<PAGE>
FORM 10-Q
United States
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
(Mark One)
|X| Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the quarterly period ended September 30, 1997
or
|_| Transition Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the transition period from to
Commission File Number 1-8609
PACIFIC TELESIS GROUP
Incorporated under the laws of the State of Nevada
I.R.S. Employer Identification Number 94-2919931
130 Kearny Street, San Francisco, California 94108
Telephone Number: (415) 394-3000
THE REGISTRANT, A WHOLLY-OWNED SUBSIDIARY OF SBC COMMUNICATIONS INC., MEETS THE
CONDITIONS SET FORTH IN GENERAL INSTRUCTION H(1)(a) AND (b) OF FORM 10-Q AND IS
THEREFORE FILING THIS FORM WITH REDUCED DISCLOSURE FORMAT PURSUANT TO GENERAL
INSTRUCTION H(2).
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
<PAGE>
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
<TABLE>
PACIFIC TELESIS GROUP
- ---------------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF INCOME
Dollars in millions
(Unaudited)
- ---------------------------------------------------------------------------------------
<CAPTION>
------------------------------------
Three months Nine months
ended ended
September 30, September 30,
--------------------------------------
1997 1996 1997 1996
- ---------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Operating Revenues
Local service $ 1,172 $ 1026 $ 3,316 $ 3,021
Network access:
Interstate 470 462 1,299 1,381
Intrastate 195 177 600 543
Long-distance service 305 330 912 969
Directory advertising 240 210 867 795
Other 154 151 469 430
- ---------------------------------------------------------------------------------------
Total operating revenues 2,536 2,356 7,463 7,139
- ---------------------------------------------------------------------------------------
Operating Expenses
Cost of services and products 1,090 902 3,080 2,637
Selling, general and administrative 491 463 2,747 1,341
Depreciation and amortization 487 470 1,962 1,399
- ---------------------------------------------------------------------------------------
Total operating expenses 2,068 1,835 7,789 5,377
- ---------------------------------------------------------------------------------------
Operating Income (Loss) 468 521 (326) 1,762
- ---------------------------------------------------------------------------------------
Other Income (Expense)
Interest expense (126) (78) (335) (265)
Other income (expense)- net (11) (17) (73) (38)
- ---------------------------------------------------------------------------------------
Total other income (expense) (137) (95) (408) (303)
- ---------------------------------------------------------------------------------------
Income (Loss) Before Income Taxes and Cumulative
Effect of Accounting Changes 331 426 (734) 1,459
- ---------------------------------------------------------------------------------------
Income Taxes 128 167 (189) 593
- ---------------------------------------------------------------------------------------
Income (Loss) Before Cumulative Effect of
Accounting Changes 203 259 (545) 866
Cumulative Effect of Accounting Changes, net of tax - - 322 85
- ---------------------------------------------------------------------------------------
Net Income (Loss) $ 203 $ 259 $ (223)$ 951
- ---------------------------------------------------------------------------------------
<FN>
See Notes to Consolidated Financial Statements.
</FN>
</TABLE>
<PAGE>
PACIFIC TELESIS GROUP
- --------------------------------------------------------------------------------
CONSOLIDATED BALANCE SHEETS
Dollars in millions except per share amounts
- --------------------------------------------------------------------------------
September 30, December 31,
-----------------------------
1997 1996
- --------------------------------------------------------------------------------
Assets (Unaudited)
Current Assets
Cash and cash equivalents $ 58 $ 72
Accounts receivable - net of allowances for
uncollectibles of $244 and $163 2,328 2,109
Prepaid expenses 62 52
Deferred income taxes 598 144
Deferred charges 27 45
Other current assets 65 52
- --------------------------------------------------------------------------------
Total current assets 3,138 2,474
- --------------------------------------------------------------------------------
Property, Plant and Equipment - at cost 30,011 29,032
Less: Accumulated depreciation and amortization 17,857 16,959
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Property, Plant and Equipment - Net 12,154 12,073
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Intangible Assets - Net of Accumulated
Amortization of $275 and $4 873 1,108
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Other Assets 1,017 953
- --------------------------------------------------------------------------------
Total Assets $ 17,182 $ 16,608
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Liabilities and Shareowner's Equity
Current Liabilities
Debt maturing within one year $ 1,457 $ 613
Accrued taxes 1,069 103
Accounts payable and accrued liabilities 2,904 2,811
- --------------------------------------------------------------------------------
Total current liabilities 5,430 3,527
- --------------------------------------------------------------------------------
Long-Term Debt 5,403 5,424
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Deferred Credits and Other Noncurrent Liabilities
Postemployment benefit obligation 2,438 2,250
Unamortized investment tax credits 209 243
Other noncurrent liabilities 630 1,391
- --------------------------------------------------------------------------------
Total deferred credits and other noncurrent liabilities 3,277 3,884
- --------------------------------------------------------------------------------
Commitments and contingencies
Corporation-obligated mandatorily redeemable
preferred securities of subsidiary trusts* 1,000 1,000
- --------------------------------------------------------------------------------
Shareowner's Equity
Common stock (par value of $1 and
$.10 at September 30, 1997 and 1996) - 43
Capital in excess of par value 2,892 3,501
Retained earnings (deficit) (702) (479)
Deferred compensation - LESOP (118) (161)
Treasury shares (at cost) - (131)
- --------------------------------------------------------------------------------
Total shareowner's equity 2,072 2,773
- --------------------------------------------------------------------------------
Total Liabilities and Shareowner's Equity $ 17,182 $ 16,608
- --------------------------------------------------------------------------------
* The trusts contain assets of $1,030 in principal amount of the Subordinated
Debentures of Pacific Telesis Group
See Notes to Consolidated Financial Statements.
<PAGE>
PACIFIC TELESIS GROUP
- ------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF CASH FLOWS
Dollars in millions, increase (decrease) in cash and cash equivalents
(Unaudited)
- ------------------------------------------------------------------------------
Nine months ended
September 30,
-----------------------
1997 1996
- ------------------------------------------------------------------------------
Operating Activities
Net income (loss) $ (223) $ 951
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization 1,962 1,399
Undistributed earnings from investments in equity
affiliates 9 28
Provision for uncollectible accounts 204 130
Amortization of investment tax credits (34) (36)
Deferred income taxes (336) 149
Cumulative effect of accounting changes, net of tax (322) (85)
Other - net 401 (762)
- ------------------------------------------------------------------------------
Total adjustments 1,884 823
- ------------------------------------------------------------------------------
Net Cash Provided by Operating Activities 1,661 1,774
- ------------------------------------------------------------------------------
Investing Activities
Construction and capital expenditures (1,822) (1,680)
Investments in affiliates (16) (35)
Dispositions - 48
Acquisitions - (180)
- ------------------------------------------------------------------------------
Net Cash Used in Investing Activities (1,838) (1,847)
- ------------------------------------------------------------------------------
Financing Activities
Net change in short-term borrowings with original
maturities of three months or less 213 (1,045)
Issuance of other short-term borrowings 610 -
Issuance of long-term debt - 700
Repayment of long-term debt (5) (18)
Issuance of trust originated preferred securities - 1,000
Issuance of treasury shares - 37
Equity received from parent 130 -
Dividends paid (785) (601)
Other - 5
- ------------------------------------------------------------------------------
Net Cash Provided by Financing Activities 163 78
- ------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents (14) 5
- ------------------------------------------------------------------------------
Cash and cash equivalents beginning of year 72 76
- ------------------------------------------------------------------------------
Cash and Cash Equivalents End of Period $ 58 $ 81
- ------------------------------------------------------------------------------
Cash paid during the nine months ended September 30 for:
Interest $ 354 $ 291
Income taxes, net of refunds $ (456) $ 366
See Notes to Consolidated Financial Statements.
<PAGE>
<TABLE>
PACIFIC TELESIS GROUP
- ----------------------------------------------------------------------------------------------------------
CONSOLIDATED STATEMENT OF SHAREOWNER'S EQUITY
Dollars in millions
(Unaudited)
<CAPTION>
- ----------------------------------------------------------------------------------------------------------
Deferred
Compensation
Capital in Retained Leveraged
Common Excess of Earnings Employee Treasury
Shares Par Value (Deficit) Stock Shares
Ownership
Trust
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Balance, December 31, 1996 $ 43 $ 3,501 $ (479) $ (161) $ (131)
Net income (loss) - - (223) - -
Dividends to parent - (511) - - -
Dividends to shareowners - (140) - - -
Reduction of debt associated with
Employee Stock Ownership Plans - - - 43 -
Recapitalization of Common and
Treasury Shares (43) (88) - - 131
Net equity received from parent - 130 - -
- ----------------------------------------------------------------------------------------------------------
Balance, September 30, 1997 $ - $ 2,892 $ (702) $ (118) $ -
- ----------------------------------------------------------------------------------------------------------
<FN>
See Notes to Consolidated Financial Statements.
</FN>
</TABLE>
<TABLE>
* * * *
SELECTED FINANCIAL AND OPERATING DATA At September 30, or for the nine months
then ended:
<CAPTION>
1997 1996
------------------------
<S> <C> <C>
Return on weighted average shareowners' equity * ........................... -25.96% 44.98%
Debt ratio ................................................................. 69.07% 61.44%
Network access lines in service (000)....................................... 16,909 16,320
Access minutes of use (000,000)............................................. 52,745 48,274
Cellular customers (000).................................................... 266 -
Number of employees......................................................... 52,880 48,430
<FN>
*Calculated using Income Before Cumulative Effect of Accounting Changes.
</FN>
</TABLE>
<PAGE>
PACIFIC TELESIS GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Dollars in millions
1. BASIS OF PRESENTATION The consolidated financial statements have been
prepared by Pacific Telesis Group (PAC) pursuant to the rules and regulations
of the Securities and Exchange Commission (SEC) and, in the opinion of
management, include all adjustments (consisting only of normal recurring
accruals) necessary to present fairly the results for the interim periods
shown. Certain information and footnote disclosures, normally included in
financial statements prepared in accordance with generally accepted
accounting principles, have been condensed or omitted pursuant to such SEC
rules and regulations. Certain reclassifications have been made to the 1996
consolidated financial statements to conform with the 1997 presentation. The
results for the interim periods are not necessarily indicative of results for
the full year. The consolidated financial statements contained herein should
be read in conjunction with the consolidated financial statements and notes
thereto included in PAC's 1996 Annual Report on Form 10-K (the Form 10-K)
filed with the SEC.
2. CONSOLIDATION The consolidated financial statements include the accounts of
PAC and its majority-owned subsidiaries. PAC's subsidiaries include, but are
not limited to, Pacific Bell (PacBell, which also includes its subsidiaries)
and Nevada Bell, which are collectively referred to as the Telephone
Companies. PAC is a wholly-owned subsidiary of SBC Communications Inc. (SBC).
During the third quarter of 1997, PAC's commercial paper was replaced by
intercompany loans from SBC. Intercompany loans as of September 30, 1997
totaled $743. All significant intercompany transactions between PAC
subsidiaries are eliminated in the consolidation process. Investments in
partnerships, joint ventures and less than majority-owned subsidiaries are
principally accounted for under the equity method.
3. COMPLETION OF MERGER On April 1, 1997, PAC and SBC completed the merger of an
SBC subsidiary with PAC, in a transaction in which each outstanding share of
PAC common stock was exchanged for 0.73145 of a share of SBC common stock
(equivalent to approximately 313 million shares). With the merger, PAC became
a wholly-owned subsidiary of SBC. The transaction was accounted for by SBC as
a pooling of interests and a tax-free reorganization. PAC exchanged the
outstanding common stock at the date of merger with SBC stock, issued 1,000
shares of $1 par stock and retired the treasury stock.
Conforming Accounting Changes
PAC's results include merger transaction costs and the effects of changes to
conform accounting methodologies between PAC and SBC for, among other items,
pensions, postretirement benefits and merger transaction costs. The
accounting changes resulted in a net benefit recorded by PAC in the second
quarter of 1997, retroactive to January 1, 1997 as a cumulative effect of
accounting changes of $322, net of deferred taxes of $221, and increased
income before cumulative effect of accounting changes for the first nine
months of 1997 by $33. Had these changes been adopted January 1, 1996, they
would have increased income before cumulative effect of accounting changes by
$51, net of taxes of $35 for the nine months ended September 30, 1996. The
changes in accounting for pension and postretirement benefits were to adopt
SBC's methodology of amortizing gains and losses on assets held within those
benefit plans. The change in accounting for merger transaction costs was to
conform to SBC's policy of recognizing these costs as incurred rather than
deferring until the pooling of interests is effective. Also, PAC recorded in
the second quarter of 1997 the present value of amounts to be returned to
California and Nevada ratepayers as a condition of the merger of $281 ($176
net of tax).
<PAGE>
PACIFIC TELESIS GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)- Continued
Dollars in millions
Post-merger initiatives
During the second quarter 1997, PAC recorded after-tax charges of $1.4
billion related to SBC's June 19, 1997 announcement of several strategic
decisions resulting from the merger integration process that began with the
April 1 closing of its merger with PAC, which included $108 ($65 after tax)
of charges related to recent regulatory rulings and $281 ($176 after tax) for
the present value of amounts to be returned to California and Nevada
ratepayers as a condition of the merger. The decisions resulted from an
extensive review of operations throughout the merged company and include
significant integration of operations and consolidation of some
administrative and support functions.
Following is a discussion of the most significant of these charges.
Reorganization SBC will centralize several key functions that will support
the operations of PacBell and two other SBC subsidiaries, Nevada Bell and
Southwestern Bell Telephone Company (SWBell), including network planning,
strategic marketing and procurement. It is also consolidating a number of
corporate-wide support activities, including research and development,
information technology, financial transaction processing and real estate
management. PacBell, Nevada Bell and SWBell will continue as separate legal
entities. These initiatives will result in the creation of some jobs and the
elimination and realignment of others, with many of the affected employees
changing job responsibilities and in some cases assuming positions in other
locations.
PAC recognized a charge of approximately $238 ($149 net of tax) during the
second quarter of 1997 in connection with these initiatives. This charge was
comprised mainly of post-employment benefits, primarily related to severance,
and costs associated with closing down duplicate operations, primarily
contract cancellations. Other charges arising out of the merger related to
relocation, retraining and other effects of consolidating certain operations
are being recognized in the periods those charges are incurred.
Impairments/asset valuation As a result of SBC's merger integration plans,
strategic review of domestic operations and organizational alignments, PAC
reviewed the carrying values of related long-lived assets. This review
included estimating remaining useful lives and cash flows and identifying
assets to be abandoned. Where this review indicated impairment, discounted
cash flows related to those assets were analyzed to determine the amount of
the impairment. As a result of these reviews, PAC wrote off some assets and
recognized impairments to the value of other assets with a combined charge of
$842 ($591 after tax) recorded in the second quarter of 1997. These
impairments and writeoffs related to the wireless digital TV operations in
southern California, certain analog switching equipment in California,
certain rural and other telecommunications equipment in Nevada, selected
wireless equipment, duplicate or obsolete equipment, cable within commercial
buildings in California, certain nonoperating plant and other assets.
Video curtailment/purchase commitments SBC also announced it is scaling back
its limited direct investment in video services. As part of this curtailment,
PAC has halted construction on the Advanced Communications Network (ACN) in
California. As part of an agreement with the ACN vendor, PAC will pay the
liabilities of the ACN trust that owns and finances ACN construction, incur
costs to shut down all construction previously conducted under the trust and
receive certain consideration from the vendor. In the second quarter, PAC
recognized its net expense of $553 ($346 after tax) associated with these
activities. During the third quarter of 1997, PAC recorded the corresponding
short-term debt of $610 previously incurred by the ACN trust on its balance
sheet.
Additionally, PAC will curtail several other video-related activities
including substantially scaling back its involvement in the Tele-TV joint
venture and evaluating its option to invest in cable television operations in
Chicago. The collective impact of these decisions resulted in a charge of $89
($56 after tax) in the second quarter of 1997.
4. CUMULATIVE EFFECT OF CHANGE IN DIRECTORY ACCOUNTING Prior to January 1, 1996,
Pacific Bell Directory (a subsidiary of PacBell and an indirect subsidiary of
PAC) recognized revenues and expenses related to publishing directories in
California using the "amortization" 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 are recognized when the
directories are issued. The change to the issue basis method was made because
it is the method generally followed in the publishing industry and better
reflects the operating activity of the business.
The change was adopted during fourth quarter 1996. The cumulative after-tax
effect of applying the change in method to prior years was recognized as of
January 1, 1996 as a one-time, non-cash gain applicable to continuing
operations of $85. The gain is net of deferred taxes of $58. The first three
quarters of 1996 were restated in the Form 10-K to reflect the new method.
5. COMMITMENTS AND CONTINGENCIES
Purchase Commitments As of September 30, 1997, PacBell had purchase
commitments of about $220 remaining in connection with its previously
announced program for deploying an all digital switching platform with ISDN
and SS-7 capabilities.
Property Tax Investigation In 1992, a settlement agreement was reached among
the State Board of Equalization, all California counties, the State Attorney
General, and 28 utilities, including PacBell, on a specific methodology for
valuing utility property for property tax purposes for a period of eight
years. The California Public Utilities Commission (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 of
annual property tax savings should be treated as an exogenous cost reduction
in PacBell's annual price cap filings. These intervenors have also asserted
that past property tax savings totaling as much as approximately $85 as of
September 30, 1997, 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 and 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 in a separate proceeding of the criteria for exogenous
cost treatment under its regulatory framework. To date the CPUC has taken no
further action on this issue.
<PAGE>
PACIFIC TELESIS GROUP
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Dollars in millions
RESULTS OF OPERATIONS
Overview Financial results for Pacific Telesis Group (PAC) for the first nine
months of 1997 and 1996 are summarized as follows:
- ------------------------------------------------------------------------
Nine-Month Period
- ------------------------------------------------------------------------
Percent
1997 1996 Change
- ------------------------------------------------------------------------
Operating revenues $ 7,463 $ 7,139 4.5%
Operating expenses $ 7,789 $ 5,377 44.9
Income (loss) before cumulative
effect of accounting changes $ (545) $ 866 -
Cumulative effect of accounting
change $ 322 $ 85 -
Net income (loss) $ (223) $ 951 -
========================================================================
Net loss for the nine months ended September 30, 1997 includes a cumulative net
benefit of $322 resulting from accounting changes related to conforming
accounting between PAC and SBC Communications Inc. (SBC) for, among other items,
pensions and postretirement benefits. The first nine months of 1996 included a
cumulative effect of a change in accounting for directory publishing revenues
and expenses.
PAC's nine-month loss before cumulative effect of accounting changes of $545
includes after-tax charges of approximately $1.4 billion reflecting strategic
initiatives resulting from SBC's comprehensive review of operations of the
merged company, the impact of several regulatory rulings during the second
quarter of 1997, costs incurred for customer number portability since the merger
and charges for ongoing merger integration costs, primarily related to movement
of employees. Excluding these items, PAC reported income before cumulative
effect of accounting changes of $865 approximately equal to the first nine
months of 1996 income before cumulative effect of accounting changes of $866.
PAC currently anticipates incurring additional after-tax charges for ongoing
merger integration costs, primarily related to movement of employees, and
customer number portability of $120 to $170 during the remainder of 1997.
Excluding these charges, the primary factors affecting income before cumulative
effect of accounting changes during the first nine months of 1997 were growth in
demand for services and products at Pacific Bell (PacBell, which also includes
its subsidiaries) and a first quarter 1997 $90 after-tax settlement gain
associated with lump-sum pension payments that exceeded the projected service
and interest costs for 1996 retirements. These increases were offset by rate
reductions from price cap filings and increased expenses at PacBell including
expenses for the introduction of Personal Communications Services (PCS)
operations in California and Nevada.
<PAGE>
PACIFIC TELESIS GROUP
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Dollars in millions
RESULTS OF OPERATIONS-Continued
Revenues PAC's operating revenues for the first nine months of 1997 reflect
reductions of $121 related primarily to the impact of several regulatory rulings
during the second quarter of 1997. Excluding these items, PAC's operating
revenues increased $445, or 6.2%. Components of operating revenues for the first
nine months of 1997 and 1996 are as follows:
- ------------------------------------------------------------------------
Nine-Month Period
- ------------------------------------------------------------------------
Percent
1997 1996 Change
- ------------------------------------------------------------------------
Local service $ 3,316 $ 3,021 9.8%
Network access
Interstate 1,299 1,381 -5.9
Intrastate 600 543 10.5
Long-distance service 912 969 -5.9
Directory advertising 867 795 9.1
Other 469 430 9.1
- --------------------------------------------------------------
Total $ 7,463 $ 7,139 4.5%
========================================================================
Local service revenues increased for the first nine months of 1997 due
primarily to increases in demand, including increases in access lines and
vertical services revenues. The number of access lines increased by 3.6%
since September 30, 1996, with approximately 46% of access line growth due
to the sales of additional access lines to existing residential customers.
Vertical services revenues, which include custom calling options, Caller
ID and other enhanced services, increased by approximately 14%. Local
service revenues also reflect the implementation of the California High
Cost Fund (CHCFB) that went into effect February 1, 1997. The California
Public Utilities Commission (CPUC) has stated that the CHCFB is intended
to directly subsidize the provision of service to high cost areas and
allow PacBell to set competitive rates for other services. The rebalancing
provisions of the CHCFB resulted in a shift of equivalent revenues from
intraLATA long-distance and intrastate network access revenues to local
service revenues in the first nine months of 1997. This shift is subject
to final CPUC approval, expected in the second quarter of 1998. For
further information on the operations of the CHCFB, see the discussion
under the heading "State Regulation" on page 10 of PAC's Annual Report
Form 10-K dated December 31, 1996 and the discussion under the heading
"Regulatory Environment-California" on page 10 of SBC's Current Report on
Form 8-K dated May 8, 1997. Additionally, Federal payphone deregulation
increased local service and decreased other operating revenues and, to a
lesser extent, long-distance service and interstate network access; the
overall impact was a slight increase in total operating revenues. Rate
reductions due to CPUC price cap orders partially offset increases in
local service revenues. Wireless revenues also contributed to the increase
in local service revenues due to product introduction of PCS in the first
nine months of 1997.
Network Access Interstate network access revenues decreased $134 in the
first nine months of 1997 due to one-time charges. These one-time charges
include billing claim settlements related to the Percentage Interstate
Usage (PIU) factor in California and several Federal regulatory issues
including end-user charges, 800 data base charges, recovery of certain
employee-related expenses and the retroactive effect of the productivity
factor adjustment mandated in the July 1, 1997 Federal price cap filing.
While the change in PIU factor in California, which is used to allocate
network access revenues between interstate and intrastate jurisdictions,
also had the effect of increasing intrastate network access revenues, it
resulted in a slight decline in total network access revenues. Without
these impacts, interstate access revenues increased in the first nine
months of 1997 due to demand for access services by interexchange carriers
and growth in revenues from end-user charges attributable to an increasing
access line base. Partially offsetting these increases were the effects of
PacBell's rate reduction related to the productivity factor adjustment and
revenue sharing adjustments made in 1996.
Intrastate network access revenues increased in the first nine months of
1997 due primarily to the PIU settlements described above. Excluding this
impact, intrastate network access revenues increased slightly in the first
nine months of 1997 as increases in demand, including usage by alternative
intraLATA toll carriers were partially offset by the effects of the CHCFB
discussed above in Local Service.
Long-Distance Service revenues decreased for the first nine months of 1997
primarily due to the effects of the CHCFB discussed above and rate
reductions due to CPUC price cap orders partially offset by increases in
demand resulting from California's growing economy.
Directory advertising revenues increased for the first nine months of 1997
due mainly to the publication of books not published in 1996 and, to a
lesser extent, increased demand.
Other operating revenues increased for the first nine months of 1997 due
primarily to increased equipment sales at Pacific Bell Mobile Services and
increased demand for PacBell's nonregulated products and services.
Revenues from new business initiatives, primarily voice messaging services
and Internet services, also contributed to the increase. Results also
reflect the impact of payphone deregulation as described in Local Service.
Expenses PAC's operating expenses for the first nine months of 1997 reflect
approximately $2 billion of charges related to strategic initiatives from a
comprehensive review of operations of the merged company, the impact of several
regulatory rulings during the second quarter of 1997 (see Note 3 to the
financial statements), costs incurred for customer number portability since the
merger and charges for ongoing merger integration costs. Excluding these
charges, operating expenses increased $434 or 8.1% over the first nine months of
1996. Components of operating expenses for the first nine months of 1997 and
1996 are as follows:
- ------------------------------------------------------------------------
Nine-Month Period
------------------------------
Percent
1997 1996 Change
- -----------------------------------------------------------------------
Cost of services and products $ 3,080 $ 2,637 16.8%
Selling, general and administrative 2,747 1,341 104.8
Depreciation and amortization 1,962 1,399 40.2
- ----------------------------------------- ---------------------
Total $ 7,789 $ 5,377 44.9%
=======================================================================
Cost of services and products for the first nine months of 1997 reflects
charges of $56 relating to SBC's strategic initiatives, operational
reviews, costs incurred for customer number portability since the merger
and ongoing merger integration costs. Excluding these charges, cost of
services and products increased $387, or 14.7%, in the first nine months
of 1997. These cost increases were significantly impacted by the
introduction of PCS operations during 1997. Additional increases were due
primarily to increases in employee compensation including increases
related to force additions and increases in contract labor. These costs
were partially offset by the conforming of accounting methodologies and
assumptions for pensions and postretirement benefits. During the third
quarter of 1997, pension settlement gains previously reported as cost of
services and products were reclassified to selling, general and
administrative expense; prior quarters of 1997 were restated to reflect
this reclassification.
Selling, general and administrative expense for the first nine months of
1997 reflects $1,406 of charges relating to SBC's strategic initiatives,
operational reviews and ongoing merger integration costs. As discussed in
Note 3 to the financial statements, the most significant of these charges
included shutdown of the Advanced Communications Network, regulatory costs
related to the approval of the merger with SBC by California and Nevada
regulators, reorganization initiatives and write-offs related to wireless
digital TV. Excluding these one-time charges, selling, general and
administrative expense remained unchanged in the first nine months of
1997. This was due to significant increases associated with the
introduction of PCS operations, increases in employee compensation and
contract labor which were offset by a first quarter 1997 $152 settlement
gain associated with lump-sum pension payments that exceeded the projected
service and interest costs for 1996 retirements and reduced expenses
resulting from conforming of accounting methodologies and assumptions for
pensions and postretirement benefits.
Depreciation and amortization for the first nine months of 1997 reflects
charges totaling $516 to record impairment of plant and intangibles. As
discussed in Note 3 to the financial statements, the most significant of
these impairments related to the wireless digital TV operations in
southern California, certain analog switching equipment in California,
certain rural and other telecommunications equipment in Nevada and cable
within commercial buildings in California. Excluding these charges,
depreciation and amortization increased $47, or 3.4% in the first nine
months of 1997. These increases were primarily due to overall higher plant
levels partially offset by reduced deprecation beginning with the second
quarter on analog switching equipment in California.
Interest Expense increased $70 or 26.4% for the first nine months of 1997 due to
interest of $27 associated with second quarter one-time charges and increased
debt levels compared to the first nine months of 1996. These increases were
somewhat offset by capitalized interest related to PCS construction.
Other Income (Expense) - net was a net expense of $73 for the first nine months
of 1997. The increased expenses include $30 in expenses related to SBC's
strategic initiatives, primarily writeoffs of nonoperating plant. Other
increases relate primarily to distributions paid on an additional $500 of Trust
Originated Preferred Securities sold by PAC in June 1996 and recognition of
investment returns on funds held in trust for deferred compensation.
Income taxes for the first nine months of 1997 reflect the tax effect of charges
for strategic initiatives resulting from SBC's comprehensive review of
operations of the merged company and the impact of several regulatory rulings
during the second quarter of 1997. The effective tax rate on these items was
lower as a result of non-deductible items included in the charges and valuation
adjustments to certain deferred tax assets.
Income taxes paid, net of refunds reflect the impact of reduced tax payments due
to merger-related and integration costs incurred and the application of the SBC
tax sharing agreement.
Cumulative Effect of Accounting Changes, as discussed in Note 3 to the financial
statements, include merger transaction costs and the effect of changes applied
retroactively to conform accounting methodologies between PAC and SBC effective
January 1, 1997. The cumulative after-tax effect of these one-time changes is
$322.
<PAGE>
PACIFIC TELESIS GROUP
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Dollars in millions
OPERATING ENVIRONMENT AND TRENDS OF THE BUSINESS
COMPETITIVE AND REGULATORY ENVIRONMENT
State Interconnection Agreements/ Reselling Developments PAC continues to enter
into interconnection agreements with companies desiring to provide local service
in its operating territory. Approximately 50 interconnection agreements have
been reached, and most have been approved by the relevant state commission. AT&T
Corp. and other competitors are reselling PAC local exchange services, and as of
September 30, 1997 there were more than 180,000 access lines supporting services
resold by competitors.
Federal Interconnection In September 1997, 28 state commissions, the National
Association of Regulatory Utilities Commissioners and the D.C. Public Service
Commission, along with many companies who have Local Exchange Carriers (LECs)
including SBC filed petitions to enforce the July 18, 1997 ruling of the U.S.
Court of Appeals for the Eighth Circuit in St. Louis (8th Circuit) that the
right to set local exchange prices, including the pricing methodology used, is
reserved exclusively to the states. The petitions respond to Federal
Communications Commission's (FCC) rejection of the Ameritech Corporation's
interLATA long-distance application in Michigan in which the FCC stated it is
applying its own pricing standards to interLATA applications. The petitioners
assert the FCC is violating state authority. On October 14, 1997, the 8th
Circuit granted the LECs' petition for rehearing and ruled that they do not have
to deliver network elements to competitors in anything other than completely
unbundled form.
Payphone Deregulation/Market Price Adjustments Final price deregulation of the
payphone industry took effect October 7, 1997. PAC raised payphone prices
throughout its operating territories, beginning in October 1997. The new prices
are the result of federal telecommunications deregulation, which prohibits
subsidy of payphone service directly or indirectly from its telephone service
operations and allows payphone providers to determine their own pricing.
Portions of the Telecommunications Act of 1996 Challenged In July 1997, SBC
brought suit against the FCC in the U.S. District Court for the Northern
District of Texas, seeking a declaration that a portion of the Telecom Act is
unconstitutional on the grounds that it improperly discriminates against SBC by
imposing restrictions that prohibit SBC from offering interLATA long-distance
and other services that other LECs are free to provide. The suit challenges only
that portion of the Telecom Act that excludes SBC from competing in certain
lines of business. SBC is currently awaiting a decision by the court on its
motion for summary judgement.
California Universal Service Rebalancing Hearings related to the PacBell March
1997 filing to permanently reduce certain toll and access rates and eliminate
universal service surcredits to ratepayers for rebalancing of the CHCFB were
held in October 1997 with a decision expected in the second quarter of 1998.
<PAGE>
PACIFIC TELESIS GROUP
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Dollars in millions
OTHER BUSINESS MATTERS
Restructuring Reserve PAC established a restructuring reserve at the end of 1993
to provide for the incremental cost of force reductions associated with
restructuring business processes through 1997. A total of $62 in cash outlays
was charged to the reserve in the first nine months of 1997. As of September 30,
1997, $32 remained in the restructuring reserve.
Local Number Portability/Interconnection Over the next few years, PAC is
expecting to incur significant capital and software expenditures for customer
number portability and interconnection. PAC expects capital costs and expenses
associated with customer number portability, which allows customers to switch to
local competitors and keep the same phone number to total up to $600 on a
pre-tax basis over the next four years. Full recovery of customer number
portability costs is required under the Telecom Act; however, the FCC has not
yet determined when or how those significant costs will be recovered. PacBell
has filed a tariff with the FCC for recovery of these costs. No action has been
taken by the FCC on this tariff, pending the issuance of its order on customer
number portability recovery. PacBell is unable to predict the likelihood of the
FCC permitting the tariff to become effective. Capital costs and expenses
associated with interconnection will vary based on the number of competitors
seeking interconnection and customers served and markets entered by those
competitors. Accordingly, PAC is currently unable to reasonably estimate these
costs.
Video Purchase Option During the third quarter of 1997, SBC reached agreement to
sell its cable television properties in Montgomery County, Maryland and
Arlington, Virginia, as well as PAC's Chicago purchase option.
CPUC Ruling A complaint filed with the CPUC challenged PacBell's practice of
charging to reconnect wires between the utility terminal board and the customer
utility board in apartment buildings, claiming that the wiring between these two
points were part of PacBell's facilities. On November 5, 1997, the CPUC ordered
PacBell to retroactively refund these charges dating from 1993. PacBell believes
it has several meritorious defenses and plans to file for rehearing and
reconsideration with the CPUC, and if appropriate, file for judicial review.
Management is evaluating the order and while it is currently unable to estimate
the specific amount of any refund that may be required, it does not believe the
amount would be material.
<PAGE>
PACIFIC TELESIS GROUP
PART II - OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit 12 Computation of Ratios of Earnings to Fixed Charges.
Exhibit 27 Financial Data Schedule.
(b) Reports on Form 8-K
There were no reports on Form 8-K filed during the third quarter ended
September 30, 1997.
.
<PAGE>
SIGNATURES
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
November 12, 1997 /s/ Donald E. Kiernan
Donald E. Kiernan
Executive Vice President,
Chief Financial Officer and Treasurer
<TABLE>
EXHIBIT 12
PACIFIC TELESIS GROUP
COMPUTATION OF RATIOS OF EARNINGS TO FIXED CHARGES
Dollars in Millions
NINE MONTHS ENDED
SEPTEMBER 30, YEAR ENDED DECEMBER 31,
<CAPTION>
--------------------- -----------------------------------------------------
1997 1996 1996 1995 1994 1993 1992
--------- --------- ------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Income (Loss) From Continuing Operations Before
Income Taxes, Extraordinary Loss and
Cumulative Effect of Accounting Changes $ (734) $ 1,459 $ 1,798 $ 1,611 $ 1,793 $ 201 $ 1,782
Add: Interest Expense 335 265 455 442 455 509 506
Dividends on Preferred Securities 60 40 60 - - - -
1/3 Rental Expense 57 40 51 31 43 40 44
--------- -------- --------- --------- -------- -------- ----------
Adjusted Earnings $ (282) $ 1,804 $ 2,364 $ 2,084 $ 2,291 $ 750 $ 2,332
========= ======== ========= ========= ======== ======== ==========
Total Interest Charges $ 406 $ 341 $ 455 $ 442 $ 455 $ 509 $ 510
Dividends on Preferred Securities 60 40 60 - - - -
1/3 Rental Expense 57 40 51 31 43 40 44
--------- -------- --------- --------- -------- -------- ----------
Adjusted Fixed Charges $ 523 $ 421 $ 566 $ 473 $ 498 $ 549 $ 554
========= ======== ========= ========= ======== ======== =========
Ratio of Earnings to Fixed Charges (0.54) 4.29 4.18 4.41 4.60 1.37 4.21
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM PACIFIC
TELESIS QUARTERLY REPORT ON FORM 10-Q AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> SEP-30-1997
<PERIOD-TYPE> 9-MOS
<CASH> 58,000
<SECURITIES> 0
<RECEIVABLES> 2,328,000
<ALLOWANCES> 244,000
<INVENTORY> 0 <F1>
<CURRENT-ASSETS> 3,138,000
<PP&E> 30,011,000
<DEPRECIATION> 17,857,000
<TOTAL-ASSETS> 17,182,000
<CURRENT-LIABILITIES> 5,430,000
<BONDS> 5,403,000
<COMMON> 0
0
0
<OTHER-SE> 2,072,000
<TOTAL-LIABILITY-AND-EQUITY> 17,182,000
<SALES> 0 <F2>
<TOTAL-REVENUES> 7,463,000
<CGS> 0 <F3>
<TOTAL-COSTS> 3,080,000
<OTHER-EXPENSES> 1,962,000
<LOSS-PROVISION> 204,000
<INTEREST-EXPENSE> 335,000
<INCOME-PRETAX> (734,000)
<INCOME-TAX> (189,000)
<INCOME-CONTINUING> (545,000)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 322,000
<NET-INCOME> (223,000)
<EPS-PRIMARY> 0
<EPS-DILUTED> 0
<FN>
<F1> THIS AMOUNT IS IMMATERIAL.
<F2> NET SALES OF TANGIBLE PRODUCTS IS NOT MORE THAN 10% OF TOTAL OPERATING
REVENUES AND THEREFORE HAS NOT BEEN STATED SEPARATELY IN THE FINANCIAL
STATEMENTS PURSUANT TO REGULATION S-X, RULE 5-03(B). THIS AMOUNT
IS INCLUDED IN THE "TOTAL REVENUES' TAG.
<F3> COST OF TANGIBLE GOODS SOLD IS INCLUDED IN COST OF SERVICES AND PRODUCTS IN
THE FINANCIAL STATEMENTS AND THE "TOTAL COST" TAG, PURSUANT TO REGULATION 2-X,
RULE 5-03(B).
</FN>
</TABLE>
