labor also recognized this effort and honored
the Corporation with its Opportunity 2000 award for fostering employment
opportunities and employee diversity.
To prosper in a competitive environment, the Corporation must continue to
provide outstanding customer service while improving efficiency. The
Corporation's core process reengineering ("CPR") projects, implemented
primarily at Pacific Bell, have resulted in better, faster customer service
with greater efficiency. CPR is a method for achieving significant increases
in performance by rethinking basic business processes and systems. For
example, Pacific Bell reduced the number of network operations centers from 25
to two. The new centers, which were fully operational in early 1996, require
fewer employees to operate than the old centers and each serves as a fully
operational backup for the other. And in 1995, Pacific Bell created customer
service centers to improve the response to service activation and repair
calls. With many functions consolidated in the centers, significant time
savings and service improvements have been achieved by reducing hands-off
between functional work groups. Reengineering processes and other efforts
contributed to the improvement in efficiency as measured by the change in the
Telephone Companies' employees per 10,000 access lines to 26.6 in 1996 from
28.8 in 1995.
Retain and Expand Existing Markets
Stimulating usage of the Telephone Companies' existing networks is the most
cost effective way to increase revenues. The Corporation is increasing its
use of alternative sales channels and targeted advertising to stimulate usage.
Focus areas include high-growth data markets, voice mail, additional
residential lines, and custom calling services.
The market for high-speed data transmission, or the Pacific Bell FasTrak(SM)
data services, grew rapidly in 1996 due to focused marketing campaigns and the
improved economy. The Telephone Companies' ISDN volumes in 1996 increased
92.4 percent from 1995. Volumes for other FasTrak data services increased as
follows for 1996 over the prior year: Frame Relay increased 111.5 percent and
Switched Multimegabit Data Service ("SMDS") increased 60.3 percent. Frame
Relay technology allows a customer to transmit 126 pages of data per second
and enables the customer to move data quickly between widely dispersed local
area networks. SMDS allows users to buy whatever bandwidth they need, and to
upgrade it later if desired.
In December 1996, Pacific Bell began testing the delivery of Asynchronous
Transfer Mode ("ATM") high-speed data to the desktop over the telephone
network using Asymmetric Digital Subscriber Line ("ADSL") technology. ATM is
4
<PAGE>
considered the multimedia switching technology of the future. ATM functions
over ADSL, a technology that delivers higher bandwidth over copper telephone
lines. Pacific Bell has been conducting a limited ADSL trial in San Ramon,
California since the fall of 1996.
Changes in technology and telecommuting are fueling increased demand for
additional telephone lines in the home. The Corporation provides
approximately 2 million residential access lines that are in addition to the
customer's primary line. Customers want extra lines for data transmission,
Internet access, fax machines, and convenience. Similarly, demand for custom
calling services, such as call waiting, grew more than 11.1 percent in 1996 as
customers asked for greater convenience and more control over their telephone
communications. Caller ID, another custom calling service, was launched in
July 1996 and displays the telephone number of the calling party on a device
that attaches to, or is part of, a customer's telephone.
The success of the Corporation's voice mail products continued in 1996.
Customers value such features as the ability of the service to answer the
phone even when they are on the line. They also like remote message retrieval
features and the reliability of the network. Voice mailbox equivalents in
service increased 18 percent in 1996 to about 1.7 million.
Capital expenditures for the Corporation in 1997 are forecast to be about $2.5
billion. This amount includes approximately $2.0 billion primarily for the
cost of upgrading and maintaining the core telecommunications network and
system capabilities. The remainder of this amount includes the cost of
building the PCS network and constructing the wireless digital television
network as described below.
New Markets
- -----------
As competition intensifies in its core telecommunications business, the
Corporation will rely increasingly on developing new products and services to
create new revenue sources. Toward that end, the Corporation is actively
creating and pursuing markets in PCS, Internet access, network integration,
digital wireless television, long-distance, and other information services.
In November 1996, Pacific Bell Mobile Services ("PBMS") launched PCS in San
Diego, California, and in February 1997, in Las Vegas, Nevada. Unlike most
cellular service, PCS is a digital wireless service, offers superior sound
quality, and protection from eavesdropping and cloning. The network will
incorporate the Global System for Mobile Communications ("GSM") standard which
is widely used in Europe. PBMS phones for PCS feature a built-in pager and
answering machine. PBMS is selling PCS as an off-the-shelf product in
approximately 100 retail stores across San Diego County and about 60 retail
stores in Las Vegas. PBMS plans to offer PCS service in San Francisco and Los
Angeles in the second quarter of 1997. Management expects a widespread
offering of PCS service in most of California and Nevada by mid-1997.
Although management anticipates significant competition, particularly from
established cellular companies, it believes that digital technology and
Pacific Bell's reputation for superior service will position our offering well
with the customer.
Pacific Bell Internet Services ("PBI") provides Internet access services to
business customers and in May 1996 rolled out its service to consumers. It is
5
<PAGE>
estimated that between 30 and 40 percent of all Internet traffic originates or
terminates in California. In 1996, PBI added over 65,000 customers in
California and Nevada. Pacific Bell Network Integration ("PBNI"), a new
business initiated in mid-1996, was formed to assist customers with the
implementation of information technology networks by providing state-of-the-
art network management and consulting services. In November 1996, Pacific Bell
unveiled its new ISDN Home Pack(TM), the nation's first fully integrated ISDN
and Internet package. The package includes Internet access through Pacific
Bell's Internet Service network, a digital modem and Internet browser
software. PBI handles the Internet access and customized software of the
package. PBNI is responsible for integrating the whole package and managing
delivery of the hardware and software components.
In 1996, Pacific Bell Interactive Media ("PBIM") launched Pacific Bell At
Hand(SM), an Internet web site (www.athand.com) designed with focus on
California. California merchants and consumers distribute, receive and
exchange information in one of the Internet's most dynamic markets.
Categories such as Entertainment and Leisure, Sports and the newly released
Real Estate provide users an intimate look at restaurants, golf courses, state
parks, multiple listing entries, and other advertiser provided content. In
1997, PBIM will continue to add to its merchant directory lineup.
In 1996, Pacific Bell Video Services ("PBVS") started testing its wireless
digital television service in the Los Angeles area. Technology and programming
market trials were completed successfully. PBVS plans to move forward in
Spring 1997 with a commercial launch in the Los Angeles and Orange County
areas. The Corporation currently provides analog wireless television service
to over 46,000 video customers in portions of Riverside and San Bernadino
counties. In September 1996, PBVS started delivering cable television over
the Advanced Communications Network in San Jose, California.
In response to the Telecommunications Act of 1996, the Corporation formed a
new subsidiary, Pacific Bell Communications ("PBCOM"), to provide long-
distance telephone service. (See "Telecommunications Legislation" on page 7.)
PBCOM has filed applications in California and Nevada to provide competitive
long-distance telephone service between and within service areas. Both federal
and state approvals are needed before PBCOM may enter these markets. The
Telephone Companies must separately comply with a competitive checklist
mandated by law to enable PBCOM to enter the long distance business. By mid-
February 1997, Pacific Bell had 26 interconnection agreements with a wide
range of companies, of which ten met the FCC's 14-point checklist. In
addition, six agreements with cellular service providers had been signed.
PBCOM is required to have independent network capabilities, operating support
systems, other support systems and customer care/billing center capabilities
separate from the Telephone Companies, which PBCOM is currently building or
acquiring. As a result of significant progress in complying with the
competitive checklist, the Corporation intends to make a filing with the FCC
during the first half of 1997 to seek approval to enter the long distance
market.
Management sees these new markets as attractive investment opportunities even
though substantial start-up costs will be incurred.
6
<PAGE>
Public Policy
- -------------
Telecommunications policy reform has been, and will continue to be, the
subject of much debate in Congress, the California Legislature, the courts,
the FCC, the CPUC, and the PSCN. Management supports public policy reform
that promotes fair competition and ensures that the responsibility for
universal service is shared by all who seek to provide telecommunications
services.
Telecommunications Legislation
In February 1996, the Telecommunications Act of 1996 was signed into law,
easing certain restrictions imposed by the Communications Act of 1934 and the
1984 Cable Act, and replacing the 1982 Consent Decree. Among the provisions,
the new law allows telephone companies and cable television companies to
compete in each others' markets, and permits the former Bell Operating
Companies to apply to the FCC for authority to offer long-distance service,
subject to certain conditions. Once the new law is fully implemented,
consumers will have many new options for their local telephone, long-distance,
and cable television services. (See "FCC Recommendation on Universal Service"
and "FCC Interconnection Order" below.)
FCC Recommendation on Universal Service
In November 1996, the Joint Federal-State Board on Universal Service (the
"Board") issued a recommendation on how to implement sections of the
Telecommunications Act of 1996 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
subsidies 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 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 Telecommunications Act of 1996, 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 Telecommunications Act of 1996 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
7
<PAGE>
overturn the stay imposed by the Court of Appeals. The Court of Appeals is
expected to issue a decision by mid-1997.
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 and has
signed agreements with six CMRS providers, including the major California
providers.
FCC Regulatory Framework Review
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.
The revised FCC price cap plan was intended to be an interim plan that would
be revised in 1996. However, with the passage of the Telecommunications Act
of 1996, the FCC is conducting further proceedings to address various pricing
and productivity issues, and is performing a broader review of price cap
regulation in a competitive environment. Additionally, the FCC has indicated
that it will also examine universal service (see "FCC Recommendation on
Universal Service" on page 7) and access charge rules during 1997.
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 before the CPUC issues final rules for local
competition. These issues include final rates for resale, presubscription,
implementation of number portability and LEC provisioning and pricing of
essential network functions to competitors. In order to provide services to
resellers, Pacific Bell will use operating support systems currently in place,
and it is also building electronic ordering systems and a customer
care/billing center. Costs to implement local competition, especially number
portability, will be material and it is uncertain whether regulators will
8
<PAGE>
allow for recovery of these costs. 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 and maximizes benefit for the consumer.
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 went into effect on February 1, 1997.
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 initially, this is far short of
Pacific Bell's estimate of the true cost of providing universal service.
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 in a modified form for the
new program, but has determined that the average cost is only $20.30 per line
per month. The universal service fund provides full funding for the
difference between the adopted CPUC cost and price only for those lines with
costs above $20.30. Pacific Bell's price for basic service, including federal
charges, is $14.75. Lines that cost more than $14.75, but less than $20.30
will not receive any funding. About 25 percent of Pacific Bell's residence
primary lines qualify for funding.
In order to ensure revenue neutrality, Pacific Bell must reduce its rates
dollar for dollar for any funds it receives from the newly created universal
service fund. This reduction 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 order allows Pacific Bell
to file an application to replace the initial across-the-board surcredit with
permanent price reductions for those services that previously subsidized
universal 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
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
9
<PAGE>
price changes approved through the CPUC's application process. In December
1996, the CPUC adjusted Pacific Bell's rates due to exogenous cost changes by
an annual revenue reduction of approximately $66 million effective January 1,
1997.
Management continues to believe that the CPUC should adopt pure price cap
regulation and permanently eliminate sharing, earnings caps, and all other
vestiges of rate-of-return regulation.
PSCN Regulatory Review
The 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. In August 1996, the PSCN redesigned rates by
increasing the monthly residential flat rate service while reducing intra-
service area toll call services and business basic prices. The Plan was
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.
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
Pacific Bell'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. Pacific Bell also faces
competition from cable television companies and others.
Effective January 1, 1995, the CPUC authorized toll services competition.
Management estimates that share losses since January 1, 1995 have been in the
five to six percent range. However, this loss combined with losses prior to
the official opening of this market has resulted in Pacific Bell currently
serving less than 50 percent of the business toll market. In April 1995, the
CPUC also ordered Pacific Bell to offer expanded interconnection to
competitive access providers. These competitors are allowed to carry the
intrastate portion of long-distance and local toll calls between Pacific
Bell's central offices and long distance carriers. Competitors may choose to
locate their transmission facilities within or near Pacific Bell's central
offices.
Effective January 1, 1996, the CPUC authorized local exchange competition. By
early February 1997, the CPUC had authorized about 90 companies, including
large and well-capitalized long distance carriers, competitive access
providers, and cable television companies to begin providing local phone
service in California, and 38 additional applications were pending. These
companies are prepared to compete in major local exchange markets and many
have already deployed switches or other facilities. All of Pacific Bell's
10
<PAGE>
customers have already chosen a long distance company, and these companies
have established widespread customer awareness through extensive advertising
campaigns over several years.
Local exchange competition may affect toll and access revenues, as well as
local service revenues, since customers may select a competitor for all their
telecommunications services. Local exchange competition may also affect other
service revenues as Pacific Bell Directory will have to acquire listings from
other providers for its products, and competing directory publishers may ally
themselves with other telecommunications providers. Management estimates the
CPUC's proposed local competition rules could materially reduce revenue growth
for Pacific Bell's regulated California operations by late 1997.
The characteristics of the California market make it attractive to new
competitors. Pacific Bell's business and residence revenues and profitability
are concentrated among a small portion of its customer base and geographic
areas. Competitors need only serve selected portions of Pacific Bell's
service area to compete for the majority of its 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. California is also attractive because it has one of the lowest
switched access rates in the country. By combining the low switched access
rates and discounted resale rates, competitors have the ability to price their
services below Pacific Bell's prices while maintaining high margins.
Reselling allows competitors to offer local services with little or no
investment.
Management believes that now that our markets are open to all competitors, the
Corporation should be granted access to markets that are currently closed to
LECs. A truly open competitive market, in which the Corporation can compete
without restrictions, offers long-term opportunity to build the business and
maximizes benefits for consumers. Management believes its key strategies of
strengthening the core business by upgrading its network and systems
capabilities, improving customer service and efficiency, expanding existing
markets, developing new markets and promoting public policy reform, will
provide a strong response to its competitive challenge. (See "Key Strategies"
on page 2.)
In Nevada, the PSCN issued a ruling opening the local exchange market to
competition. It includes requirements that the LECs allow interconnection,
unbundling, interim number portability and resale. Current PSCN proceedings
are addressing pricing, interconnection and other local competition issues.
At least two long distance carriers have requested resale of Nevada Bell
services, and two competitive access providers have entered the Northern
Nevada market, with the express intent of providing an alternative basic
business service to high-margin customers. Further, long distance carriers
can now transport toll calls both within and between service areas, and there
is evidence that such transport is increasing at a rapid rate. As in
California, Nevada Bell's market is attractive to new competitors.
Competition is expected to target the high-usage, high-profit customers.
These customers are geographically concentrated in the Reno/Sparks
metropolitan area and business parks.
11
<PAGE>
RESULTS OF OPERATIONS
The following discussions and data summarize the results of operations of the
Corporation for the periods 1996 compared to 1995, and 1995 compared to 1994.
The Corporation's previous interests in the operating results of wireless
operations that were spun off to shareowners on April 1, 1994, are classified
separately as "spun-off operations" in the accompanying financial statements.
(See Note B - "Spun-off Operations" on page 46.) The spun-off operations are
excluded from the Corporation's results from continuing operations.
% %
Operating Statistics 1996 Change 1995 Change 1994
- --------------------------------------------------------------------------
Capital expenditures ($ millions). 2,753 -7.0 2,961 75.8 1,684
Total employees at December 31.... 48,330 -1.1 48,889 -5.2 51,590
Telephone Companies' employees
at December 31*................. 43,713 -3.7 45,413 -6.2 48,404
Telephone Companies' employees per
ten thousand access lines*...... 26.6 -7.6 28.8 -8.9 31.6
- --------------------------------------------------------------------------
* Excludes Pacific Bell Directory and Pacific Bell Mobile Services
employees.
Earnings
- --------
Earnings and earnings per share for 1996 were $1,142 million and $2.67,
respectively. 1996 earnings included a one-time, non-cash after-tax gain of
$85 million, or $0.20 per share associated with a change in accounting for
directory publishing revenues and expenses, which was substantially offset by
a number of other one-time items. (See "Cumulative Effect of Accounting
Change" under Note A on page 45.) Earnings for 1996 reflect the revenue
growth from increased customer demand for local telephone products associated
with marketing efforts and California's growing economy. Earnings remained
stable despite substantial increases in expenditures associated with entering
new businesses, increased demand and regulatory mandates for local
competition.
The Corporation reported a loss of $2,312 million for 1995, or loss per share
of $5.43. Earnings and earnings per share for 1995 before extraordinary item
were $1,048 million and $2.46, respectively. The reported loss is due
primarily to a non-cash, extraordinary charge to net income during third
quarter 1995 of $3.4 billion, after taxes, or $7.89 per share. The charge
resulted from the discontinued application by the Corporation's Pacific Bell
subsidiary of special accounting rules for entities subject to traditional
regulation and Pacific Bell's change to the general accounting rules used by
competitive enterprises. (See Note C - "Discontinuance of Regulatory
Accounting - SFAS 71" on page 47.)
Revenue shortfalls also contributed to the decline in 1995 earnings. Demand
growth as a result of the January 1995 local toll price reductions fell far
short of the level anticipated by the CPUC. As a result, the revenue
neutrality intended by the CPUC's price rebalancing order was not achieved.
(See "CPUC Revenue Rebalancing Shortfall" on page 28.) Price cap revenue
reductions ordered by the CPUC and the FCC further reduced earnings.
Additional pressure on earnings resulted from incremental labor expense
12
<PAGE>
associated with the severe storms in 1995. Pressure on earnings was mitigated
by the Corporation's continuing cost containment initiatives.
Management cannot predict the effects on earnings for 1997 from competition
and issues remaining to be resolved with the Telecommunications Act of 1996.
Management anticipates earnings dilution from the development of new markets
and increased local competition, but believes that the California economy will
continue to improve and that our history of effective cost controls will
continue. (See "Planned Merger" through "Competitive Risk" on pages 1-11.)
Volume Indicators
- -----------------
% %
1996 Change 1995 Change 1994
- ---------------------------------------------------------------------------
Switched access lines at Dec. 31
(thousands)....................... 16,427 4.2 *15,767 3.0 *15,307
Residence....................... 10,225 3.7 *9,862 *2.0 *9,670
Business........................ 5,986 5.2 *5,691 4.9 5,426
Other........................... 216 0.9 214 *1.4 *211
ISDN access lines at Dec. 31
(thousands, included in above). 102 92.4 53 130.4 23
Total interexchange carrier access
minutes-of-use (millions)......... 64,635 9.2 59,193 *13.0 *52,370
Interstate...................... 36,361 10.9 32,774 *7.2 *30,575
Intrastate...................... 28,274 7.0 26,419 *21.2 *21,795
Toll messages (millions).......... 5,176 7.4 4,819 *7.7 *4,473
Toll minutes-of-use (millions).... 15,935 9.5 14,547 *4.5 *13,917
Voice mailbox equivalents at Dec. 31
(thousands)...................... 1,714 18.0 1,453 27.0 1,144
Custom calling services at Dec. 31
(thousands)...................... 8,011 11.1 *7,211 *8.2 *6,666
- ---------------------------------------------------------------------------
* Restated.
The total number of access lines in service at December 31, 1996, grew to
16.427 million, an increase of 4.2 percent for the year, up from 3.0 percent
in 1995. The residential access line growth rate increased to 3.7 percent for
1996, up from 2.0 percent in 1995 reflecting the growing California economy.
The growth rate in business access lines was 5.2 percent in 1995, up from 4.9
percent in 1995. The growth in business access lines reflects increased
employment levels in California. The number of ISDN lines in service grew to
102 thousand, an increase of 92.4 percent for 1996, as customers increased
telecommuting and 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 1996 increased by 9.2 percent over 1995. The increase in access
minutes-of-use was primarily attributable to economic growth. The growth rate
of 13.0 percent in 1995 was higher than 1996 due to the introduction of toll
services competition in 1995. In California, the official introduction of
13
<PAGE>
toll services competition in January 1995 had the effect of increasing
intrastate access minutes-of-use. This phenomenon occurs because Pacific Bell
provides access service to competitors who complete local toll calls over
Pacific Bell's network.
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. In 1996, toll minutes-of-use increased by
9.5 percent compared to an increase of 4.5 percent for 1995. The increase was
driven primarily by economic growth.
Management cannot predict the effects on volumes for 1997 from competition and
issues remaining to be resolved with the Telecommunications Act of 1996.
However, management believes that the California economy will continue to
improve and that its business strategies will position the Corporation to
compete effectively in the changing telecommunications industry. (See
"Planned Merger" through "Competitive Risk" on pages 1-11.)
Operating Revenues
- ------------------
($ millions) 1996 Change 1995 Change 1994
- --------------------------------------------------------------------------
Total operating revenues...... $9,588 $546 $9,042 $-193 $9,235
6.0% -2.1%
- --------------------------------------------------------------------------
Revenues for 1996 increased from 1995 primarily due to increased customer
demand driven by the expansion of business data services, strong usage levels
for new custom calling services, increases in access line and minutes-of-use
volumes, and growth in directory advertising. The Corporation's marketing
efforts and California's growing economy contributed to the increased customer
demand. Increases in 1996 revenues were partially offset by $50 million of
rate reductions 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 $10 million. The CPUC
price cap order effective January 1, 1996, had a minimal effect on Pacific
Bell revenues due to an order in December 1995 suspending use of the
"inflation minus productivity" component of the price cap formula for 1996
through 1998. This action freezes the price caps on most of Pacific Bell's
regulated services through 1998 except for adjustments due to exogenous costs
or price changes approved through the CPUC's application process. (See "CPUC
Regulatory Framework Review" on page 9.) Primary factors affecting 1996
revenue changes from 1995 are summarized in the table below.
14
<PAGE>
CHANGE IN 1996 REVENUES FROM 1995: Total
Price Change
Cap Customer from
($ millions)
Orders Misc. Demand 1995
- --------------------------------------------------------------------------
Local service....................... $ - $14 $205 $219
Network access:
Interstate......................... -50 37 140 127
Intrastate......................... - -21 34 13
Toll service........................ - -21 84 63
Other service revenues.............. - 24 100 124
----- ----- ----- -----
Total operating revenues............ $-50 $33 $563 $546
==========================================================================
Local service revenues include basic monthly service fees and usage charges.
Fees and charges for custom calling services, coin phones, installation, and
service connections are also included in this category. The $205 million
increase in customer demand for local service is the result of the 4.2 percent
growth in access lines and the 11.1 percent growth in custom calling services,
such as call waiting, generated by the improved economy in California and
effective marketing.
Network access revenues reflect charges to interexchange carriers and to
business and residential customers for access to the Telephone Companies'
local networks. The $140 million increase in interstate network access
revenues due to customer demand reflects increased interexchange carrier
access minutes-of-use, as well as increased access lines. The $34 million
demand-related increase in intrastate network access revenues also resulted
from growth in access minutes-of-use.
Toll service revenues include charges for local toll as well as 800 services
within service area boundaries. The increase of $84 million in toll service
revenues due to customer demand was driven primarily by increased local toll
usage resulting from California's growing economy. The customer demand-
related increases in local toll service was partially offset by competitive
losses in 800 services. Interexchange carriers currently have the competitive
advantage of being able to offer these services both within and between
service areas.
Other service revenues are generated from a variety of services including
directory advertising, information services, PCS, Internet services, network
integration and billing and collection services provided by the Telephone
Companies. Increases in other service revenues reflect growth in the
Telephone Companies' information services and directory advertising due to
continued growth in the California economy. In addition, other service
revenues for Internet, network integration and wireless cable increased over
1995 primarily due to the introduction of these new services.
Total operating revenues for 1995 were reduced from 1994 primarily because
demand growth as a result of lower prices due to toll services competition
effective January 1, 1995, was less than assumed in the CPUC-ordered price
rebalancing. (See "CPUC Revenue Rebalancing Shortfall" on page 28.) Revenues
were also reduced because of price cap revenue reductions ordered by the CPUC
and FCC under incentive-based regulation as well as the effects of toll
15
<PAGE>
services competition. The decreases in total operating revenues were
partially offset by a net increase in customer demand in 1995. The decrease in
1995 revenues compared to 1994 was lessened by a CPUC-ordered refund of $27
million in 1994 related to Pacific Bell's payment processing system.
Management cannot predict the effects on revenues for 1997 from competition
and issues remaining to be resolved with the Telecommunications Act of 1996.
However, management believes that the California economy will continue to
improve and that its business strategies will position the Corporation to
compete effectively in the changing telecommunications industry. (See
sections "Planned Merger" through "Competitive Risk" on pages 1-11.)
Operating Expenses
- ------------------
($ millions) 1996 Change 1995 Change 1994
- --------------------------------------------------------------------------
Total operating expenses...... $7,390 $359 $7,031 $-10 $7,041
5.1% -0.1%
- --------------------------------------------------------------------------
The increase in total operating expenses for 1996 reflects the Corporation's
costs for increased demand for products and services, new business initiatives
and costs incurred to prepare for local competition. Increased expenses were
partially offset by cost reductions from the Corporation's ongoing efficiency
efforts and savings due to changes in employee benefit plans and benefit plan
assumptions. Primary factors affecting expense changes are summarized below.
CHANGE IN 1996 OPERATING EXPENSES FROM 1995:
Pacific Pacific Total
Bell* Bell* Pacific Other Change
Salaries Employee Bell* PTG** from
($ millions) & Wages Benefits Misc. Entities 1995
- --------------------------------------------------------------------------
Cost of products and
services..................... $38 $-121 $55 $32 $4
Customer operations and
selling expenses............. 9 -74 26 116 77
General, administrative,
and other expenses........... 27 4 178 63 272
Depreciation and amortization.. - - -3 9 6
--- ---- ---- ---- ----
Total operating expenses....... $74 $-191 $256 $220 $359
==========================================================================
* Excludes Pacific Bell subsidiaries.
** Includes Pacific Telesis Group and Pacific Bell subsidiaries.
At Pacific Bell, excluding subsidiaries, salary and wage expense increased
$74 million in 1996, primarily due to wage increases associated with new labor
agreements effective August 1995 and overtime due to increased business
volumes. These increases were somewhat offset by force reduction programs.
(See "Status of Reserves" on page 20.) Salary and wage expense for the
Corporation's other entities increased $66 million in 1996 due primarily to
entry into new businesses. Due to increased demand for products and services
16
<PAGE>
and entry into new businesses, management anticipates that the workforce will
increase in 1997 and related salary and wage expense will also increase.
At Pacific Bell, excluding subsidiaries, employee benefits expense decreased
$191 million in 1996. This decrease was due primarily to the net effect of
changes in employee benefit plans and changes in employee benefit plan
assumptions and the discontinued application of Statement of Financial
Accounting Standards No. ("SFAS") 71, "Accounting for the Effects of Certain
Types of Regulation," at Pacific Bell. (See Note C - "Discontinuance of
Regulatory Accounting - SFAS 71" on page 47, Note F - "Employee Retirement
Plans" on page 52 and Note G - "Other Postretirement and Postemployment
Benefits" on page 56.) Despite 1997 expected force increases, management
anticipates that the changes in employee benefit plans and benefit plan
assumptions will continue to produce savings in 1997.
At Pacific Bell, excluding subsidiaries, the increase in miscellaneous
expenses in 1996 primarily reflects costs incurred to prepare for local
competition, increased costs for software and contract services associated
with increased demand for products and services.
The Corporation's other entities' expenses increased primarily due to new
business initiatives, such as PCS, Internet access, long distance and network
integration.
Management anticipates total operating expenses to increase in 1997 due to new
business initiatives and increased demand. Also, costs to implement local
competition, especially number portability, will be material and it is
uncertain whether regulators will allow for recovery of these costs. (See
"CPUC Local Services Competition" on page 8.) In addition, over the next few
years, management is expecting to incur additional expenditures to modify its
software to operate correctly for the year 2000.
The decrease in total operating expenses for 1995 reflects the Corporation's
cost reduction efforts and reduced settlements expense. These decreases were
largely offset by increased depreciation expense, costs resulting from severe
storm damage in early 1995, and increased software expenses.
At Pacific Bell, excluding subsidiaries, salary and wage expense decreased $85
million in 1995, primarily as a result of a net workforce reduction of 3,114
employees. The effect of Pacific Bell's declining workforce was partially
offset in 1995 by increased overtime for storm and flood repairs and by a $29
million increase related to higher compensation rates. The Corporation's
salary and wage expense was $2,215 million for 1995, a decrease of $56 million
from 1994.
At Pacific Bell, excluding subsidiaries, employee benefits expense decreased
$51 million in 1995 primarily due to the Corporation's health care cost-
reduction efforts and Pacific Bell's force reduction programs. The
Corporation's employee benefits expense was $660 million for 1995, a decrease
of $36 million from 1994.
17
<PAGE>
Interest Expense
- ----------------
($ millions) 1996 Change 1995 Change 1994
- --------------------------------------------------------------------------
Interest expense.............. $341 $-101 $442 $-13 $455
-22.9% -2.9%
- --------------------------------------------------------------------------
Interest expense decreased in 1996 due primarily to a change in the
Corporation's capital structure (see Note K - "Corporation-Obligated
Mandatorily Redeemable Preferred Securities of Subsidiary Trusts" on page 66)
and a change in classification of interest capitalized during construction
from an item of other income to a reduction in interest expense due to the
discontinued application of SFAS 71 at Pacific Bell. (See Note C -
"Discontinuance of Regulatory Accounting - SFAS 71" on page 47.)
Interest expense decreased in 1995 primarily due to a decrease in the balance
of long-term debt from 1994 and interest expense associated with a CPUC refund
order in 1994. These decreases were partially offset by interest expense
associated with increased short-term borrowings, adjustments on capital leases
and the completion of amortization of gains on certain investments.
Other Income (Expense) - Net
- ----------------------------
($ millions) 1996 Change 1995 Change 1994
- --------------------------------------------------------------------------
Other income (expense)-net.......... $-59 $-101 $42 $-13 $55
-240.5% -23.6%
- --------------------------------------------------------------------------
Other income (expense)-net decreased in 1996 primarily due to a change in
classification of interest capitalized during construction from an item of
other income to a reduction of interest expense, interest income from tax
refunds received in 1995 of approximately $30 million and in 1996, dividends
paid on Trust Originated Preferred Securities ("TOPrS"). (See Note K - "Cor-
poration-Obligated Mandatorily Redeemable Preferred Securities of Subsidiary
Trusts" on page 66.) These decreases were partially offset by bond redemption
costs incurred in 1995 associated with Pacific Bell's redemption of
debentures.
Other income (expense)-net decreased in 1995 primarily due to equity losses of
joint ventures and bond redemption costs associated with Pacific Bell's
redemption of debentures. These decreases were partially offset by increased
interest income of approximately $30 million from tax refunds received in 1995
related to prior years and unrealized gains on trust assets under an executive
compensation deferral plan. These unrealized gains will fluctuate over time
and may be offset by unrealized losses depending on market conditions.
18
<PAGE>
Income Taxes
- ------------
($ millions) 1996 Change 1995 Change 1994
- --------------------------------------------------------------------------
Income taxes........................ $741 $178 $563 $-95 $658
31.6% -14.4%
Effective tax rate (%).............. 41.2 34.9 36.7
- --------------------------------------------------------------------------
Income tax expense increased for 1996 primarily due to higher pre-tax income,
tax adjustments and tax refunds received in 1995. Effective January 1, 1997,
California's maximum statutory tax rate will decrease from 9.3 percent to 8.84
percent. Due to this rate reduction, at December 31, 1996, the Corporation
revalued its net deferred tax assets. This revaluation increased state income
tax expense $16 million for 1996, which contributed to the overall income tax
expense increase for 1996.
The decrease in income tax expense for 1995 was primarily due to lower pre-tax
income and tax refunds received in that year.
Cumulative Effect of Accounting Change
- --------------------------------------
During fourth quarter 1996, Pacific Bell Directory ("Directory") changed its
method of recognizing directory publishing revenues and related expenses
effective January 1, 1996. Directory previously recognized revenues and
expenses related to publishing using the "amortized" method, under which
revenues and expenses were recognized over the lives of the directories,
generally one year. Under the new "issue basis" method, revenues and expenses
will be recognized when the directories are issued. The cumulative after-tax
effect of applying the new method to prior years is recognized as of January
1, 1996 as a one-time, non-cash gain applicable to continuing operations of
$85 million, or $0.20 per share. The gain is net of deferred taxes of $58
million. The first three quarters of 1996 were restated to reflect the new
method. Management believes this change to the issue basis method is
preferable because it is the method generally followed in the publishing
industry and better reflects the operating activity of the business. This
accounting change is not expected to have a significant net income effect on
future periods. (See "Cumulative Effect of Accounting Change" under Note A on
page 45.)
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 1995, the
Corporation recorded a non-cash, extraordinary, after-tax charge of $3.4
billion, or $7.89 per share. The Corporation's Nevada Bell subsidiary
continues to apply SFAS 71 accounting, but is evaluating its continued use as
competition in its markets increases. If Nevada Bell were to discontinue
application of SFAS 71 it would not have a material effect on the
Corporation's financial statements. (See Note C - "Discontinuance of
Regulatory Accounting - SFAS 71" on page 47.)
19
<PAGE>
Status of Reserves
- ------------------
The Corporation has established a number of reserves to record the effects of
discontinuing and restructuring certain parts of its business.
In 1991, a $203 million reserve was established for the cost of management
force reduction programs through 1994. A balance of $77 million remained at
the end of 1993. An additional $1,020 million reserve was established in
December 1993 to record the incremental cost of force reductions associated
with restructuring Pacific Bell's business processes through 1997. This
restructuring was expected to allow Pacific Bell to eliminate more than
14,000 employee positions from 1994 through 1997. After considering new
positions expected to be created, a net reduction of approximately
10,000 positions was anticipated. In addition, Pacific Bell has relocated
employees in conjunction with consolidating business offices, network
facilities, installation and collection centers, and other operations.
Pacific Bell's gross force reductions under the restructuring plan, excluding
subsidiaries, totaled 4,142 employees in 1996. Total gross force reductions
for the first three years of the plan, 1994 through 1996, totaled 14,181. Net
force reductions were 1,926 for 1996 and 9,168 for the three-year period 1994
through 1996. The pace of net force loss moderated in 1996 due to strong
volume growth at Pacific Bell.
Annual cash savings are expected to reach approximately $1 billion when the
restructuring is completed in 1997. In 1996, expense savings due to the
restructuring totaled approximately $757 million primarily from savings in
labor costs due to cumulative force reductions since restructuring began.
Charges to the restructuring reserve in 1996 totaled $131 million, including
cash outlays of $195 million and a $64 million non-cash charge reversal
described below. 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. These costs will be paid
from pension fund assets and do not require current outlays of the
Corporation's funds. Based on its experience, in 1996 Pacific Bell revised
its estimate of these retirement costs. Consequently, $64 million of these
1995 non-cash charges were reversed in 1996. There was no effect on net
income from either the 1995 charge or the 1996 change in this estimate.
Management expects to use the remaining reserve balance during 1997.
In fourth quarter 1996, the Corporation established a reserve of $43 million
to reflect the restructuring of portions of its video-related businesses.
Other reserves were recorded in 1993, 1992, and 1990 related to the spun-off
operations and the Corporation's withdrawal from, or restructuring of, its
real estate, cable, and customer premises equipment businesses. Management
believes the $116 million balance in these reserves remaining at the end of
1996 is adequate. (See Note D - "Restructuring Charges and Other Reserves" on
page 49.)
20
<PAGE>
The table below sets forth the status and activity of these reserves.
($ millions) 1996 1995 1994
- --------------------------------------------------------------------------
Reserve for force reductions and restructuring:
Balance - beginning of year.................. $228 $ 819 $1,097
Additions.................................... - - -
Charges: cash outlays........................ -195 -372 -216
non-cash............................ 64 -219 -62
-------------------------
Balance - end of year........................ $ 97 $ 228 $ 819
=========================
Other reserves:
Balance - beginning of year.................. $98 $ 119 $ 428
Additions.................................... 43 - -
Charges: cash outlays........................ -2 -6 -61
non-cash............................ -23 -15 -248
-------------------------
Balance - end of year........................ $116 $ 98 $ 119
===========================================================================
21
<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. Management 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 December 31, 1996, the unused
lines of credit available totaled approximately $2.8 billion.
For longer-term borrowings, in February 1997, the CPUC approved Pacific Bell's
application to issue up to $1.75 billion of long- and intermediate-term debt
and preferred securities. The proceeds may be used to redeem maturing debt, to
refinance other debt issues and to finance construction expenditures or
acquisition of property. The CPUC's authorization is in effect until the full
$1.75 billion has been issued. Pacific Bell also 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. In addition, 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 December 1994, Pacific Bell contracted for the purchase of up to $2 billion
of Advanced Communications Network ("ACN") facilities, which incorporated new
technologies. During 1995, the ability to deploy the facilities outstripped
the ACN vendors' ability to deliver necessary products and software.
Accordingly, management decided to suspend construction at certain sites,
which reduced the expected cost to less than $700 million. If ACN facilities
meet certain quality and performance criteria (the "Network Test"), Pacific
Bell is committed to purchase the ACN facilities in 1998. If ACN facilities
fail the Network Test, Pacific Bell's will not be committed to buy the ACN
facilities but might be liable to reimburse the principal ACN vendor for some
construction costs up to $300 million. If competition or other factors affect
Pacific Bell s ability to recover its investment in these facilities, the
value of the ACN facilities could be materially impaired.
In 1997, the Corporation anticipates further investments in new business
initiatives and expects to generate the required funds through internal and
external sources.
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 ("TOPrS") 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,
Standard & Poor's Corporation revised the outlook on Pacific Telesis Group's
22
<PAGE>
corporate credit ratings, including PTCR, to stable from negative. (See
"Merger Agreement" under Note O on page 70.) The outlook for Pacific Bell
remains negative. Also reflecting the merger agreement announcement, Duff and
Phelps Credit Rating Co. reaffirmed its ratings of Duff 1+ and Double-A-Minus
("AA-") on Pacific Bell's commercial paper and debentures, respectively.
The following are commercial paper, bond, and TOPrS ratings for the
Corporation and its subsidiaries:
Moody's Standard Duff and
Investors Poor's Phelps Credit
Services, Inc. Corp. Rating Co.
-------------- --------- ------------
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.
During 1996 the Corporation 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
December 31, 1996, the financing obtained under the leases was $285 million.
Management expects the total financing to reach about $350 million, of which
approximately one-third will be repaid in Japanese yen. To hedge exposure to
foreign currency exchange fluctuations, the Corporation has entered into
foreign currency forward contracts to purchase yen in amounts equal to the
current yen lease obligations when they become due. Gains or losses due to
foreign currency rate fluctuations on these contracts and on the yen lease
obligations offset each other in results of operations. Management does not
expect to realize any loss from counterparty nonperformance under these
contracts. (See Note J - "Financial Instruments" on page 64.)
The Corporation holds an equity swap contract to hedge its exposure to the
risk of market changes related to its recorded liability for outstanding
employee stock options of the spun-off operations' common stock and associated
stock appreciation rights. (See Note H - "Stock Options and Stock
Appreciation Rights" on page 59.) Off-balance-sheet risk exists to the extent
the market price of the spun-off operations' stock rises above the market
price reflected in the liability's current carrying value. The equity swap
was entered into to hedge this exposure and minimize the impact of market
fluctuations. The equity swap itself involves certain off-balance-sheet
23
<PAGE>
risks. (See Note J - "Financial Instruments" on page 64.)
Cash From Operating Activities
- ------------------------------
($ millions) 1996 Change 1995 Change 1994
- --------------------------------------------------------------------------
Cash from operating activities
of continuing operations.... $2,592 $-177 $2,769 $-178 $2,947
-6.4% -6.0%
- --------------------------------------------------------------------------
The decrease in 1996 cash from operating activities of continuing operations
is primarily due to entry into new businesses. In addition, a tax refund
received in 1996 of approximately $133 million was $32 million less than tax
refunds and related interest income received in 1995.
The decrease in 1995 cash from operating activities of continuing operations
is primarily due to timing differences in the payment of liabilities and lower
revenues. The decrease in cash flow was partially offset by tax refunds and
associated interest income of approximately $165 million received in 1995.
Management is unable to predict the impact that competition will have on cash
from operating activities of continuing operations in 1997.
Cash Used For Investing Activities
- ----------------------------------
($ millions) 1996 Change 1995 Change 1994
- --------------------------------------------------------------------------
Cash used by continuing operations
for investing activities...........
$2,648 $-26 $2,674 $1,172 $1,502
-1.0% 78.0%
- --------------------------------------------------------------------------
Cash used by continuing operations for investing activities decreased $26
million in 1996. During 1996, the Corporation's investments in the core
telecommunications network and PBMS' PCS network were slightly lower than the
Corporation's investments in 1995 which included payments of $656 million for
PCS licenses.
Cash used by continuing operations for investing activities increased in 1995
primarily due to payments of $656 million for PCS licenses and associated
capitalized interest. In addition, the increase also reflects investments to
upgrade the core telecommunications network and the Corporation's 1995
investments in joint ventures.
In 1996, the Corporation made capital expenditures of about $2.75 billion.
Management currently anticipates capital spending in 1997 to reach about $2.5
billion. (See "Upgrade Network and Systems Capabilities" on page 2.)
Pacific Bell has purchase commitments of about $208 million remaining in
connection with its previously announced program for deploying an all-digital
switching platform with ISDN and SS-7 capabilities. (See Note O - "Commitments
and Contingencies" on page 70.)
24
<PAGE>
Cash From (Used For) Financing Activities
- -----------------------------------------
($ millions) 1996 Change 1995 Change 1994
- --------------------------------------------------------------------------
Cash from (used by) continuing operations
for financing activities......... $52 $206 $-154 $1,225 $-1,379
133.8% -88.8%
- --------------------------------------------------------------------------
Cash from continuing operations for financing activities increased
$206 million in 1996. The 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 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. The proceeds were used to retire outstanding
short-term indebtedness, primarily commercial paper. Under certain
circumstances, dividends on TOPrS could be deferred for up to a period of five
years. (See Note K - "Corporation-Obligated Mandatorily Redeemable Preferred
Securities of Subsidiary Trusts" on page 66.) 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 redeemed in December 1995. In addition during 1996,
the Corporation financed $285 million through its leasing arrangements for
equipment purchases for the PCS network. Also, the Corporation reduced its
second and third quarter 1996 dividends to $0.315 per share which contributed
to the increase in cash flow in 1996.
In 1995, cash used by continuing operations for financing activities decreased
primarily due to proceeds from short-term borrowings of approximately
$1.5 billion. Whereas, in 1994, the Corporation substantially repaid its
short-term borrowings. The decrease was partially offset by the retirement of
approximately $800 million of long-term debt during 1995.
25
<PAGE>
Long-term borrowing activity, excluding spun-off operations, included the
following issuances and redemptions:
Interest Maturity Principal
($ millions) Rate Date Amount
- --------------------------------------------------------------------------
Issuances:
1996................. 5.875% to 6.875% 2006 $ 500
1995................. - - -
1994................. 6.960% 2006 $ 10
Retirements:
1996................. 8.650% 1996 $ 15
1995*................ 7.625% to 9.320% 1995 to 2030 $ 814
1994................. 9.250% 2008 $ 12
- --------------------------------------------------------------------------
* Amount includes approximately $55 million of debt assumed in the CCW
acquisition, which was subsequently retired, and approximately $12 million
of recall premium.
The Corporation's debt ratio improved to 61.5 percent at December 31, 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 6.7 times for 1996. Pre-tax interest coverage
for 1995 was negative due to the Corporation's reported loss in 1995.
Pursuant to the terms of the merger agreement, the Corporation reduced its
second, third and fourth quarter dividends to $0.315 per share. The lower
second and third quarter dividends paid in 1996 improved 1996 cash flow by
approximately $195 million. (See "Merger Agreement" under Note O on page 70.)
26
<PAGE>
PENDING REGULATORY ISSUES
Uniform Systems of Account ("USOA") Turnaround Adjustment
- ---------------------------------------------------------
In May 1995, Pacific Bell filed an application with the CPUC to eliminate the
USOA Turnaround Adjustment effective January 1, 1995. This Turnaround
Adjustment is a vestige of traditional rate-of-return regulation and has been
in effect since 1988. Because of the adjustment, Pacific Bell's revenues were
reduced by over $23 million each year from 1988 through 1995. 1996 and 1997
revenues are subject to refund. These adjustments were intended to reflect
annual revenue requirement reductions resulting from the CPUC's adoption of a
capital-to-expense accounting change in 1988. The CPUC held evidentiary
hearings in October 1995 addressing whether the USOA Turnaround Adjustment
should be eliminated. The CPUC's Office of Ratepayer Advocates has proposed
that Pacific Bell be ordered to permanently reduce its revenues by
$106 million effective January 1, 1996. Another intervenor has proposed that
Pacific Bell should be ordered to reduce its annual revenues by $43 million
effective January 1, 1996, with additional revenue reductions of about $11
million made on a cumulative basis over the next ten years. After year ten,
the proposed revenue reduction would be about $155 million permanently for
each year. Management cannot predict the outcome of this matter.
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 $221 million at December 31, 1996. Management believes
postretirement benefits costs are appropriately recoverable in Pacific Bell's
price cap filings.
Other Billing and Collecting ("OB&C")
- -------------------------------------
The FCC adopted new rules for recovery of OB&C expenses which will go into
effect mid-March 1997. The new rules shift an additional 25 percent of OB&C
costs from the intrastate to the interstate jurisdiction. The shift could
result in revenue reductions of approximately $40 million a year. Management
is evaluating options to mitigate the effect on revenues.
27
<PAGE>
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 $70 million as of December 31, 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.
CPUC Revenue Rebalancing Shortfall
- ----------------------------------
In September 1995, Pacific Bell filed with the CPUC for $214 million of
revenue increases. The request was to compensate Pacific Bell for the revenue
shortfall that resulted from the CPUC's price rebalancing plan that
accompanied the official introduction of toll services competition on
January 1, 1995. Revenue reductions due to lower prices were intended to be
offset by other price increases and by increased network usage generated by
the lower prices. Demand growth as a result of local toll price reductions
fell far short of the level anticipated by the CPUC. As a result, the revenue
neutrality intended by the CPUC was not achieved. On February 19, 1997, the
CPUC denied Pacific Bell's petition. Management is currently evaluating
whether to appeal the order.
SALE OF BELLCORE
In November 1996, the owners of Bell Communications Research ("Bellcore")
reached an agreement to sell the company to Science Applications International
Corp. Bellcore is a leading provider of communications software and
consulting services. It is owned by Pacific Bell and six of the telephone
regional holding companies formed at the divestiture of AT&T Corp. in 1984.
The sale is expected to be finalized by the end of 1997 after obtaining the
necessary regulatory approvals.
28
<PAGE>
PACIFIC TELESIS GROUP AND SUBSIDIARIES
SELECTED FINANCIAL AND OPERATING DATA
(Dollars in millions,
except per share amounts) 1996 1995 1994 1993 1992
- --------------------------------------------------------------------------
RESULTS OF OPERATIONS
Operating revenues.............. $ 9,588 $ 9,042 $ 9,235 $ 9,244 $ 9,108
Operating expenses.............. 7,390 7,031 7,041 8,582 7,025
Operating income................ 2,198 2,011 2,194 662 2,083
Income from continuing
operations.................... 1,057 1,048 1,136 191 1,173
Income (loss) from spun-off
operations.................... - - 23 29 (31)
Extraordinary item, net of tax.. - (3,360) - - -
Cumulative effect of accounting
changes, net of tax........... 85 - - (1,724) -
Net income (loss)............... $ 1,142 $(2,312) $1,159 $(1,504) $1,142
- --------------------------------------------------------------------------
EARNINGS (LOSS) PER SHARE
Income from continuing
operations.................... $ 2.47 $ 2.46 $ 2.68 $ 0.46 $ 2.91
Income (loss) from spun-off
operations.................... - - 0.05 0.07 (0.08)
Extraordinary item.............. - (7.89) - - -
Cumulative effect of
accounting changes............ 0.20 - - (4.16) -
Net income (loss)............... $ 2.67 $ (5.43) $ 2.73 $ (3.63) $ 2.83
- --------------------------------------------------------------------------
OTHER FINANCIAL AND OPERATING DATA
Dividends per share............. $ 1.49 $ 2.18 $ 2.18 $ 2.18 $ 2.18
Total assets***................. $16,608 $15,841 $20,139 $23,437 $21,849
Net assets of spun-off
operations.................... $ - $ - $ - $ 2,874 $ 745
Shareowners' equity............. $ 2,773 $ 2,190 $ 5,233 $ 7,786 $ 8,251
Continuing Operations**:
Book value per share............ $ 6.47 $ 5.11 $ 12.34 $ 11.61 $ 18.53
Return on equity (%)............ 46.0 -51.3 22.0 -26.3 16.1
Return on capital (%)........... 17.2 -18.0 14.3 -8.6 12.0
Debt maturing within one year... $ 613 $ 1,530 $ 246 $ 595 $ 1,158
Long-term obligations........... $ 5,424 $ 4,737 $ 4,897 $ 5,129 $ 5,207
Debt ratio (%).................. 61.5 74.1 49.6 53.8 45.9
Capital expenditures............ $ 2,753 $ 2,961 $ 1,684 $ 1,886 $ 1,852
Cash from operating activities.. $ 2,592 $ 2,769 $ 2,947 $ 2,727 $ 2,807
Total employees at December 31.. 48,330 48,889 51,590 55,355 57,023
- --------------------------------------------------------------------------
(Continued on next page)
29
<PAGE>
PACIFIC TELESIS GROUP AND SUBSIDIARIES
SELECTED FINANCIAL AND OPERATING DATA
(Continued)
(Dollars in millions,
except per share amounts) 1996 1995 1994 1993 1992
- --------------------------------------------------------------------------
Volume Indicators:
Toll messages (millions); 1994* 5,176 4,819 4,473 4,251 4,145
Carrier access minutes-of-use
(millions); 1994*............ 64,635 59,193 52,370 49,674 46,800
Customer switched access lines
in service at December 31
(thousands); 1994-95*......... 16,427 15,767 15,307 14,873 14,551
- --------------------------------------------------------------------------
* Restated.
** Excludes spun-off operations.
*** Includes net assets of spun-off operations for the years 1992-1993.
During fourth quarter 1996, Pacific Bell Directory changed its method of
recognizing directory publishing revenues and related expenses effective
January 1, 1996 to a preferable method. The cumulative after-tax effect of
applying the new method to prior years is recognized as of January 1, 1996 as
a one-time, non-cash gain applicable to continuing operations of $85 million,
or $0.20 per share. The first three quarters of 1996 were restated to reflect
the new method. (See "Cumulative Effect of Accounting Change" under Note A on
page 45.)
Effective third quarter 1995, for external financial reporting purposes,
Pacific Bell discontinued the application of SFAS 71, "Accounting for the
Effects of Certain Types of Regulation," an accounting standard for entities
subject to traditional regulation. As a result, during 1995 the Corporation
recorded a non-cash, extraordinary charge of $3.4 billion, or $7.89 per share,
which is net of a deferred income tax benefit of $2.4 billion. As a result of
the extraordinary charge, the Corporation's shareowners' equity was reduced by
$3.4 billion. (See Note C - "Discontinuance of Regulatory Accounting -
SFAS 71" on page 47.)
Effective April 1, 1994, the Corporation spun off to its shareowners its
domestic and international cellular, paging, and other wireless operations in
a one-for-one stock distribution of its 86 percent interest in these
operations. As a result, the Corporation's total assets and shareowners'
equity were each reduced by $2.9 billion during 1994. The Corporation's
previous interests in the operating results and net assets of spun-off
operations are classified separately and excluded from the Corporation's
revenues, expenses, and other amounts presented for continuing operations.
(See "Spun-off Operations" under Note A on page 43.)
Results for 1993 reflect restructuring charges which reduced income from
continuing operations by $861 million, or $2.08 per share. Results for 1993
also reflect the cumulative after-tax effects of applying new accounting rules
for postretirement and postemployment benefits to prior years.
30
<PAGE>
REPORT OF MANAGEMENT
To the Shareowners of Pacific Telesis Group:
The management of Pacific Telesis Group is responsible for preparing the
accompanying financial statements and for their integrity and objectivity.
The statements have been prepared in accordance with generally accepted
accounting principles applied on a consistent basis and management believes
they are not misstated due to material fraud or error. In instances where
exact measurement is not possible, the financial statements include amounts
based on management's best estimates and judgments. Management also prepared
the other information in this annual financial review and is responsible for
its accuracy and consistency with the financial statements.
The Corporation's financial statements have been audited by Coopers & Lybrand
L.L.P., independent accountants, whose appointment has been ratified by the
shareowners. Management has made available to Coopers & Lybrand L.L.P. all
the Corporation's financial records and related data, as well as the minutes
of shareowners' and directors' meetings. Furthermore, management believes that
all of its representations made to Coopers & Lybrand L.L.P. during their audit
are valid and appropriate.
Management has established and maintains a system of internal control that
provides reasonable assurance as to the integrity and reliability of the
financial statements, the protection of assets from unauthorized use or
disposition, and the prevention and detection of fraudulent financial
reporting. The system of internal control provides for appropriate division
of responsibility and is documented by written policies and procedures that
are communicated to employees with significant roles in the financial
reporting process and are updated as necessary. Management continually
monitors the system of internal control for compliance, and maintains a strong
internal auditing program that independently assesses the effectiveness of the
internal controls and recommends improvements when necessary. In addition, as
part of their audit of the Corporation's financial statements, Coopers &
Lybrand L.L.P. have obtained a sufficient understanding of the internal
control structure to determine the nature, timing, and extent of audit tests
to be performed. Management has considered the internal auditors' and
Coopers & Lybrand L.L.P.'s recommendations concerning the Corporation's system
of internal control and has taken actions that it believes are cost-effective
under the circumstances to respond appropriately to these recommendations.
Management believes that the Corporation's system of internal control is
adequate to accomplish the objectives discussed.
Management also recognizes its responsibility to foster a strong ethical
climate that enables the Corporation to conduct its affairs according to the
highest standards of personal and corporate conduct. This responsibility is
characterized and reflected in the Corporation's code of corporate conduct,
which is publicized throughout the Corporation. The code of conduct
addresses, among other things: potential conflicts of interest; compliance
with domestic laws, including those relating to foreign transactions and
financial disclosure; and the confidentiality of proprietary information. The
Corporation maintains a systematic program to assess compliance with these
policies.
31
<PAGE>
The Audit Committee of the Board of Directors is responsible for overseeing
the Corporation's financial reporting process on behalf of the Board. In
fulfilling its responsibility, the Committee recommends to the Board, subject
to shareowner ratification, the selection of the Corporation's independent
accountants. During 1996, the Committee consisted of four members of the
Board who were neither officers nor employees of the Corporation. It meets
regularly with representatives of management, internal audit, and the
independent accountants to review internal accounting controls and accounting,
auditing, and financial reporting matters. During 1996, the Committee held
five meetings. The Corporation's internal auditors and independent
accountants periodically meet alone with the Committee to discuss the matters
previously noted and have direct access to it for private communication at any
time.
/s/ Philip J. Quigley
Chairman, President, and Chief Executive Officer
/s/ William E. Downing
Executive Vice President, Chief Financial Officer, and Treasurer
February 28, 1997
32
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareowners
of Pacific Telesis Group:
We have audited the accompanying consolidated balance sheets of Pacific
Telesis Group and Subsidiaries as of December 31, 1996 and 1995, and the
related consolidated statements of income, shareowners' equity, and cash flows
for each of the three years in the period ended December 31, 1996. These
financial statements are the responsibility of management. Our responsibility
is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform an audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Pacific Telesis
Group and Subsidiaries as of December 31, 1996 and 1995, and the consolidated
results of their operations and their cash flows for each of the three years
in the period ended December 31, 1996, in conformity with generally accepted
accounting principles. In addition, in our opinion, the financial statement
schedule referred to above, when considered in relation to the basic financial
statements taken as a whole, presents fairly, in all material respects, the
information required to be included therein.
As discussed in Note A to the Consolidated Financial Statements, Pacific Bell,
a subsidiary of Pacific Telesis Group, changed its method of recognizing
directory publishing revenues and related expenses effective January 1, 1996.
Also discussed in Note A, Pacific Bell discontinued its application of
Statement of Financial Accounting Standards No. 71 during 1995.
/s/ Coopers & Lybrand L.L.P.
San Francisco, California
February 27, 1997
33
<PAGE>
PACIFIC TELESIS GROUP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
For the Year Ended December 31
------------------------------
(Dollars in millions, except per share amounts) 1996 1995 1994
- --------------------------------------------------------------------------
OPERATING REVENUES
Local service................................ $ 4,034 $ 3,815 $ 3,455
Network access:
Interstate................................. 1,863 1,736 1,612
Intrastate................................. 724 711 734
Toll service................................. 1,295 1,232 2,006
Other service revenues....................... 1,672 1,548 1,428
-----------------------------
TOTAL OPERATING REVENUES..................... 9,588 9,042 9,235
- --------------------------------------------------------------------------
OPERATING EXPENSES
Cost of products and services................ 1,826 1,822 1,903
Customer operations and selling expenses..... 1,906 1,829 1,848
General, administrative, and other expenses.. 1,788 1,516 1,503
Depreciation and amortization................ 1,870 1,864 1,787
-----------------------------
TOTAL OPERATING EXPENSES..................... 7,390 7,031 7,041
- --------------------------------------------------------------------------
OPERATING INCOME............................. 2,198 2,011 2,194
Interest expense............................. 341 442 455
Other income(expense)-net.................... (59) 42 55
- --------------------------------------------------------------------------
INCOME FROM CONTINUING OPERATIONS
BEFORE INCOME TAXES........................ 1,798 1,611 1,794
Income taxes................................. 741 563 658
- --------------------------------------------------------------------------
INCOME FROM CONTINUING OPERATIONS............ 1,057 1,048 1,136
Income from spun-off operations, net of
income taxes of $29 (Notes A and B)........ - - 23
- --------------------------------------------------------------------------
INCOME BEFORE EXTRAORDINARY ITEM AND
CUMULATIVE EFFECT OF ACCOUNTING CHANGE..... 1,057 1,048 1,159
Extraordinary item, net of tax (Note C)...... - (3,360) -
Cumulative effect of accounting change, net
of tax (Note A)............................ 85 - -
-----------------------------
NET INCOME (LOSS)............................ $ 1,142 $(2,312) $ 1,159
==========================================================================
(Continued on next page)
34
<PAGE>
PACIFIC TELESIS GROUP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Continued)
For the Year Ended December 31
------------------------------
(Dollars in millions, except per share amounts) 1996 1995 1994
- --------------------------------------------------------------------------
Earnings (loss) per share:
Income from continuing operations.......... $ 2.47 $ 2.46 $ 2.68
Income from spun-off operations............ - - 0.05
-----------------------------
Income before extraordinary item and
cumulative effect of accounting change... 2.47 2.46 2.73
Extraordinary item......................... - (7.89) -
Cumulative effect of accounting change..... 0.20 - -
-----------------------------
Net income (loss).......................... $ 2.67 $ (5.43) $ 2.73
==========================================================================
Dividends per share.......................... $ 1.49 $ 2.18 $ 2.18
Average shares outstanding (thousands)....... 428,388 425,996 423,969
==========================================================================
The accompanying Notes are an integral part of the Consolidated Financial
Statements.
35
<PAGE>
PACIFIC TELESIS GROUP AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31
-------------------------
(Dollars in millions, except per share amounts) 1996 1995
- ---------------------------------------------------------------------------
ASSETS
Cash and cash equivalents........................ $ 72 $ 76
Accounts receivable - net of allowances
for uncollectibles of $163 and $132............ 1,982 1,505
Prepaid expenses and other current assets........ 593 1,002
-------------------------
Total current assets............................. 2,647 2,583
-------------------------
Property, plant, and equipment - at cost......... 29,032 27,222
Less: accumulated depreciation................ (16,959) (15,837)
-------------------------
Property, plant, and equipment - net............. 12,073 11,385
-------------------------
Other noncurrent and intangible assets........... 1,888 1,873
-------------------------
TOTAL ASSETS..................................... $16,608 $15,841
===========================================================================
LIABILITIES AND SHAREOWNERS' EQUITY
Accounts payable and accrued liabilities......... $ 2,187 $ 2,203
Debt maturing within one year.................... 613 1,530
Other current liabilities........................ 727 908
-------------------------
Total current liabilities........................ 3,527 4,641
-------------------------
Long-term obligations............................ 5,424 4,737
-------------------------
Other noncurrent liabilities and
deferred credits............................... 3,884 4,273
-------------------------
(Continued on next page)
36
<PAGE>
PACIFIC TELESIS GROUP AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Continued)
December 31
-------------------------
(Dollars in millions, except per share amounts) 1996 1995
- ---------------------------------------------------------------------------
LIABILITIES AND SHAREOWNERS' EQUITY (Continued)
Commitments and contingencies (Notes J and O)
Corporation-obligated mandatorily redeemable
preferred securities of subsidiary trusts*
(Note K)....................................... 1,000 -
-------------------------
Common stock ($0.10 par value; 432,827,595
shares issued; 428,312,698 and 428,434,672
shares outstanding)............................ 43 43
Additional paid-in capital....................... 3,501 3,498
Accumulated deficit.............................. (479) (982)
Treasury stock, at cost (4,514,897 and 4,392,923
shares)........................................ (131) (127)
Deferred compensation - LESOP trust.............. (161) (242)
-------------------------
Total shareowners' equity........................ 2,773 2,190
-------------------------
TOTAL LIABILITIES AND SHAREOWNERS' EQUITY........ $16,608 $15,841
===========================================================================
* The trusts contain assets of $1,030 million in principal amount
of the Subordinated Debentures of Pacific Telesis Group.
The accompanying Notes are an integral part of the Consolidated Financial
Statements.
37
<PAGE>
PACIFIC TELESIS GROUP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREOWNERS' EQUITY
For the Year Ended December 31
------------------------------
(Dollars in millions, except per share amounts) 1996 1995 1994
- ---------------------------------------------------------------------------
COMMON STOCK
Balance at beginning of year................. $ 43 $ 43 $ 43
-----------------------------
Balance at end of year....................... 43 43 43
- ---------------------------------------------------------------------------
ADDITIONAL PAID-IN CAPITAL
Balance at beginning of year................. 3,498 3,493 6,372
Spin-off stock distribution (Note B)......... - - (2,901)
Issuance of shares........................... - - 22
Acquisition of wireless cable
company (Note M)........................... - (9) -
Other changes................................ 3 14 -
-----------------------------
Balance at end of year....................... 3,501 3,498 3,493
- ---------------------------------------------------------------------------
(ACCUMULATED DEFICIT) REINVESTED EARNINGS
Balance at beginning of year................. (982) 2,257 2,040
Net income (loss)............................ 1,142 (2,312) 1,159
Dividends declared ($1.49 per share in 1996;
$2.18 per share in 1995 and 1994) (Note O). (638) (929) (924)
Other changes................................ (1) 2 (18)
-----------------------------
Balance at end of year....................... (479) (982) 2,257
- ---------------------------------------------------------------------------
TREASURY STOCK, AT COST
Balance at beginning of year................. (127) (254) (283)
Issuance of shares........................... - - 29
Acquisition of wireless cable
company (Note M)........................... (3) 127 -
Reacquisition of shares....................... (1) - -
-----------------------------
Balance at end of year....................... (131) (127) (254)
- ---------------------------------------------------------------------------
DEFERRED COMPENSATION
Balance at beginning of year................. (242) (306) (386)
Cost of LESOP trust shares allocated
to employee accounts (Note M).............. 81 64 80
-----------------------------
Balance at end of year....................... (161) (242) (306)
- ---------------------------------------------------------------------------
TOTAL SHAREOWNERS' EQUITY.................... $2,773 $2,190 $5,233
===========================================================================
(Continued on next page)
38
<PAGE>
PACIFIC TELESIS GROUP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREOWNERS' EQUITY
(Continued)
For the Year Ended December 31
------------------------------
(Shares in millions) 1996 1995 1994
- ---------------------------------------------------------------------------
===========================================================================
COMMON SHARES AUTHORIZED AT DECEMBER 31...... 1,100 1,100 1,100
===========================================================================
COMMON SHARES OUTSTANDING
Balance at beginning of year................. 428 424 423
Treasury shares reissued..................... - 4 1
-----------------------------
Balance at end of year....................... 428 428 424
===========================================================================
PREFERRED SHARES AUTHORIZED AT DECEMBER 31... 50 50 50
===========================================================================
The accompanying Notes are an integral part of the Consolidated Financial
Statements.
39
<PAGE>
PACIFIC TELESIS GROUP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Year Ended December 31
------------------------------
(Dollars in millions) 1996 1995 1994
- ---------------------------------------------------------------------------
CASH FROM (USED FOR) OPERATING ACTIVITIES
Net income (loss)............................... $ 1,142 $(2,312) $ 1,159
Adjustments to reconcile net income (loss)
to cash from operating activities:
(Income) from spun-off operations............. - - (23)
Extraordinary item............................ - 3,360 -
Cumulative effect of accounting change........ (85) - -
Depreciation and amortization................. 1,870 1,864 1,787
Changes in deferred income taxes.............. 363 94 44
Amortization of investment tax credits........ (49) (53) (63)
Changes in operating assets and liabilities:
Accounts receivable......................... (156) 55 (17)
Prepaid expenses and other current assets... (66) (60) (17)
Other noncurrent and intangible assets...... (95) (34) (4)
Accounts payable and accrued liabilities.... 4 297 195
Other current liabilities................... (84) (33) 1
Noncurrent liabilities and deferred credits. (335) (481) (85)
Other adjustments, net........................ 83 72 (30)
---------------------------
Cash from continuing operations................. 2,592 2,769 2,947
Cash from spun-off operations................... - - 18
---------------------------
Cash from operating activities.................. 2,592 2,769 2,965
- ---------------------------------------------------------------------------
CASH FROM (USED FOR) INVESTING ACTIVITIES
Additions to property, plant, and equipment..... (2,454) (2,002) (1,631)
Investment in PCS licenses...................... (95) (674) -
Proceeds from disposals of assets of real
estate subsidiary............................. 12 13 129
Net investment in spun-off operations (Note L).. - - 33
Other investing activities, net................. (111) (11) (33)
---------------------------
Cash used by continuing operations.............. (2,648) (2,674) (1,502)
Cash used by spun-off operations................ - - (332)
---------------------------
Cash used for investing activities.............. (2,648) (2,674) (1,834)
- ---------------------------------------------------------------------------
(Continued on next page)
40
<PAGE>
PACIFIC TELESIS GROUP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Continued)
For the Year Ended December 31
------------------------------
(Dollars in millions) 1996 1995 1994
- ---------------------------------------------------------------------------
CASH FROM (USED FOR) FINANCING ACTIVITIES
Proceeds from issuance of common
and treasury shares........................... 111 74 140
Proceeds from issuance of long-term debt........ 495 - 10
Retirements of long-term debt................... (15) (814) (12)
Proceeds from issuance of trust originated
preferred securities.......................... 1,000 - -
Proceeds from sale and leaseback transactions... 285 - -
Dividends paid.................................. (736) (927) (907)
Increase (decrease) in short-term borrowings
with original maturities of 90 days
or less, net.................................. (982) 1,509 (588)
Other financing activities, net................. (106) 4 (22)
---------------------------
Cash from (used by) continuing operations....... 52 (154) (1,379)
Cash from spun-off operations................... - - 39
---------------------------
Cash from (used for) financing activities....... 52 (154) (1,340)
- ---------------------------------------------------------------------------
Net cash used for all activities................ (4) (59) (209)
Less spun-off operations........................ - - (275)
---------------------------
Increase (decrease) in cash and
cash equivalents.............................. (4) (59) 66
Cash and cash equivalents at January 1.......... 76 135 69
---------------------------
Cash and cash equivalents at December 31........ $ 72 $ 76 $ 135
===========================================================================
The accompanying Notes are an integral part of the Consolidated Financial
Statements.
41
<PAGE>
PACIFIC TELESIS GROUP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The 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. All significant
intercompany balances and transactions have been eliminated. Investments in
partnerships, joint ventures, and less than majority-owned subsidiaries are
principally accounted for under the equity method. The consolidated financial
statements reflect reclassifications made to conform with the current year
presentation. These reclassifications did not affect net income or
shareowners' equity.
The Corporation's principal business, communications and information services,
accounts for substantially all of its revenues. The Telephone Companies
provide local exchange services, network access, local toll services,
directory advertising, Internet access, and selected information services in
California and Nevada.
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the amounts reported in the financial statements and accompanying
notes. Actual results could differ from those estimates.
Regulatory Accounting
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. (See Note C - "Discontinuance of Regulatory Accounting
- - SFAS 71" on page 47.) Nevada Bell continues to apply SFAS 71 accounting but
is evaluating its continued applicability. If Nevada Bell were to discontinue
application of SFAS 71 it would not have a material effect on the
Corporation's financial statements.
42
<PAGE>
A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Cont'd)
Spun-off Operations
The Corporation's previous interests in the operating results and net assets
of wireless operations that were spun off effective April 1, 1994 are reported
separately as spun-off operations. (See Note B - "Spun-off Operations" on
page 46.) These operations are excluded from amounts reported for the
Corporation's revenues, expenses, assets, and liabilities that reflect
"continuing operations." Amounts presented for spun-off operations have been
prepared solely for the purpose of reporting Pacific Telesis Group results.
Property, Plant, and Equipment
Property, plant, and equipment (which consists primarily of telecommunications
plant dedicated to providing telecommunications services) is carried at cost.
The cost of self-constructed plant includes employee wages and benefits,
materials, capitalized interest during the construction period, and other
costs. Capital leases are recorded at the present value of future minimum
lease payments. 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.
No gain or loss is recognized on the disposition of depreciable
telecommunications plant. At the time of retirement of telecommunication
property, plant, and equipment, the original cost of the plant retired plus
cost of removal is charged to accumulated depreciation. Accumulated
depreciation is credited with salvage value or insurance recovery, if any.
Depreciation expense is computed using the straight-line method based on
management's estimate of economic lives for various categories of property,
plant, and equipment.
The Telephone Companies continue to invest heavily in improvements to their
core telecommunications networks. The Corporation has also made significant
investments in Personal Communications Services ("PCS"), Internet access,
wireless video and long distance. These technologies are subject to
technological risks and rapid market changes due to new products and services
and changing customer demand. These changes may result in changes to the
estimated economic lives or net realizable value of these assets.
The Corporation carries catastrophic insurance coverage with large deductibles
on its telecommunications switching and building assets, and is self-insured
for its outside telecommunications plant.
43
<PAGE>
A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Cont'd)
Intangible Assets and Capitalized Interest
Included in other noncurrent and intangible assets is $696 million
representing the amounts paid for two PCS licenses recorded at cost. In
addition, interest and other costs related to these licenses are being
capitalized during construction. These costs will be amortized over 40 years.
Cash and Cash Equivalents
Cash equivalents include all highly liquid monetary instruments with
maturities of ninety days or less from the date of purchase. In its cash
management practices, the Corporation maintains zero-balance disbursement
accounts for which funds are made available as checks are presented for
clearance. Checks outstanding are included in accounts payable.
Income Taxes
Deferred income taxes are provided to reflect the tax effects of temporary
differences between the carrying amounts of assets and liabilities for
financial reporting purposes and the amounts used for tax purposes.
Investment tax credits earned prior to their repeal by the Tax Reform Act of
1986 are amortized as reductions in tax expense over the lives of the assets
which gave rise to the credits.
Advertising Costs
Costs for advertising products and services or corporate image are expensed as
incurred.
Earnings Per Share
Earnings (loss) per share calculations are based on the weighted average
number of common shares outstanding, including those shares held by a
leveraged employee stock ownership trust.
Computer Software Costs
The costs of computer software purchased or developed for internal use are
expensed as incurred. However, initial operating system software costs are
capitalized and amortized over the lives of the associated hardware.
44
<PAGE>
A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Cont'd)
Change in Accounting for Postretirement and Postemployment Costs
Effective January 1, 1993, the Corporation adopted SFAS 106, "Employers'
Accounting for Postretirement Benefits Other than Pensions," and SFAS 112,
"Employers' Accounting for Postemployment Benefits." (See also Note G -
"Other Postretirement and Postemployment Benefits" on page 56.) The
cumulative after-tax effects of applying the new rules to prior years were
recognized by one-time charges applicable to continuing operations totaling
$1.724 billion. The charges were net of deferred income tax benefits of
$1.155 billion and reduced earnings applicable to continuing operations for
1993 by $4.16 per share. The annual periodic expense under SFAS 112 does not
differ materially from expense under the prior method. (See "Revenues Subject
to Refund" in Note O on page 71.)
Change in Estimates
In 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, the Corporation updated its actuarial assumptions to reflect
changes in market interest rates and recent actuarial experience. (See Note F
- - "Employee Retirement Plans" on page 52 and Note G - "Other Postretirement
and Postemployment Benefits" on page 56.)
Stock-Based Compensation
Effective January 1, 1996, the Corporation adopted the disclosure requirements
of SFAS 123, "Accounting for Stock-Based Compensation." The Corporation
continues to recognize compensation in accordance with Accounting Principles
Board Opinion No. 25, "Accounting for Stock Issued to Employees." (See Note H
- - "Stock Options and Stock Appreciation Rights" on page 59.)
Cumulative Effect of Accounting Change
Effective January 1, 1996, Pacific Bell Directory ("Directory"), a wholly-
owned subsidiary of Pacific Bell, changed its method of recognizing directory
publishing revenues and related expenses. Directory previously recognized
revenues and expenses related to publishing using the "amortized" method,
under which revenues and expenses were recognized over the lives of the
directories, generally one year. Under the new "issue basis" method, revenues
and expenses will be recognized when the directories are issued.
Management believes this change to the issue basis method is preferable
because it is the method generally followed in the publishing industry and
better reflects the operating activity of the business.
45
<PAGE>
A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Cont'd)
The cumulative after-tax effect of applying the new method to prior years is
recognized as of January 1, 1996 as a one-time, non-cash gain applicable to
continuing operations of $85 million, or $0.20 per share. The gain is net of
deferred taxes of $58 million.
The effect of applying the new method for the twelve months ended December 31,
1996 is a non-cash gain included in income before extraordinary item and
cumulative effect of accounting change of $3 million. The total effect of the
change is a non-cash gain included in net income of $88 million.
Pro forma results, assuming the issue basis method had been applied during
prior periods, are as follows:
For the Year Ended December 31
--------------------------------
(Dollars in millions, except per
share amounts) 1996 1995 1994
- ----------------------------------------------------------------------
Pro Forma (Unaudited)
- ---------------------
Income before extraordinary item $1,057 $1,061 $1,145
Earnings per share $2.47 $2.49 $2.70
Net income (loss) $1,057 $(2,299) $1,145
Earnings (loss) per share $2.47 $(5.40) $2.70
As Reported
- -----------
Income before extraordinary item $1,057 $1,048 $1,159
Earnings per share $2.47 $2.46 $2.73
Net income (loss) $1,142 $(2,312) $1,159
Earnings (loss) per share $2.67 $(5.43) $2.73
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. ("spun-off operations"). The stock distribution was
recorded 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 total
assets and shareowners' equity were each reduced by $2.9 billion in 1994. The
stock distribution itself was a non-cash transaction, which did not affect the
Corporation's cash flow statement.
46
<PAGE>
B. SPUN-OFF OPERATIONS (Cont'd)
Under a separation agreement, any unrecorded non-tax contingent liabilities
that become certain after the spin-off date will be allocated based on origin
of the claim, and acts by, or benefits to, the Corporation or the spun-off
operations. In addition, the Corporation's responsibilities have been
terminated in connection with any future obligations under the spun-off
operations' joint venture agreement with Cellular Communications, Inc., and
under various financial instrument contracts.
The Corporation's previous interests in the net revenues and expenses of the
spun-off operations prior to April 1, 1994, are classified separately as
income from spun-off operations in the income statement.
The components of income are summarized below:
(Dollars in millions) 1994
---------------------------------------------------------------------
Operating revenues...................................... $259
Operating expenses...................................... 225
-------
Operating income........................................ 34
Other income/(expense)- net............................. 22
-------
Income before income taxes.............................. 56
Income taxes............................................ 29
-------
Income before minority interest......................... 27
Minority interest of other shareowners.................. (4)
-------
Income from spun-off operations*........................ $ 23
======================================================================
* See "Spun-off Operations" in Note A - on page 43. Amounts reflect
operations through March 31, 1994.
The Corporation's cash flow statement for 1994 includes separately the cash
flows of spun-off operations.
C. DISCONTINUANCE OF REGULATORY ACCOUNTING - SFAS 71
Effective third quarter 1995, for external financial reporting purposes,
Pacific Bell discontinued the application of SFAS 71, "Accounting for the
Effects of Certain Types of Regulation," an accounting standard for entities
subject to traditional regulation. As a result, during 1995 the Corporation
recorded a non-cash, extraordinary, after-tax charge of $3.4 billion, or $7.89
per share, net of a deferred income tax benefit of $2.4 billion. The charge
includes a write-down of net telephone plant and the elimination of net
regulatory assets as summarized in the following table.
47
<PAGE>
C. DISCONTINUANCE OF REGULATORY ACCOUNTING - SFAS 71 (Cont'd)
(Dollars in millions) Pre-Tax After-Tax
- ----------------------------------------------------------------------
Increase in telephone plant and equipment
accumulated depreciation..................... $4,819 $2,842
Elimination of net regulatory assets........... 962 518
------------------
Total.......................................... $5,781 $3,360
======================================================================
Pacific Bell historically accounted for the economic effects of regulation in
accordance with the provisions of SFAS 71. Under SFAS 71, Pacific Bell
depreciated telephone plant using lives prescribed by regulators and, as a
result of actions of regulators, deferred recognizing certain costs, or
recognized certain liabilities (referred to as "regulatory assets" and
"regulatory liabilities").
Effective third quarter 1995, management determined that, for external
financial reporting purposes, it was no longer appropriate for Pacific Bell to
use the special SFAS 71 accounting rules for entities subject to traditional
regulation. Management's decision to change to the general accounting rules
used by competitive enterprises was based upon an assessment of the emerging
competitive environment in California. Pacific Bell's prices for its products
and services are being driven increasingly by market forces instead of
regulation. Nevada Bell continues to apply SFAS 71 accounting but is
evaluating its continued applicability. If Nevada Bell were to discontinue
application of SFAS 71 it would not have a material effect on the
Corporation's financial statements.
In 1995, the $4.8 billion increase in Pacific Bell's accumulated depreciation
for its telephone plant reflects the adoption of new, shorter depreciation
lives. The estimated useful lives historically prescribed by regulators did
not keep up with the rapid pace of technology. Pacific Bell's previous and new
asset lives are compared in the following table.
Asset Lives (in years) Old New
- ------------------------------------------------------------------------
Copper cable...................................... 19-26 14
Digital switches.................................. 16.5 10
Digital circuits.................................. 9.6-11.5 8
Fiber optic cable................................. 28-30 20
Conduit........................................... 59 50
- ------------------------------------------------------------------------
The discontinuance of SFAS 71 for external financial reporting purposes in
1995 by Pacific Bell also required the elimination of net regulatory assets
totaling $962 million. Regulators sometimes include costs in allowable costs
for ratemaking purposes in a period other than the period in which those costs
would be charged to expense under general accounting rules. The accounting
for these timing differences created regulatory assets and regulatory
liabilities on Pacific Bell's balance sheet.
48
<PAGE>
C. DISCONTINUANCE OF REGULATORY ACCOUNTING - SFAS 71 (Cont'd)
Significant changes occurred in the Corporation's balance sheet in 1995 as a
result of the discontinuance of SFAS 71. Details of Pacific Bell's net
regulatory assets that have been eliminated are displayed in the following
table.
(Dollars in millions)
- ------------------------------------------------------------------------
Regulatory assets/(liabilities) due to:
Deferred pension costs*...................................... $460
Unamortized debt redemption costs**.......................... 337
Deferred compensated absence costs*.......................... 206
Unamortized purchases of property, plant, and
equipment under $500....................................... 82
Deferred income taxes***..................................... (159)
Other........................................................ 36
------
Total........................................................ $962
========================================================================
* Previously included primarily in "Other noncurrent and intangible assets"
in the Corporation's balance sheets.
** Previously included in "Long-term obligations."
*** Previously included in "Other current liabilities" and "Other noncurrent
liabilities and deferred credits."
Due to the discontinued application of SFAS 71 in 1995, pension costs for both
intrastate and interstate operations are now determined under SFAS 87,
"Employers' Accounting for Pensions," and SFAS 88, "Employers' Accounting for
Settlements and Curtailments of Defined Benefit Pension Plans and for
Termination Benefits." Capitalized interest cost is reported as a cost of
telephone plant and equipment and as a reduction in interest expense, as
required by SFAS 34, "Capitalization of Interest Cost." Prior to the
discontinuance of SFAS 71, Pacific Bell recorded an allowance for funds used
during construction, which included both interest and equity return
components, as a cost of plant and as an item in miscellaneous income.
Pacific Bell's accounting and reporting for regulatory purposes are not
affected by the discontinued application of SFAS 71 for external financial
reporting purposes.
D. RESTRUCTURING CHARGES AND OTHER RESERVES
In 1991, a $203 million reserve was established for the cost of management
force reduction programs through 1994. A balance of $77 million remained at
the end of 1993. An additional $1,020 million reserve was established in
December 1993 to record the incremental cost of force reductions associated
with restructuring Pacific Bell's business processes through 1997. This
reserve is to cover the incremental severance costs associated with
terminating more than 14,000 employees from 1994 through 1997. It is also to
cover the incremental costs of consolidating and streamlining operations and
facilities to support this downsizing initiative. The remaining reserve
balance as of December 31, 1996 and 1995, was $97 and $228 million,
respectively.
49
<PAGE>
D. RESTRUCTURING CHARGES AND OTHER RESERVES (Cont'd)
During 1993, management completed a reevaluation of investment alternatives
relating to its 1990 decision to dispose of its real estate subsidiary's
assets. Based on this reevaluation, the Corporation recorded an additional
restructuring reserve of $347 million to cover future losses on sales and
estimated operating losses. In December 1994, the Corporation's real estate
subsidiary sold substantially all of its assets for approximately $160
million. Charges to the reserve in 1994 totaled $287 million, $248 million
for losses on sale of its assets and $39 million for operating losses. Net
charges both in 1996 and 1995 were $19 million. Other reserves were recorded
in 1993, 1992, and 1990 related to the spun-off operations and the withdrawal
from, or restructuring of, the Corporation's cable and customer premises
equipment businesses. During 1996 the Corporation established a reserve of $43
million to reflect the restructuring of portions of its video-related
businesses. Management believes the $116 million balance in these reserves as
of December 31, 1996, is adequate.
E. INCOME TAXES
The components of income tax expense applicable to continuing operations each
year are as follows:
(Dollars in millions) 1996 1995 1994
----------------------------------------------------------------------
Current:
Federal........................................ $302 $408 $480
State and local income taxes................... 80 115 142
--------------------
Total current..................................... 382 523 622
Deferred:
Federal........................................ 304 64 77
State and local income taxes................... 103 29 22
--------------------
Total deferred ................................... 407 93 99
Amortization of investment tax credits - net...... (48) (53) (63)
--------------------
Total income taxes................................$741 $563 $658
===========================================================================
50
<PAGE>
E. INCOME TAXES (Cont'd)
Significant components of the Corporation's deferred tax assets and
liabilities are as follows:
December 31
---------------------
(Dollars in millions) 1996 1995
----------------------------------------------------------------------
Deferred tax assets/(liabilities) - due to:
Depreciation and amortization................. $(1,072) $(1,013)
Postretirement and postemployment benefits.... 1,007 1,042
Restructuring reserves........................ 38 116
Customer rate reductions...................... 113 133
Other, net.................................... 437 666
-------------------
Net deferred tax assets* ....................... $ 523 $ 944
=====================================================================
* Reflects reclassification of certain current and noncurrent amounts by
federal and state tax jurisdiction to a net presentation. Amounts
include both current and noncurrent portions. (See Note Q -
"Additional Financial Information" on page 74 for current portion of
deferred tax assets.)
In 1996 the State of California reduced the corporate tax rate from 9.3
percent to 8.84 percent, effective for taxable years beginning on or after
January 1, 1997. In accordance with generally accepted accounting principles,
net deferred tax assets at December 31, 1996 were revalued to reflect the
lower tax rate. This revaluation increased state tax expense, net of federal
tax, and decreased net income $16 million, or $0.04 per share, in 1996.
An income tax expense related to the cumulative effect of the accounting
change in 1996 for the change in accounting for directory revenue and expenses
is $58 million. (See Note A - "Cumulative Effect of Accounting Change" on
page 45.)
An income tax benefit related to the extraordinary charge in 1995 for the
discontinued application of SFAS 71 for depreciated telephone plant is $2.0
billion and for regulatory assets and liabilities is $0.4 billion. (See Note
C - "Discontinuance of Regulatory Accounting - SFAS 71" on page 47.)
The reasons for differences each year between the Corporation's effective
income tax rate and applying the statutory federal income tax rate to income
from continuing operations before income taxes are provided in the following
reconciliation:
51
<PAGE>
E. INCOME TAXES (Cont'd)
1996 1995 1994
----------------------------------------------------------------------
Statutory federal income tax rate (%)....... 35.0 35.0 35.0
Increase/(decrease) in taxes resulting from:
Amortization of investment tax credits... (1.8) (3.3) (3.5)
Plant basis differences - net of
applicable depreciation................ - - 0.3
Interest during construction............. - (1.1) (0.6)
State income taxes - net of federal
income tax benefit..................... 6.6 5.8 5.9
Other.................................... 1.4 (1.5) (0.4)
----------------------
Effective income tax rate (%)............... 41.2 34.9 36.7
======================================================================
F. EMPLOYEE RETIREMENT PLANS
Defined Benefit Plans
The Corporation provides pension, death, and survivor benefits under defined
benefit pension plans that cover substantially all employees. Benefits of the
Pacific Telesis Group Pension Plan (for non-salaried employees) are based on a
flat dollar amount and vary according to job classification, age, and years of
service. Benefits of the Pacific Telesis Group Pension Plan for Salaried
Employees accrue in a separate account balance based on a fixed percentage of
each employee's monthly salary with interest.
The Corporation is responsible for contributing enough to the pension plans,
while the employee is still working, to ensure that adequate funds are
available to provide the benefit payments upon the employee's retirement.
These contributions are made to an irrevocable trust fund in amounts
determined using the aggregate cost actuarial method, one of the actuarial
methods specified by the Employee Retirement Income Security Act of 1974
("ERISA"), subject to ERISA and Internal Revenue Code limitations.
52
<PAGE>
F. EMPLOYEE RETIREMENT PLANS (Cont'd)
The Corporation reports pension costs and related obligations under the
provisions of SFAS 87 and SFAS 88. However, prior to discontinuing
application of SFAS 71 during 1995, Pacific Bell recognized pension costs
consistent with the methods adopted for ratemaking. Nevada Bell continues to
follow the accounting method prescribed by the Public Service Commission of
Nevada. Pension costs recognized by Pacific Bell under SFAS 71 reflected a
California Public Utilities Commission ("CPUC") order requiring the continued
use of the aggregate cost method for intrastate operations and an Federal
Communications Commission ("FCC") requirement to use SFAS 87 and SFAS 88 for
interstate operations. (See Note C - "Discontinuance of Regulatory Accounting
- - SFAS 71" on page 47.)
Annual pension cost each year consisted of the following components:
(Dollars in millions) 1996 1995 1994
----------------------------------------------------------------------
Service cost - benefits earned during year......
$ 116 $ 149 $ 198
Interest cost on projected benefit obligations.. 620 678 681
Actual return on assets.........................(1,710)(2,215) (173)
Net amortization and deferral of items subject
to delayed recognition*....................... 807 1,477 (601)
--------------------
Net periodic pension cost under SFAS 87......... (167) 89 105
Adjustment to reflect differing regulatory
treatment**................................... - - (79)
--------------------
Pension cost (credit) recognized................$ (167) $ 89 $ 26
======================================================================
* Under SFAS 87, differences between actual returns and losses on
assets and assumed returns, which are based on an expected long-term
rate-of-return, are deferred and included with "unrecognized net
gain" (see table below). During 1994, actual returns were less than
assumed returns by $551 million. During 1996 and 1995, actual
returns exceeded assumed returns by $891 and $1,524 million,
respectively.
** See Note C - "Discontinuance of Regulatory Accounting - SFAS 71" on
page 47. Regulatory assets due to deferred pension costs were $407
as of December 31, 1994.
53
<PAGE>
F. EMPLOYEE RETIREMENT PLANS (Cont'd)
The following table sets forth the status of the plans' assets and obligations
and the amounts recognized in the Corporation's consolidated balance sheets:
December 31
--------------------
(Dollars in millions) 1996 1995
--------------------------------------------------------------------
Plan assets at estimated fair value............ $11,445 $11,490
Actuarial present value of projected benefit
obligations*................................. 7,674 10,111
--------------------
Plan assets in excess of projected benefit
obligations.................................. 3,771 1,379
Less items subject to delayed recognition:
Unrecognized net gain**...................... (4,328) (2,179)
Unrecognized transition amount***............ (368) (412)
Unrecognized prior service cost.............. 6 42
--------------------
Accrued pension cost liability recognized in
the consolidated balance sheets.............. $ 919 $ 1,170
====================================================================
* The projected benefit obligation was increased $202 and $407 million
at December 31, 1996 and 1995, respectively, for the cost of force
reductions anticipated to take place in 1996 and 1997 and recognized
in the Corporation's financial statements under SFAS 88.
** Gains or losses from actual returns on assets different than assumed
returns, as well as from demographic experience different than
assumed and the effects of changes in other assumptions, are
recognized through amortization, over time, when the cumulative gains
or losses exceed certain limits.
*** A $1,078 million excess of the fair value of plan assets over
projected benefit obligations as of the January 1, 1987 adoption of
SFAS 87 is being recognized through amortization over approximately
18 years.
The assets of the plans are primarily composed of common stocks, U.S.
Government and corporate obligations, index funds, and real estate
investments. The plans' projected benefit obligations for employee service to
date reflect management's expectations of the effects of future salary
progression and benefit increases. As of December 31, 1996 and 1995, the
actuarial present values of the plans' accumulated benefit obligations, which
do not anticipate future salary increases, were $7,443 and $9,122 million,
respectively. Of these amounts, $6,904 and $7,997 million, respectively, were
vested.
54
<PAGE>
F. EMPLOYEE RETIREMENT PLANS (Cont'd)
Liabilities and expenses for employee benefits are based on actuarial
assumptions. The assumed discount rate used to measure the present value of
benefit obligations was 7.5 percent and 7.25 percent at December 31, 1996 and
1995, respectively. Due to the amendment of the salaried pension plan
discussed below, 1996 expense was calculated using a discount rate of 7.25
percent until March. The remainder of 1996 expense was calculated at 7.75
percent. The long-term rate-of-return on assets assumed in calculating
pension costs was 9.0 percent for 1996 and 8.0 percent for 1995 and 1994.
These actuarial assumptions are subject to change over time, which could have
a material impact on the Corporation's financial statements.
In March 1996, management amended the salaried pension plan from a final pay
plan to a cash balance plan effective July 1, 1996. As a result 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. Taken together, the change in plan design, discount rate,
assumed long-term rate-of-return and other assumptions increased net income by
approximately $151 million, or $0.35 per share, during 1996. An enhanced
transition benefit, based on frozen pay and service as of June 30, 1996, was
established to preserve benefits already accrued by salaried employees under
the final pay plan. Effective January 1, 1995, the salaried pension plan was
amended to cap net credited service for pension benefits at 30 years or, if
greater, the amount of the employee's service on January 1, 1995. Upon
adoption, this amendment affected approximately 800 employees.
During 1996, 1995 and 1994, special pension benefits and cash incentives were
offered in connection with Pacific Bell's restructuring and related force
reduction program. Effective October 1, 1995, pension benefit increases may
be offered to various groups of non-salaried employees under 1995 plan
amendments which increase benefits for specified groups who elect early
retirement under incentive programs. On March 28, 1994, Pacific Bell offered
a special pension benefit that removed any age discount from pensions for
management employees who were eligible to retire with a service pension on
that date. Also during 1994, pension benefit increases were offered to
various groups of non-salaried employees under 1992 plan amendments that
increase benefits for specified groups who elect early retirement under
incentive programs. Approximately 1,500, 1,900 and 3,400 employees left
Pacific Bell during 1996, 1995 and 1994, respectively, under early retirement
or voluntary and involuntary severance programs. Annual pension cost excludes
$(64), $219 and $62 million of additional pension costs charged to Pacific
Bell's restructuring reserve in 1996, 1995 and 1994, respectively.
55
<PAGE>
F. EMPLOYEE RETIREMENT PLANS (Cont'd)
The Corporation has entered into labor negotiations with union-represented
employees in the past and expects to do so in the future. Pension benefits
have been included in these negotiations, and improvements in benefits have
been made periodically. Additionally, the Corporation has increased benefits
to pensioners on an ad hoc basis. While no assurance can be offered with
respect to future increases, management's expectations for future benefit
increases, other than ad hoc increases, have been considered in determining
pension costs.
Defined Contribution Plans
The Corporation sponsors defined contribution retirement plans covering
substantially all employees. These plans include the Pacific Telesis Group
Supplemental Retirement and Savings Plan for Salaried Employees, and the
Pacific Telesis Group Supplemental Retirement and Savings Plan for Nonsalaried
Employees (collectively, the "Savings Plans").
The Corporation's contributions to the Savings Plans are based on matching a
portion of employee contributions. All matching employer contributions to the
Savings Plans are made through a leveraged employee stock ownership plan
("LESOP") trust (see "Employee Stock Ownership Trust" in Note M on page 68).
Total contributions to these plans, including contributions allocated to
participant accounts through the LESOP trust, were $65, $66, and $66 million
in 1996, 1995, and 1994, respectively. These amounts exclude costs applicable
to spun-off operations.
G. OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS
Substantially all retirees and their dependents are covered under the
Corporation's plans for medical, dental, and life insurance benefits.
Approximately 44,000 retirees were eligible to receive benefits as of January
1, 1996. Currently, the Corporation pays the full cost of retiree health
benefits. However, by 1999, all employees retiring after 1990 will pay a
share of the costs of medical coverage that exceeds a defined dollar medical
cap. Such future cost sharing provisions have been reflected in determining
the Corporation's postretirement benefit costs. The Corporation retains the
right, subject to applicable legal requirements, to amend or terminate these
benefits.
56
<PAGE>
G. OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS (Cont'd)
Effective January 1, 1993, the Corporation adopted SFAS 106 on an immediate-
recognition basis. The standard requires that the cost of retiree benefits be
recognized in the financial statements from an employee's date of hire until
the employee becomes eligible for these benefits. Previously, the Corporation
expensed retiree benefits as they were paid. Immediate recognition of the
value of prior benefits earned, (the "transition obligation") resulted in a
one-time, non-cash charge applicable to continuing operations of
$1.573 billion, or $3.80 per share. The charge is net of a deferred income
tax benefit of $1.054 billion, which will be recognized over the remaining
lives of the workforce.
The Corporation's periodic expense under SFAS 106 in 1996 and 1995, as
displayed in the table below, increased from $106 million in 1992 under the
prior method. Because the Telephone Companies' higher costs are being
partially recovered in revenues, the increased costs have not materially
affected reported earnings. (See "Change in Accounting for Postretirement and
Postemployment Costs" in Note A on page 45.) However, a CPUC order held that
related revenues collected after October 12, 1994, are subject to refund. (See
"Revenues Subject to Refund" in Note O on page 71.)
The components of net periodic postretirement benefit cost are as follows:
(Dollars in millions) 1996 1995
---------------------------------------------------------------------
Service cost........................................... $ 45 $ 50
Interest cost on accumulated postretirement
benefit obligation................................... 239 262
Actual return on plan assets........................... (187) (250)
Net amortization and deferral of items subject to
delayed recognition.................................. 70 176
--------------
Net periodic postretirement benefit cost............... $167 $238
=====================================================================
Both Pacific Bell and Nevada Bell partially fund their obligations by
contributing to Voluntary Employees' Beneficiary Association trusts. Plan
assets are invested primarily in domestic and international stocks and
domestic investment-grade bonds.
57
<PAGE>
G. OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS (Cont'd)
In March 1996, in conjunction with a change in the pension plan assumptions,
management revised the assumed discount rate used to measure the accumulated
postretirement benefit obligation and remeasured plan assets. These changes
did not have a material effect on 1996 net income. In addition, in 1996 the
medical trend rate decreased to 6.0 percent, which increased net income by
approximately $18 million, or $0.04 per share, during 1996 in comparison to
1995.
The funded status of the plans follows:
December 31
----------------
(Dollars in millions) 1996 1995
----------------------------------------------------------------------
Accumulated postretirement benefit obligation:
Retirees............................................ $2,191 $2,311
Eligible active employees........................... 253 222
Other active employees.............................. 766 788
------------------
Total accumulated postretirement benefit obligation... 3,210 3,321
Less:
Fair value of plan assets........................... (1,542) (1,246)
Unrecognized net gain*.............................. 434 167
Unrecognized prior service cost..................... 37 39
------------------
Accrued postretirement benefit obligation recognized
in the consolidated balance sheets.................. $2,139 $2,281
======================================================================
* The unrecognized net gain is amortized over the expected future service
lives of approximately 16 years and reflects differences between
actuarial assumptions and actual experience. It also includes the
impact of changes in actuarial assumptions.
Liabilities and expenses for employee benefits are based on actuarial
assumptions. The assumed discount rate to measure the accumulated
postretirement benefit obligation was 7.50 percent and 7.25 percent at
December 31, 1996 and 1995, respectively. The 1996 expense was calculated at
7.25 percent until March. The remainder of 1996 expense was calculated at
7.75 percent. The 1996 accrued postretirement benefit obligation and the 1997
expense are based on an assumed annual increase in health care costs of 6.0
percent. Increasing the assumed health care cost trend rates by one percent
each year would increase the December 31, 1996 accumulated postretirement
benefit obligation by $412 million and would increase the combined service and
interest cost components of net periodic postretirement benefit cost for 1996
by $36 million. A 9.0 percent long-term rate-of-return on assets is assumed in
calculating postretirement benefit costs. These actuarial assumptions are
subject to change over time, which could have a material impact on the
Corporation's financial statements.
58
<PAGE>
G. OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS (Cont'd)
Effective January 1, 1993, the Corporation adopted SFAS 112 for accounting for
postemployment benefits, which required a change from cash to accrual
accounting. Postemployment benefits offered by the Corporation include
workers compensation, disability benefits, medical benefit continuation, and
severance pay. These benefits are paid to former or inactive employees who
terminate without retiring. A one-time, non-cash charge representing prior
benefits earned was recorded in 1993, which reduced earnings applicable to
continuing operations by $151 million, or $0.36 per share. The charge was net
of a deferred income tax benefit of $101 million. The annual periodic expense
under SFAS 112 does not differ materially from expense under the prior method.
H. STOCK OPTIONS AND STOCK APPRECIATION RIGHTS
Key employees of the Corporation have outstanding options and stock
appreciation rights ("SARs") that were granted under the Pacific
Telesis Group 1994 Stock Incentive Plan (the "Stock Plan") and a previous
plan (collectively, the "Plans"). The Stock Plan was approved by shareowners
effective January 1, 1994. The previous plan expired December 31, 1993. A
total of 21,000,000 shares of the Corporation's common stock was authorized by
the Board of Directors (the "Board") for grants of options, SARs, restricted
stock, and stock units under the Stock Plan. As of December 31, 1996, the
remaining shares authorized were 9,002,950, including 91,000 remaining shares
separately authorized for grant to nonemployee directors of the Board.
Options granted under the Plans were granted as nonqualified options or as
incentive stock options, and portions were granted in conjunction with SARs.
The original exercise price of each outstanding option and SAR was equal to
the fair market value of the Corporation's common stock on the date of grant.
The exercise prices of options and SARs outstanding at the time of the spin-
off (see Note B - "Spun-off Operations" on page 46) were adjusted as
described below. The exercise price of each option may be paid in cash or by
surrendering shares of common stock already owned by the holder, or with a
combination of cash and such shares. Options and associated SARs ordinarily
become exercisable at stated times beginning at least one year after the date
of grant. The term of any option or SAR cannot exceed ten years.
Options and SARs held by the continuing employees of the Corporation at the
time of the spin-off were supplemented with an equal number of options and
SARs for common shares of spun-off operations. The exercise prices for the
Corporation's outstanding options and SARs were adjusted downward to reflect
the value of the supplemental spun-off operations options and SARs. The
Corporation's balance sheet reflects a related liability equal to the
difference between the current market price of spun-off operations stock and
the exercise prices of the supplemental options outstanding. (See "Off-
Balance-Sheet Risk" in Note J on page 65.) As of December 31, 1996, 2,182,369
supplemental spun-off operations options and SARs were outstanding.
Expiration dates for the supplemental options and SARs range from 1997 to
2003.
59
<PAGE>
H. STOCK OPTIONS AND STOCK APPRECIATION RIGHTS (Cont'd)
Outstanding options and SARs of the Corporation that were held by employees of
the wireless operations at the spin-off date were replaced by options and SARs
for common shares of spun-off operations. The spun-off operations assumed
liability for these replacement options and SARs.
The Corporation applies Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees," and related interpretations in
accounting for its plans. Accordingly, no compensation expense has been
recognized for its stock-based compensation plans other than for restricted
stock which totaled $1.4 and $0.7 million for 1996 and 1995, respectively.
Had compensation cost for the Corporation's stock option plans been determined
based upon the fair value at the grant date for awards under these plans
consistent with the optional expense measurement method described in SFAS 123,
"Accounting for Stock-Based Compensation," the Corporation's net income would
have been reduced by approximately $3 million for 1996 and $1 million for 1995
with no per share effect for either year. The pro forma effect on net income
for 1996 and 1995 is not representative of the pro forma effect on net income
in future years because it does not take into consideration pro forma
compensation expense related to grants made prior to 1995.
The weighted-average fair value, on the date of grant, of options granted
during 1996 and 1995 is estimated at $2.92 and $2.80, respectively. Fair
value is determined using the Black-Scholes option-pricing model with the
following weighted-average assumptions used for grants in 1996 and 1995,
respectively: dividend yield of 7.9 and 7.2 percent, expected volatility of
23.4 and 17.0 percent, risk-free interest rate of 6.0 and 7.0 percent, and
expected lives of 5 years.
60
<PAGE>
H. STOCK OPTIONS AND STOCK APPRECIATION RIGHTS (Cont'd)
The following table summarizes option and SAR activity during 1996, 1995, and
1994:
Weighted Weighted Weighted
Average Average Average
Per Per Per
1996 Share* 1995 Share* 1994 Share*
--------- --------- -------- --------- --------- --------
Shares is-
suable under
outstanding
options and
SARs at
January 1 9,512,848 $29.97 10,742,408 $29.42 6,185,201 $24.11
Options and
SARs
granted 5,514,800 $27.40 363,700 $29.39 7,215,800 $31.98
Options and
SARs
exercised (1,459,477) $27.50 (1,057,347) $23.37 (1,255,080) $23.75
Options and
SARs canceled
or forfeited (429,050) $28.64 (535,913) $31.64 (9,520) $25.22
Options and
SARs replaced
for employees
of spun-off
operations - - - - (1,393,993) $24.26
----------- ----------- -----------
Shares is-
suable under
outstanding
options and
SARs at
December 31 13,139,121 $29.21 9,512,848 $29.97 10,742,408 $29.42
============================================================================
Options and
SARs exer-
cisable at
December 31 7,928,221* $30.41 5,773,723 $28.82 3,541,608 $ 24.21
* In accordance with the 1994 stock plan; should a change in ownership
control of Pacific Telesis Group occur, all 13,139,121 outstanding options
and SARs would become exercisable.
61
<PAGE>
H. STOCK OPTIONS AND STOCK APPRECIATION RIGHTS (Cont'd)
The following table summarizes information about options and SARs outstanding
at December 31, 1996:
Options and SARs Outstanding
--------------------------------------------------------------------
Range of Weighted Average Weighted Average
Exercise Number Remaining Exercise Price
Prices Outstanding Life Per Share*
-------------- ------------- ------------- ----------
$16.10 - 17.66 107,055 1.83 years $ 17.59
$25.53 - 33.87 13,032,066 7.71 years $ 29.30
-------------
$16.10 - 33.87 13,139,121 7.67 years $ 29.21
Options Exercisable
---------------------------------------------------
Range of Weighted Average
Exercise Number Exercise Price
Prices Exercisable Per Share*
-------------- ------------ ----------------
$16.10 - 17.66 107,055 $ 17.59
$25.53 - 33.87 7,821,166 $ 30.59
------------
$16.10 - 33.87 7,928,221 $ 30.41
===========================================================================
* Exercise prices per share were adjusted to reflect the spin-off of wireless
operations on April 1, 1994.
62
<PAGE>
I. DEBT AND LEASE OBLIGATIONS
Long-term obligations as of December 31, 1996 and 1995, consist of debentures
of $4,044 and $3,545 million, respectively, and corporate notes of $1,210 and
$1,279 million, respectively. Maturities and interest rates of long-term
obligations are summarized as follows:
December 31
---------------------
Maturities and Interest Rates 1996 1995
----------------------------------------------------------------------
(Dollars in millions)
1997 8.990% to 9.250% $ - $ 69
1999 4.625% 100 100
2000 4.625% 125 125
2001 8.700% 200 200
2002-2043 5.875% to 9.500% 4,829 4,330
-------------------
5,254 4,824
Long-term capital lease obligations 277 18
Unamortized discount - net of premium (107) (105)
-------------------
Total long-term obligations $5,424 $4,737
======================================================================
In February 1997, the CPUC approved Pacific Bell's application to issue up to
$1.75 billion of long- and intermediate-term debt and preferred securities.
The proceeds may be used to redeem maturing debt, to refinance other debt
issues and to finance construction expenditures or acquisition of property.
The CPUC's authorization is in effect until the full $1.75 billion has been
issued. Pacific Bell also 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 subsidiary may issue up to $192 million
of medium-term notes through a shelf registration on file with the SEC.
During 1996, the Corporation entered into sale and leaseback arrangements to
finance equipment associated with the buildout of its PCS network. As of
December 31, 1996 the obligation remaining is $270 million. These leases are
classified as capital leases and the related assets are classified as
property, plant and equipment. (See "Off-Balance-Sheet Risk" in Note J on
page 65.)
63
<PAGE>
I. DEBT AND LEASE OBLIGATIONS (Cont'd)
As of December 31, 1996 and 1995, the weighted-average interest rate on total
short-term borrowings was 7.05 percent and 5.91 percent, respectively. Debt
maturing within one year in the balance sheets consists of short-term
borrowings and the portion of long-term obligations that matures within one
year as follows:
December 31
----------------
(Dollars in millions) 1996 1995
----------------------------------------------------------------------
Commercial paper................................... $530 $1,416
Notes payable to banks............................. - 95
----------------
Total short-term borrowings........................ 530 1,511
Current maturities of long-term obligations........ 83 19
----------------
Total debt maturing within one year................ $613 $1,530
===========================================================================
Lines of Credit
The Corporation has various uncommitted lines of credit with certain banks.
These arrangements do not require compensating balances or commitment fees
and, accordingly, are subject to continued review by the lending institutions.
As of December 31, 1996 and 1995, the total unused lines of credit available
were approximately $2.8 and $2.7 billion, respectively.
J. FINANCIAL INSTRUMENTS
The following table presents the estimated fair values of the Corporation's
financial instruments:
December 31, 1996 December 31, 1995
----------------- -----------------
Estimated Estimated
Carrying Fair Carrying Fair
(Dollars in millions) Amount Value Amount Value
----------------------------------------------------------------------
Cash and cash equivalents......... $ 72 $ 72 $ 76 $ 76
Debt maturing within one year..... 613 613 1,530 1,530
Deposit liabilities............... 269 269 358 358
Long-term debt.................... 5,147 5,157 4,719 5,021
Trust originated preferred
securities of mandatorily
redeemable preferred stock(Note K) 1,000 990 - -
======================================================================
64
<PAGE>
FINANCIAL INSTRUMENTS (Cont'd)
The following methods and assumptions were used to estimate the fair values of
each category of financial instrument:
The fair values of cash and cash equivalents, debt maturing within one year,
and deposit liabilities approximate their carrying amounts because of the
short-term maturities of these instruments.
The fair value of long-term debt issues and trust-originated preferred
securities was estimated based on the net present value of future expected
cash flows, which were discounted using current interest rates and current
market prices. The carrying amounts of long-term debt include the unamortized
net discount.
Off-Balance-Sheet Risk
The Corporation has entered into an equity swap contract to hedge exposure to
risk of market changes related to its recorded liability for outstanding
employee stock options for common stock of spun-off operations and associated
SARs. (See Note H - "Stock Options and Stock Appreciation Rights" on page 59.)
The Corporation plans to make open market purchases of the stock of spun-off
operations to satisfy its obligation for options that are exercised. Off-
balance-sheet risk exists to the extent the market price of the stock of spun-
off operations rises above the market price reflected in the liability's
current carrying value. The equity swap was entered into to hedge this
exposure and minimize the impact of market fluctuations. The contract
entitles the Corporation to receive settlement payments to the extent the
price of the common stock of spun-off operations rises above the notional
value of $23.74 per share, but imposes an obligation to make payments to the
extent the price declines below this level. The swap also obligates the
Corporation to make a monthly payment of a fee based on LIBOR. The total
notional amount of the contract, $60 million and $77 million as of December
31, 1996 and 1995 respectively, covers the approximate number of the options
and SARs outstanding of spun-off operations on that date. The Corporation
plans to periodically adjust downward the outstanding notional amount as the
options and SARs are exercised. The equity swap contract expires April 1999.
Both the equity swap and the Corporation's liability for the stock options and
SARs of spun-off operations are carried in the balance sheet at their market
values, which were immaterial as of December 31, 1996 and 1995. Gains and
losses from quarterly market adjustments of the carrying amounts substantially
offset in results of operations. As of December 31, 1996 and 1995, the
accounting loss that would be incurred from nonperformance by the counterparty
to the equity swap was $4 million and $14 million, respectively. However,
management does not expect to realize any loss from counterparty
nonperformance.
65
<PAGE>
J. FINANCIAL INSTRUMENTS (Cont'd)
In 1996, the Corporation has entered into sale and leaseback arrangements to
finance equipment associated with the buildout of its PCS network. As of
December 31, 1996, the amount outstanding under these capital leases was $270
million, $88 million of which 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. The total
notional amount of the contracts, which cover both interest and principal
payments, is $137 million as of December 31, 1996 and they expire June 2004.
Both the forward contracts and the portion of the Corporation's lease
liability payable in yen are carried in the balance sheet at their market
values. Gains or losses due to foreign currency rate fluctuations on these
contracts and on the yen lease obligations offset each other in the income
statement. As of December 31, 1996, there was no accounting loss that would be
incurred from nonperformance by the counterparties to the forward contracts.
Management does not expect to realize any loss from counterparty
nonperformance under these contracts.
K. 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 five years after date of sale at par. The proceeds
were used to retire short-term indebtedness, primarily commercial paper.
As of December 31, 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.
66
<PAGE>
L. RELATED PARTY TRANSACTIONS
Spun-off operations repaid previous intercompany borrowings, which represented
a net receivable balance of $33 million in 1994. (See Note B - "Spun-off
Operations" on page 46.)
The Corporation provided certain administrative services to spun-off
operations and charged for these services through 90 days following the April
1, 1994, spin-off date.
A separation agreement for the spin-off provided for complete separation of
all properties of the spun-off operations from the Corporation. The
Corporation's consolidated federal income tax return for 1994 included spun-
off operations through the spin-off date.
M. CAPITAL STOCK
Shareowners
As of January 31, 1997, the number of shareowners of record was 664,327.
Preferred Stock
The Corporation's Articles of Incorporation include a provision for the
issuance of up to 50,000,000 preferred shares (par value $0.10 per share) in
one or more series with full or limited voting powers or without voting
powers, and with such designations, preferences, and rights as the Board may
determine.
Treasury Stock
From time to time, the Corporation purchases shares of its common stock and
holds these shares as treasury stock. Treasury stock that is held may be
reissued later in connection with acquisitions, the Corporation's shareowner
dividend reinvestment and stock purchase plan ("DRISPP"), and employee benefit
plans.
During 1996, the Corporation reacquired 121,974 treasury shares primarily
related to adjustments to the 1995 acquisition of Cross Country Wireless Inc.
("CCW"). (See Note N - "Acquisition" on page 69.) During 1995, the
Corporation reissued 4,369,507 treasury shares, primarily in connection with
the acquisition of CCW. During 1994 the Corporation reissued 1,006,122
treasury shares for the DRISPP and employee benefit plans. As of December 31,
1996, 4,514,897 shares remained held as treasury stock pending their ultimate
disposition.
67
<PAGE>
M. CAPITAL STOCK (Cont'd)
Employee Stock Ownership Trust
All matching employer contributions to the Savings Plans are made through a
LESOP trust. (See "Defined Contribution Plans" in Note F on page 56.) During
1989, Bankers Trust Company, as trustee of the Pacific Telesis Group Employee
Stock Ownership Plan Trust, purchased 13,900,000 of the Corporation's treasury
shares at a price of $691,052,400 in exchange for a promissory note from the
trust to the Corporation. The note payable by the trust is not reflected as a
liability of the Corporation and the remaining cost of unallocated trust
shares is carried as a reduction of shareowners' equity (as "deferred
compensation"). Principal and interest on the note is paid from employer
contributions and dividends received by the trust.
The following table summarizes the Corporation's expense each year from the
allocation of shares held by the LESOP trust to the accounts of employees
participating in the Savings Plans:
(Dollars in millions) 1996 1995 1994
----------------------------------------------------------------------
Total compensation and interest expense recognized*... $57 $66 $60
Interest expense portion**............................ 15 23 19
Other information:
Employer contributions to trust..................... 99 60 77
Dividends received by trust......................... 33 44 35
======================================================================
* Determined using the shares-allocated accounting method and after
being reduced by dividends paid on shares held by the trust.
** The Corporation's LESOP interest expense is matched by an equal
amount of interest income earned on the promissory note from the
trust and reflected in miscellaneous income.
Shares held by the LESOP trust are released for allocation to the accounts of
employees as employer matching contributions are earned. The following table
summarizes the Corporation's shares held by the trust:
December 31
-------------------------
1996 1995
----------------------------------------------------------------------
Shares allocated to employee accounts....... 5,755,053 8,238,685
Shares committed to be allocated*........... 224,267 340,519
Shares unallocated.......................... 12,442,831 11,228,756
-------------------------
Total shares held by trust.................. 18,422,151 19,807,960
======================================================================
* Represents employer matching contributions earned by employees, but not
yet allocated to employee accounts.
68
<PAGE>
M. CAPITAL STOCK (Cont'd)
Statement of Position 93-6 ("SOP 93-6"), "Employers' Accounting for Employee
Stock Ownership Plans," issued by the American Institute of Certified Public
Accountants, established new accounting rules for new LESOP shares. As
allowed by specific provisions of SOP 93-6, the Corporation continues to
follow the prior rules in accounting for the LESOP trust.
Shareowner Rights Plan
During 1989, the Board adopted a shareowner rights plan to enhance its ability
to protect the shareowners' interests if the Corporation is faced with a
hostile acquisition proposal. Under the terms of the plan, shareowners of
record as of October 10, 1989, received one right for each share of the
Corporation's common stock held on that date. Initially, the rights are not
exercisable and trade automatically with the Corporation's common stock. If a
takeover attempt occurred that satisfied the tests described in the plan, each
right (except for rights held by the person or group making that takeover
attempt) would become the right to purchase common stock at one-half its then
market value (or, at the Board's discretion, could be exchanged for an
additional share of common stock). The rights do not have any voting rights,
may be redeemed under certain circumstances at $0.01 per right, and expire on
October 10, 1999.
N. ACQUISITION
In July 1995, the Corporation acquired 100 percent of the stock of CCW to
provide wireless television service in Southern California. The acquisition
was accounted for by the purchase method of accounting. The acquisition
included existing wireless cable operations with over 40,000 video customers
in Riverside, California and 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 4.4 million shares, for the outstanding stock of CCW.
The Corporation also assumed approximately $55 million of CCW debt, which was
retired during the third quarter of 1995.
69
<PAGE>
O. 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. 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, third and fourth quarter 1996 dividends to
$0.315 per share.
The transaction is intended to be accounted for as a pooling of interests and
to be a tax-free reorganization. Adjustments typically associated with the
pooling of interests method are to conform accounting policies of the merged
entities. Management is unable to determine if these policy changes and other
merger-related adjustments will be material.
The merger is subject to certain conditions and regulatory approvals. On
January 31, 1997, the FCC approved the merger, and in November 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. In December 1996, the Public Service Commission
of Nevada ("PSCN") approved the merger with the stipulation that Nevada Bell
customers be paid the greater of $4 million or 2.0 percent of the amount, if
any, ordered by the CPUC to be paid to Pacific Bell customers. The payment to
Nevada Bell customers is conditioned on closing of the merger. In addition,
the California State Attorney General has told the CPUC that the merger will
not hurt competition in California and is consistent with emerging trends.
On September 30, 1996, the Office of Ratepayer Advocates ("ORA"), the consumer
interest branch of the CPUC, filed testimony in the CPUC merger proceeding
recommending a $2.1 billion rebate to customers payable over five years.
Management does not agree with the ORA's recommendation and believes no
customer rebate or payment should be required in connection with the merger.
On February 21, 1997, two California administrative law judges issued a
proposed decision approving the merger but with a number of conditions,
including payment of up to $750 million. Management does not agree with the
level of payment or the restrictive conditions and intends to work towards
their reduction or elimination. A proposed decision by the administrative law
judges is not binding. The CPUC is expected to review the full case and the
proposed decision and issue a final decision by March 31, 1997. Depending on
the final CPUC decision, the merger could close in early second quarter.
70
<PAGE>
O. COMMITMENTS AND CONTINGENCIES (Cont'd)
Purchase Commitments
In December 1994, Pacific Bell contracted for the purchase of up to $2 billion
of Advanced Communications Network ("ACN") facilities, which incorporated new
technologies. During 1995, the ability to deploy the facilities outstripped
the ACN vendors' ability to deliver necessary products and software.
Accordingly, management decided to suspend construction at certain sites,
which reduced the expected cost to less than $700 million. If ACN facilities
meet certain quality and performance criteria (the "Network Test"), Pacific
Bell is committed to purchase the ACN facilities in 1998. If ACN facilities
fail the Network Test, Pacific Bell will not be committed to buy the ACN
facilities but might be liable to reimburse the principal ACN vendor for some
construction costs up to $300 million. If competition or other factors affect
Pacific Bell's ability to recover its investment in these facilities, the
value of the ACN facilities could be materially impaired.
As of December 31, 1996, Pacific Bell had purchase commitments of about $208
million remaining in connection with its previously announced program for
deploying an all digital switching platform with ISDN and SS-7 capabilities.
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 for
regulatory accounting purposes. Annual price cap decisions by the CPUC
granted Pacific Bell approximately $100 million in each of the years 1993-
1997 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 totaled
about $221 million at December 31, 1996. Management believes postretirement
benefits costs are appropriately recoverable in Pacific Bell's price cap
filings.
71
<PAGE>
O. COMMITMENTS AND CONTINGENCIES (Cont'd)
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 $70 million as of December 31, 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.
P. 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
Pacific Bell'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. Pacific Bell also faces
competition from cable television companies and others.
Effective January 1, 1995, the CPUC authorized toll services competition.
Management estimates that share losses since January 1, 1995 have been in the
five to six percent range. However, this loss combined with losses prior to
the official opening of this market has resulted in Pacific Bell currently
serving less than 50 percent of the business toll market. In April 1995, the
CPUC also ordered Pacific Bell to offer expanded interconnection to
competitive access providers. These competitors are allowed to carry the
intrastate portion of long-distance and local toll calls between Pacific
Bell's central offices and long distance carriers. Competitors may choose to
locate their transmission facilities within or near Pacific Bell's central
offices.
72
<PAGE>
P. COMPETITIVE RISK (Cont'd)
Effective January 1, 1996, the CPUC authorized local exchange competition. By
early February 1997, the CPUC had authorized about 90 companies, including
large and well-capitalized long distance carriers, competitive access
providers, and cable television companies to begin providing local phone
service in California, and 38 additional applications were pending. These
companies are prepared to compete in major local exchange markets and many
have already deployed switches or other facilities. All of Pacific Bell's
customers have already chosen a long distance company, and these companies
have established widespread customer awareness through extensive advertising
campaigns over several years.
Local exchange competition may affect toll and access revenues, as well as
local service revenues, since customers may select a competitor for all their
telecommunications services. Local exchange competition may also affect other
service revenues as Pacific Bell Directory will have to acquire listings from
other providers for its products, and competing directory publishers may ally
themselves with other telecommunications providers. Management estimates the
CPUC's proposed local competition rules could materially reduce revenue growth
for Pacific Bell's regulated California operations by late 1997.
The characteristics of the California market make it attractive to new
competitors. Pacific Bell's business and residence revenues and profitability
are concentrated among a small portion of its customer base and geographic
areas. Competitors need only serve selected portions of Pacific Bell's
service area to compete for the majority of its 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. California is also attractive because it has one of the lowest
switched access rates in the country. By combining the low switched access
rates and discounted resale rates, competitors have the ability to price their
services below Pacific Bell's prices while maintaining high margins. Reselling
allows competitors to offer local services with little or no investment.
Management believes that now that our markets are open to all competitors, the
Corporation should be granted access to markets that are currently closed to
LECs. A truly open competitive market, in which the Corporation can compete
without restrictions, offers long-term opportunity to build the business and
maximizes benefits for consumers. Management believes its key strategies of
strengthening the core business by upgrading its network and systems
capabilities, improving customer service and efficiency, expanding existing
markets, developing new markets and promoting public policy reform, will
provide a strong response to its competitive challenge.
73
<PAGE>
P. COMPETITIVE RISK (Cont'd)
In Nevada, the PSCN issued a ruling opening the local exchange market to
competition. It includes requirements that the LECs allow interconnection,
unbundling, interim number portability and resale. Current PSCN proceedings
are addressing pricing, interconnection and other local competition issues.
At least two long distance carriers have requested resale of Nevada Bell
services, and two competitive access providers have entered the Northern
Nevada market, with the express intent of providing an alternative basic
business service to high-margin customers. Further, long distance carriers
can now transport toll calls both within and between service areas, and there
is evidence that such transport is increasing at a rapid rate. As in
California, Nevada Bell's market is attractive to new competitors. Competition
is expected to target the high-usage, high-profit customers. These customers
are geographically concentrated in the Reno/Sparks metropolitan area and
business parks.
Q. ADDITIONAL FINANCIAL INFORMATION
December 31
--------------------
(Dollars in millions) 1996 1995
----------------------------------------------------------------------
Prepaid expenses and other current assets:
Prepaid directory expenses.................. $ 50 $ 320
Miscellaneous prepaid expenses............... 47 38
Notes and other receivables.................. 127 101
Inventory and supplies....................... 35 58
Current deferred tax benefits................ 144 300
Deferred compensation trusts................. 172 152
Other........................................ 18 33
--------------------
Total.......................................... $ 593 $ 1,002
======================================================================
Property, plant, and equipment - net:
Land and buildings........................... $ 2,868 $ 2,758
Cable and conduit............................ 11,531 11,175
Central office equipment..................... 10,114 9,562
Furniture, equipment, and other.............. 3,135 2,917
Construction in progress..................... 1,384 810
--------------------
29,032 27,222
Less accumulated depreciation................ (16,959) (15,837)
--------------------
Total.......................................... $12,073 $11,385
======================================================================
Other noncurrent and intangible assets:
PCS licenses and costs....................... $ 826 $ 730
Other........................................ 1,062 1,143
--------------------
Total.......................................... $ 1,888 $ 1,873
======================================================================
74
<PAGE>
Q. ADDITIONAL FINANCIAL INFORMATION (Cont'd)
December 31
----------------
(Dollars in millions) 1996 1995
---------------------------------------------------------------------
Accounts payable and accrued liabilities:
Accounts payable:
Trade..................................... $ 791 $ 753
Payroll................................... 31 56
Checks outstanding........................ 411 302
Other:
Incentive awards payable................ 200 200
Other................................... 359 429
Interest accrued............................ 135 124
Advance billing and customers' deposits..... 260 339
------------------
Total......................................... $2,187 $2,203
=====================================================================
Other current liabilities:
Accrued compensated absences................ $ 268 $ 278
Dividends payable........................... 135 234
Restructuring and other reserves............ 213 311
Other....................................... 111 85
------------------
Total......................................... $ 727 $ 908
=====================================================================
Other noncurrent liabilities and deferred credits:
Unamortized investment tax credits.......... $ 243 $ 292
Accrued pension cost liability.............. 919 1,170
Restructuring and other reserves............ - 15
Accrued postretirement benefit obligation... 2,139 2,281
Other....................................... 583 515
------------------
Total......................................... $3,884 $4,273
=====================================================================
75
<PAGE>
Q. ADDITIONAL FINANCIAL INFORMATION (Cont'd)
For the Year Ended
December 31
-----------------------
(Dollars in millions) 1996 1995 1994
----------------------------------------------------------------------
Other service revenues:
Directory Advertising...................... $1,071 $1,031 $1,003
Other...................................... 601 517 425
-----------------------
Total........................................ $1,672 $1,548 $1,428
======================================================================
Interest expense:
Gross interest expense..................... $ 455 $ 480 $ 455
Less capitalized interest.................. (114) (38) -
-----------------------
Net interest expense......................... $ 341 $ 442 $ 455
======================================================================
Other income(expense) - net:
Interest income............................ $ 27 $ 62 $ 29
Dividends on preferred securities of
subsidiary trusts........................ (60) - -
Other...................................... (26) (20) 26
-----------------------
Total........................................ $ (59) $ 42 $ 55
======================================================================
Advertising expense.......................... $ 144 $ 97 $ 99
======================================================================
CASH PAYMENTS FOR:
Interest..................................... $ 439 $ 492 $ 442
Income taxes................................. $ 453 $ 530 $ 737
======================================================================
NON-CASH TRANSACTIONS:
Spin-off stock distribution.................. $ - $ - $2,901
Acquisition of CCW (Note N)
Treasury shares (reacquired)issued......... $ (3) $ 117 $ -
Debt assumed............................... $ - $ 55 $ -
Treasury shares reacquired................... $ ( 1) $ - $ -
======================================================================
Major Customer
Substantially all of the Corporation's operating revenues were from
telecommunications and information services. Approximately 7 percent, 9
percent, and 11 percent of these revenues were earned in 1996, 1995, and 1994,
respectively, for services provided to AT&T Corp. No other customer accounted
for more than 10 percent of revenues.
76
<PAGE>
-----------------------------------------------------------------------
QUARTERLY FINANCIAL DATA
(Unaudited)
(Dollars in millions, except per share amounts)
-----------------------------------------------
1996 First* Second* Third* Fourth**
------------------------------------------------------------------------
Operating revenues.................. $2,378 $2,405 $ 2,356 $2,449
Operating income.................... 623 618 521 436
Earnings:
Income before cumulative effect of
accounting change............... 316 291 259 191
Cumulative effect of accounting
change.......................... 85 - - -
-------------------------------
Net income ......................... $ 401 $ 291 $259 $ 191
Earnings per share:
Income before cumulative effect of
accounting change............... $ 0.74 $ 0.68 $ 0.60 $ 0.45
Cumulative effect of accounting
change.......................... 0.20 - - -
-------------------------------
Net income.......................... $ 0.94 $ 0.68 $ 0.60 $ 0.45
------------------------------------------------------------------------
1995 First Second Third*** Fourth
------------------------------------------------------------------------
Operating revenues.................. $2,254 $2,231 $ 2,275 $2,282
Operating income.................... 490 518 530 473
Earnings (loss):
Income before extraordinary item.. 282 260 275 231
Extraordinary item................ - - (3,360) -
-------------------------------
Net income (loss)................... $ 282 $ 260 $(3,085) $ 231
Earnings (loss) per share:
Income before extraordinary item.. $ 0.67 $ 0.61 $ 0.64 $ 0.54
Extraordinary item................ - - (7.86) -
-------------------------------
Net income (loss)................... $ 0.67 $ 0.61 $ (7.22) $ 0.54
=======================================================================
77
<PAGE>
QUARTERLY FINANCIAL DATA (Cont'd)
(Unaudited)
* During fourth quarter 1996, Pacific Bell Directory changed its method of
recognizing directory publishing revenues and related expenses effective
January 1, 1996 to a preferable method. The cumulative after-tax effect of
applying the new method to prior years is recognized as of January 1, 1996
as a one-time, non-cash gain applicable to continuing operations of $85
million, or $0.20 per share. The first three quarters of 1996 were
restated to reflect the new method. (See "Cumulative Effect of Accounting
Change" under Note A on page 45.)
** Fourth quarter 1996 results reflect a number of one-time items that
reduced earnings by $91 million, or $0.21 per share.
*** Third quarter 1995 results reflect an after-tax extraordinary charge as a
result of Pacific Bell's discontinuance of regulatory accounting. (See
Note C - "Discontinuance of Regulatory Accounting - SFAS 71" on page 47.)
- ---------------------------------------------------------------------------
STOCK TRADING ACTIVITY AND DIVIDENDS PAID
Payment
1996 High Low Dividends Date
- ---------------------------------------------------------------------------
First Quarter.................... $35.250 $25.875 $0.545 5/1/96
Second Quarter*.................. $34.750 $31.500 $0.315 8/1/96
Third Quarter*................... $35.250 $31.750 $0.315 11/1/96
Fourth Quarter*.................. $39.000 $32.875 $0.315 2/3/97
- ---------------------------------------------------------------------------
Payment
1995 High Low Dividends Date
- ---------------------------------------------------------------------------
First Quarter................... $31.250 $28.000 $0.545 5/1/95
Second Quarter.................. $31.250 $25.625 $0.545 8/1/95
Third Quarter................... $30.875 $25.625 $0.545 11/1/95
Fourth Quarter.................. $34.375 $29.125 $0.545 2/1/96
- ---------------------------------------------------------------------------
(Stock trading activity: based on New York Stock Exchange - Composite
Transactions)
* Under the terms of the merger agreement with SBC Communications Inc., the
Corporation reduced the quarterly dividend to $0.315 per share. (See Note
O - "Merger Agreement" on page 70.)
Dividends
The record date is set by the Pacific Telesis Group Board of Directors at the
time it declares a dividend. Quarterly reports are mailed with dividend
checks.
78
<PAGE>
Stock Listing
New York, Pacific, Chicago exchanges PAC
London, Swiss exchanges Pacific Telsis
Newspaper stock tables Pac Telesis
79
