<PAGE>
FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
(X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1995
OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number 1-1414
PACIFIC BELL
I.R.S. Employer No. 94-0745535
A California Corporation
140 New Montgomery Street, San Francisco, California 94105
Telephone - Area Code (415) 542-9000
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days. Yes X No .
--- ---
At October 31, 1995, 224,504,982 common shares were outstanding.
THE REGISTRANT, A WHOLLY OWNED SUBSIDIARY OF PACIFIC TELESIS GROUP, 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).
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PACIFIC BELL AND SUBSIDIARIES
TABLE OF CONTENTS
Page
PART I. FINANCIAL INFORMATION Number
- ------------------------------ ------
Item 1. Financial Statements
Review Report of Independent Accountants .............. 1
Condensed Consolidated Statements of Income ........... 2
Condensed Consolidated Balance Sheets ................. 3
Condensed Consolidated Statements of Shareowner's
Equity.............................................. 4
Condensed Consolidated Statements of Cash Flows ....... 5
Notes to Condensed Consolidated Financial Statements .. 7
Item 2. Management's Discussion and Analysis of Results of
Operations ............................................ 12
PART II. OTHER INFORMATION
- ---------------------------
Item 6. Exhibits and Reports on Form 8-K ........................ 29
SIGNATURE ........................................................ 30
<PAGE>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
REVIEW REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareowners of Pacific Bell:
We have reviewed the accompanying condensed consolidated balance sheet of
Pacific Bell and Subsidiaries as of September 30, 1995, and the related
condensed consolidated statements of income for the three- and nine-month
periods ended September 30, 1995 and 1994, and the condensed consolidated
statements of shareowner's equity and cash flows for the nine-month periods
ended September 30, 1995 and 1994. These financial statements are the
responsibility of the Company's management.
We conducted our review in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures
to financial data, and making inquiries of persons responsible for financial
and accounting matters. It is substantially less in scope than an audit
conducted in accordance with generally accepted auditing standards, the
objective of which is the expression of an opinion regarding the financial
statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that
should be made to the accompanying condensed consolidated financial statements
for them to be in conformity with generally accepted accounting principles.
As discussed in Note B on page 8, the Company discontinued application of
Statement of Financial Accounting Standards No. 71 effective third quarter
1995.
We have previously audited, in accordance with generally accepted auditing
standards, the consolidated balance sheet of Pacific Bell and Subsidiaries as
of December 31, 1994, and the related consolidated statements of income,
shareowner's equity, and cash flows for the year then ended (not presented
herein); and in our report dated February 23, 1995, we expressed an
unqualified opinion on those consolidated financial statements. In our
opinion, the information set forth in the accompanying condensed consolidated
balance sheet as of December 31, 1994, is fairly stated, in all material
respects, in relation to the consolidated balance sheet from which it has been
derived.
/s/Coopers & Lybrand L.L.P.
San Francisco, California
November 13, 1995
1
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PACIFIC BELL AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
For the 3 Months Ended For the 9 Months Ended
September 30, September 30,
---------------------- ----------------------
(Dollars in millions) 1995 1994 1995 1994
- ----------------------------------------------------------------------------
OPERATING REVENUES
Local service.................... $ 944 $ 858 $2,803 $2,525
Network access:
Interstate..................... 413 387 1,257 1,171
Intrastate..................... 179 191 522 532
Toll service..................... 306 491 910 1,485
Other service revenues........... 386 358 1,134 1,028
------- ------ ------- ------
TOTAL OPERATING REVENUES......... 2,228 2,285 6,626 6,741
------- ------ ------- ------
OPERATING EXPENSES
Cost of products and services 399 468 1,323 1,415
Customer operations and
selling expenses............... 476 452 1,351 1,335
General, administrative, and
other expenses................. 340 296 959 908
Property and miscellaneous taxes. 45 45 141 135
Depreciation and amortization.... 461 444 1,381 1,312
------- ------ ------- ------
TOTAL OPERATING EXPENSES......... 1,721 1,705 5,155 5,105
------- ------ ------- ------
OPERATING INCOME................. 507 580 1,471 1,636
Interest expense................. 110 103 327 324
Miscellaneous income............. 17 2 45 1
------- ------ ------- ------
INCOME BEFORE INCOME TAXES
AND EXTRAORDINARY ITEM 414 479 1,189 1,313
Income taxes..................... 156 187 442 489
------- ------ ------- ------
INCOME BEFORE
EXTRAORDINARY ITEM.............. 258 292 747 824
Extraordinary item, net of tax
(Note B)....................... (3,360) - (3,360) -
------- ------ ------- ------
NET INCOME (LOSS)................
$(3,102) $ 292 $(2,613) $ 824
======== ====== ======== ======
The accompanying Notes are an integral part of the Condensed Consolidated
Financial Statements.
2
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PACIFIC BELL AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
September 30, December 31,
(Dollars in millions) 1995 1994
- ---------------------------------------------------------------------------
ASSETS: (Unaudited)
Cash and cash equivalents................... $ 66 $ 62
Accounts receivable -(net of allowances for
uncollectibles of $135 and $143 in 1995 and
1994, respectively)....................... 1,486 1,531
Prepaid expenses and other current assets... 891 950
------- -------
Total current assets........................ 2,443 2,543
------- -------
Property, plant, and equipment - at cost.... 26,389 26,107
Less: accumulated depreciation........... 15,563 10,243
------- -------
Property, plant, and equipment - net........ 10,826 15,864
------- -------
Deferred charges and other noncurrent assets 123 963
------- -------
TOTAL ASSETS................................ $13,392 $19,370
======= =======
LIABILITIES AND SHAREOWNER'S EQUITY:
Accounts payable............................ $ 1,212 $ 1,580
Debt maturing within one year............... 375 255
Other current liabilities................... 1,374 1,366
------- -------
Total current liabilities................... 2,961 3,201
------- -------
Long-term obligations....................... 5,103 4,752
------- -------
Deferred income taxes....................... 6 2,315
------- -------
Other noncurrent liabilities and
deferred credits.......................... 2,414 2,878
------- -------
Commitments and contingencies (Note C)......
Total shareowners' equity................... 2,908 6,224
------- -------
TOTAL LIABILITIES AND SHAREOWNER'S EQUITY... $13,392 $19,370
======= =======
The accompanying Notes are an integral part of the Condensed Consolidated
Financial Statements.
3
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PACIFIC BELL AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF SHAREOWNER'S EQUITY
(Unaudited)
For the 9 Months Ended
September 30,
---------------------
(Dollars in millions) 1995 1994
- ---------------------------------------------------------------------------
COMMON STOCK
Balance at beginning of period...................... $ 225 $ 225
------ ------
Balance at end of period............................ 225 225
------ ------
ADDITIONAL PAID-IN CAPITAL
Balance at beginning of period...................... 5,169 5,168
Other Changes ...................................... 58 1
------ ------
Balance at end of period............................ 5,227 5,169
------ ------
REINVESTED EARNINGS
Balance at beginning of period...................... 830 761
Net income (loss)................................... (2,613) 824
Dividends declared.................................. (763) (747)
Other changes....................................... 2 (4)
------ ------
Balance at end of period............................ (2,544) 834
------ ------
TOTAL SHAREOWNER'S EQUITY ............................ $2,908 $6,228
====== ======
The accompanying Notes are an integral part of the Condensed Consolidated
Financial Statements.
4
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PACIFIC BELL AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
For the 9 Months Ended
September 30,
----------------------
(Dollars in millions) 1995 1994
- ---------------------------------------------------------------------------
CASH FROM (USED FOR) OPERATING ACTIVITIES:
Net income (loss)..................................... $(2,613) $ 824
Adjustments to net income (loss):
Extraordinary item (Note B) .......................... 3,360 -
Depreciation and amortization....................... 1,381 1,312
Deferred income taxes............................... 53 (23)
Unamortized investment tax credits ................. (37) (49)
Allowance for funds used during construction ....... (36) (22)
Changes in operating assets and liabilities:
Accounts receivable............................... 49 (4)
Prepaid expenses and other current assets......... (22) 16
Deferred charges and other noncurrent assets...... 135 (16)
Accounts payable and accrued liabilities.......... (115) (18)
Other current liabilities......................... 24 68
Noncurrent liabilities and deferred credits....... (343) 26
Other adjustments, net.............................. 44 6
------ ------
Cash from operating activities........................ 1,880 2,120
CASH FROM (USED FOR) INVESTING ACTIVITIES:
Additions to property, plant, and equipment........... (1,285) (1,041)
Other investing activities, net....................... (1) (11)
------ ------
Cash used for investing activities.................... (1,286) (1,052)
------ ------
CASH FROM (USED FOR) FINANCING ACTIVITIES:
Equity infusion from parent .......................... 57 -
Dividends paid........................................ (763) (747)
Increase (decrease) in short-term borrowings, net..... 120 (331)
Principal payments under capital lease obligations.... (4) (3)
Other financing activities, net ...................... - 1
------ ------
Cash used for financing activities.................... (590) (1,080)
------ ------
Increase (decrease) in cash and cash equivalents ..... 4 (12)
Cash and cash equivalents at January 1................ 62 57
------ ------
Cash and cash equivalents at September 30............. $ 66 $ 45
====== ======
(Continued on next page)
5
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PACIFIC BELL AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
For the 9 Months Ended
September 30,
----------------------
(Dollars in millions) 1995 1994
- ---------------------------------------------------------------------------
Cash payments for:
Interest............................................ $ 317 $ 315
Income taxes........................................ $ 396 $ 540
- ----------------------------------------------------------------------------
The accompanying Notes are an integral part of the Condensed Consolidated
Financial Statements.
6
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PACIFIC BELL AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
A. BASIS OF PRESENTATION
The Condensed Consolidated Financial Statements include the accounts of
Pacific Bell, and its wholly owned subsidiaries, Pacific Bell Directory
("Directory") Pacific Bell Information Services ("PBIS"), Pacific Bell
Mobile Services ("PBMS"), and Pacific Bell Internet Services, hereinafter
referred to as the "Company." All significant intercompany balances and
transactions have been eliminated. The Condensed Consolidated Income
Statement and Statement of Cash Flows for 1994 reflect certain
reclassifications made to conform with the current presentation.
The Condensed Consolidated Financial Statements have been prepared in
accordance with the rules and regulations of the Securities and Exchange
Commission ("SEC") applicable to interim financial information. Certain
information and footnote disclosures included in financial statements
prepared in accordance with generally accepted accounting principles have
been condensed or omitted in these interim statements pursuant to such SEC
rules and regulations. Management recommends that these interim financial
statements be read in conjunction with the Company's 1994 annual report on
Form 10-K that includes the audited 1994 financial statements. Effective
third quarter 1995, the Company discontinued accounting under Statement of
Financial Accounting Standards No. 71 ("SFAS 71"), "Accounting for the
Effects of Certain Types of Regulation." (See Note B - "Discontinuance of
Regulatory Accounting - SFAS 71" on page 8.)
In management's opinion, the Condensed Consolidated Financial Statements
include all adjustments (consisting of only normal recurring adjustments,
except for the extraordinary charge of $3.4 billion associated with the
discontinuance of SFAS 71 as stated in Note B on page 8) necessary to
present fairly the financial position and results of operations for each
interim period shown. The Condensed Consolidated Financial Statements have
been reviewed by Coopers & Lybrand L.L.P., independent accountants. Their
report is on page 1.
7
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PACIFIC BELL AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
B. DISCONTINUANCE OF REGULATORY ACCOUNTING - SFAS 71
Effective third quarter 1995, the Company discontinued its application of
SFAS 71 in accordance with the provisions of Statement of Financial
Accounting Standards ("SFAS") No. 101, "Accounting for the Discontinuance
of Application of FASB Statement No. 71." As a result, the Company
recorded a non-cash, extraordinary charge of $3.4 billion, during third
quarter which is net of a deferred income tax benefit of $2.4 billion. The
charge includes a write-down of net telephone plant and the elimination of
net regulatory assets as summarized in the following table.
($ millions) Pre-tax After-tax
----------------------------------------------------------------------
Increase in telephone plant and equipment
accumulated depreciation $4,819 $2,714
Elimination of net regulatory assets 962 646
------ ------
Total $5,781 $3,360
=========================================================================
The Company has historically accounted for the economic effects of
regulation in accordance with the provisions of SFAS 71. Under SFAS 71, the
Company has depreciated telephone plant using lives prescribed by
regulators and, as a result of actions of regulators, has deferred
recognizing certain costs or has recognized certain liabilities (referred
to as "regulatory assets" and "regulatory liabilities").
Effective third quarter 1995, management determined that, for external
financial reporting purposes, it is no longer appropriate for the Company
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. Prices
for the Company's products and services are being driven increasingly by
market forces instead of regulation.
The $4.8 billion increase in accumulated depreciation for the Company's
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. The Company's previous and new
asset lives are compared in the following table.
8
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PACIFIC BELL AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
ASSET LIVES (in years) Old New
-------------------------------------------------------------------------
Copper ........................................ 19 - 26 14
Digital Switches .............................. 16.5 10
Digital Circuits .............................. 9.6 - 11.5 8
Fiber ......................................... 28 - 30 20
Conduit ....................................... 59 50
=========================================================================
The discontinuance of SFAS 71 for external financial reporting purposes
also required the elimination of the Company's net regulatory assets, which
totaled $962 million. Regulators sometimes include costs in allowable
costs for ratemaking purposes in a period other than the period in which
those costs would be charged to expense under general accounting rules. The
accounting for these timing differences created regulatory assets and
regulatory liabilities on the balance sheet. Details of the net regulatory
assets which have been eliminated are displayed in the following table.
($ 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 "deferred charges and other
noncurrent assets" in the Company's balance sheets.
** Previously included in "long-term obligations."
*** Previously included in "other current liabilities" and "other
noncurrent liabilities and deferred credits."
9
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PACIFIC BELL AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The $460 million regulatory asset for deferred pension costs reflected an
order by the California Public Utilities Commission ("CPUC") requiring the
Company to use the "aggregate cost method" for regulatory accounting
purposes for its intrastate operations. This regulatory asset represented
differences between the Company's intrastate pension costs calculated using
this actuarial method, subject to Internal Revenue Service and other
limitations, and costs determined under the provisions of SFAS No. 87 ,
"Employers' Accounting for Pensions," and SFAS No. 88, "Employers'
Accounting for Settlements and Curtailments of Defined Benefit Pension
Plans and for Termination Benefits."
Previously, when debt was refinanced before maturity, the Company had
amortized to expense any difference between net book value and redemption
price evenly over the term of the replacing issue in accordance with the
ratemaking treatment of such costs by regulators. The above unamortized
debt redemption costs of $337 million represented costs deferred in
accordance with the previous ratemaking treatment. The elimination of the
$337 million unamortized debt redemption costs balance for external
reporting purposes has resulted in a corresponding increase in the
Company's reported amount of long-term obligations.
In prior years, the CPUC and the Federal Communications Commission ("FCC")
changed the required accounting for the costs of compensated absences, such
as vacation days, from a cash basis to an accrual basis. A transition
liability for earned but unused compensated absence days was being
amortized to expense over periods prescribed by each regulator. However,
the CPUC had required the Company to recognize certain compensated absence
costs on a cash basis for ratemaking. The above regulatory asset of $206
million for compensated absences reflected those costs which were deferred
in accordance with this ratemaking treatment.
In 1989 and 1990, respectively, the FCC and the CPUC increased the
threshold for directly expensing purchases of property, plant, and
equipment from $200 to $500. Purchases of less than $500 which were
previously capitalized were being amortized to expense over periods
prescribed by regulators.
Specific provisions of SFAS No. 109, "Accounting for Income Taxes,"
requires regulated companies to record a regulatory asset or a regulatory
liability when recognizing deferred income taxes if it is probable that
these deferred taxes would be reflected in future rates. The net regulatory
liability for deferred income taxes reflected this regulatory treatment.
10
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PACIFIC BELL AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Due to its discontinued application of SFAS 71, the Company will no longer
account for the economic effects of regulation for external financial
reporting purposes. The Company's reported depreciation expense will be
based on estimated economic asset lives. Pension costs for both intrastate
and interstate operations will be determined under SFAS No. 87 and SFAS No.
88. Capitalized interest cost will be reported as a cost of telephone plant
and equipment and a reduction in interest expense, as required by SFAS No.
34, "Capitalization of Interest Cost." Prior to the discontinuance of SFAS
71, the Company 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 of miscellaneous income. The Company's accounting and
reporting for regulatory purposes are not affected by the discontinued
application of SFAS 71 for external financial reporting purposes.
C. COMMITMENTS AND CONTINGENCIES
Broadband Network
In December 1994, the Company contracted for the purchase of up to $2
billion of broadband network facilities which will incorporate emerging
technologies. The Company is committed to purchase these facilities in
1998 if they meet certain quality and performance criteria.
Revenues Subject to Refund
In 1992, the CPUC issued a decision adopting, with modification, SFAS No.
106, "Employers' Accounting for Postretirement Benefits Other than
Pensions," for regulatory accounting purposes. Annual price cap decisions
by the CPUC granted the Company $100 million in each of the years 1995 and
1994 for partial recovery of higher costs under SFAS No. 106. However, the
CPUC in October 1994 reopened the proceeding to determine the criteria for
exogenous cost treatment and whether the Company should continue to recover
these costs. The CPUC's order held that related revenues collected after
October 12, 1994 are subject to refund.
Beginning August 1, 1995, approximately $25 million annually of 1993-94
postretirement benefits costs are being recovered subject to potential
refund in the interstate jurisdiction. The FCC is examining the
appropriateness of this cost recovery in a new proceeding. Management
believes postretirement benefits costs are appropriately recoverable in the
Company's price cap filings, but is unable to predict the outcome of the
CPUC's or FCC's proceedings.
11
<PAGE>
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
- ----------------------------------------------------------------------
RESULTS OF OPERATIONS
The following discussions and data compare the results of operations of
Pacific Bell and subsidiaries (the "Company") for the nine-month period ended
September 30, 1995 to the same period in 1994. Results for the first nine
months of 1995 may not be indicative of results for the full year.
A summary of selected operating data is shown below:
For the 9 Months Ended
September 30, Change
---------------------- -----------------
Selected Operating Data 1995 1994 Amount Percent
- ---------------------------------------------------------------------------
Return on shareowner's equity (%) -57.5 17.6 -75.1 -
Operating ratio* (%).............. 77.8 75.7 2.1 -
Revenues per employee*
($ thousands) ................. 137 130 7 5.4
Total employees ................. 48,359 51,757 -3,398 -6.6
Employees per ten thousand
access lines** ................ 29.8 32.8 -3.0 -9.1
==========================================================================
* Restated
** Excludes Pacific Bell Directory and Pacific Bell Mobile Services
employees
Earnings
- --------
For the 9 months ended
September 30, Change
---------------------- -----------------
($ millions) 1995 1994 Amount Percent
- --------------------------------------------------------------------------
Net income -$2,613 $824 -$3,437 -
- --------------------------------------------------------------------------
The Company reported a loss for the nine months ended September 30, 1995 of
$2,613 million. The reported loss reflects a non-cash, extraordinary charge
to net income during third quarter of $3.4 billion, after taxes. The charge
results from the discontinued application of special accounting rules for
entities subject to traditional regulation and the Company's change to the
general accounting rules used by competitive enterprises. As a result of this
extraordinary charge, the Company expects to record a net loss for the year.
(See "Extraordinary Item" on page 18.)
Earnings for the first nine months of 1995 decreased $3.4 billion in
comparison to the same period last year reflecting this year's one-time,
extraordinary third quarter charge. Revenue shortfalls also contributed to
the decline in earnings. Demand growth as a result of the January 1995 intra-
12
<PAGE>
service area toll ("local toll") price reductions fell far short of the level
anticipated by the California Public Utilities Commission ("CPUC"). As a
result, the revenue neutrality intended by the CPUC's price rebalancing order
was not achieved. Price cap revenue reductions ordered by the CPUC and the
Federal Communications Commission ("FCC") further reduced earnings. Additional
pressure on earnings resulted from incremental labor expense associated with
the severe storms in early 1995. Last year's results included a one-time
after-tax charge of about $29 million for a CPUC refund order. Management
believes 1995 earnings without one-time charges could be about ten percent
less than 1994 due primarily to the revenue rebalancing shortfall. (See
"Revenue Rebalancing Shortfall Filing" on page 23.)
Volume Indicators
- ------------------
For the 9 months ended
September 30, Change
---------------------- ------------------
Volume Indicators 1995 1994 Amount Percent
- ----------------------------------------------------------------------------
Customer switched access lines
in service at
September 30 (thousands).......... 15,358 14,955 403 2.7
Interexchange Carrier access
minutes-of-use (millions) ........ 43,210 39,155 4,055 10.4
Interstate ....................... 23,715 22,934 781 3.4
Intrastate ....................... 19,495 16,221 3,274 20.2
Toll messages (millions) ........... 3,596 3,326 270 8.1
============================================================================
The total number of access lines in service grew to 15,358 thousand, an
increase of 2.7 percent for the twelve months ended September 30, 1995,
unchanged from last year. The growth rate in business access lines was 4.4
percent this year, up from 3.9 percent last year. The growth in business
access lines reflects increased employment levels in California. Business
Centrex lines grew 12.1 percent during the same period as businesses continued
to link multiple locations and improve disaster preparedness. The number of
ISDN lines in service grew to 42,635, an increase of 127 percent for the
twelve months ended September 30, 1995, as customers demanded faster data
transmission and Internet access. The residential access line growth rate
declined to 1.8 percent for the twelve months ended September 30, 1995, from
1.9 percent last year. Last year's figure included the results of a second
line sales promotion. The lower residential growth rate compared to the
business growth rate reflects weak residential construction in California.
Access minutes-of-use represent the volume of traffic carried by interexchange
carriers over the Company's local network. Total access minutes-of-use for
the nine months ended September 30, 1995 increased by 10.4 percent over the
same period last year. The increase in access minutes-of-use was primarily
attributable to economic growth and the effect of toll services competition.
The official introduction of toll services competition in January 1995 had the
effect of increasing intrastate access minutes-of-use. The Company provides
access service to competitors who complete local toll calls over the Company's
network.
13
<PAGE>
Toll messages are comprised of Message Telecommunications Service, Optional
Calling Plans, WATS and terminating 800 messages. For the nine months ended
September 30, 1995, toll messages increased by 8.1 percent compared to an
increase of 4.7 percent for the corresponding period in 1994. The increase
was driven primarily by economic growth as well as lower prices. On January
1, 1995, the Company lowered the price of its local toll services by an
average of 40 percent. The Company also began offering new discount calling
plans. Residential customers receive an automatic 15 percent off toll charges
above five dollars per month while businesses receive an automatic 20 percent
off toll charges over $15 per month. High volume customers can receive even
larger discounts. Price decreases have stimulated demand slightly but the
increase falls far short of levels included in the CPUC's order. (See also
"Competitive Risk" on page 26.)
Operating Revenues
- ------------------
For the 9 Months Ended
September 30, Change
------------------------ -----------------
($ millions) 1995 1994 Dollar Percent
- ---------------------------------------------------------------------------
Total operating revenues $6,626 $6,741 -$115 -1.7
- ---------------------------------------------------------------------------
Revenues for the nine months ended September 30, 1995, were reduced from the
same period last year primarily because demand growth as a result of lower
prices was lower than assumed in the CPUC-ordered price rebalancing. Revenues
were also reduced because of price cap revenue reductions ordered by the CPUC
under incentive-based regulation and the effects of toll services competition.
Effective January 1, 1995, the CPUC allowed long-distance companies and others
to officially compete with the Company in providing local toll services in
California. That decision also rebalanced prices for most of the Company's
regulated services so that the Company could remain competitive in the new
environment. The CPUC intended this decision to be initially revenue neutral.
Revenue reductions due to lower prices were intended to be offset by other
price increases and by increased network usage generated by the lower prices.
Although the Company observed some increased usage during the nine months
ended September 30, 1995, calling volumes were far below levels forecasted by
the CPUC and far below levels necessary to achieve revenue neutrality. (See
"Revenue Rebalancing Shortfall Filing" on page 23.)
The decrease in total operating revenues from price rebalancing and price cap
orders were partially offset by $232 million in revenues from increased
customer demand. The increase in customer demand resulted both from general
economic growth and the effect of price rebalancing.
14
<PAGE>
The revenue decreases were also partially offset by a CPUC-ordered refund in
the second quarter of 1994 related to past problems with the Company's payment
processing system. Due to the 1994 refund, miscellaneous other service
revenues for the nine-month period ending September 30, 1995, increased $27
million compared to last year. Factors affecting revenue changes are
summarized in the following table.
Price
Price Re- Cap Customer Total
($ millions) balancing Orders Misc. Demand Change
- ---------------------------------------------------------------------------
Local service.............. $289 -$ 93 $ 61 $ 21 $278
Network access
Interstate.............. 16 -18 31 57 86
Intrastate.............. -171 -12 12 161 -10
Toll service............... -454 -37 -22 -62 -575
Other service revenues..... 12 -1 40 55 106
----- ----- ----- ----- -----
Total operating revenues... -$308 -$161 $122 $232 -$115
===========================================================================
The increases in revenues due to customer demand in the above table reflect
growth in key volume indicators. The increase in customer demand for local
service revenues is the result of growth in access lines and custom calling
services generated by the improved economy in California.
The increase in interstate network access revenues due to customer demand
reflects increased interexchange carrier access minutes-of-use, as well as
increased access lines. Demand-related increases in intrastate network access
revenues also result from growth in access minutes-of-use. The official
introduction of competition in the local toll market in January 1995 had the
effect of increasing access usage revenues.
The decrease in customer demand-related toll service revenues primarily
results from competition (see "Competitive Risk" on page 26). In addition, the
Company has lost and continues to lose WATS and 800 service business to
interexchange carriers who have the competitive advantage of being able to
offer these services both within and between service areas. Partially
offsetting these reductions were increased usage revenues resulting from
general economic growth.
The demand-related increase in other service revenues reflects the continuing
success of the Company's voice mail products and directory operations.
15
<PAGE>
Operating Expenses
- ------------------
For the 9 Months Ended
September 30, Change
------------------------ -------------------
($ millions) 1995 1994 Dollar Percent
- ----------------------------------------------------------------------------
Total operating expenses $5,155 $5,105 $50 .1
- ----------------------------------------------------------------------------
Total operating expenses for the nine months ended September 30, 1995,
increased when compared with 1994 reflecting increased depreciation expense,
costs resulting from severe storm damage in early 1995, and increased customer
education and software expenses. These expenses were partially offset by the
Company's continuing cost reduction efforts and reduced settlements expense as
displayed in the table below.
Salaries Employee Settle- Subsid- Total
($ millions) & Wages Benefits ments Misc. iaries Change
- ---------------------------------------------------------------------------
Costs of products
& services -$ 4 -$20 -$58 -$14 $ 4 -$92
Customer operations
& selling expense -7 -13 - 29 7 16
General, admin.
& other expense -24 14 - -12 73 51
Property
& misc. taxes - - - 6 - 6
Depreciation
& amortization - - - 66 3 69
---- ---- ---- ---- ---- ----
Total operating
expenses -$35 -$19 -$58 $75 $87 $50
===========================================================================
Salaries and wages for the nine-month period ending September 30, 1995,
decreased compared to the same period in 1994 primarily due to force
reduction. Force reduction savings were partially offset by higher overtime
expense for storm and flood repairs in the first half of 1995. Lower employee
benefits expense was primarily due to the Company's ongoing health care cost-
reduction efforts. Certain nonrecurring adjustments in the third quarter of
1994 partially offset these decreases.
Settlements expense decreased primarily due to the CPUC-ordered price
rebalancing which eliminated reimbursements to certain other local exchange
carriers for calls terminating in their territories.
Miscellaneous customer operations and selling expense increased primarily due
to customer education expenses in the third quarter of 1995.
16
<PAGE>
Depreciation expense increased primarily due to higher depreciation rates
ordered by the CPUC effective January 1, 1995, and higher telephone plant
balances.
Pacific Bell's subsidiaries' general and administrative expense increased
primarily due to increased software expense in the third quarter of 1995.
Interest Expense
- ----------------
For the 9 Months Ended
September 30, Change
------------------------ ----------------------
($ millions) 1995 1994 Change Percent
- ----------------------------------------------------------------------------
Interest expense $327 $324 $3 1.0
- ----------------------------------------------------------------------------
Interest expense for the nine-month period in 1995 compared to 1994 increased
slightly primarily due to interest adjustments on capital leases offset by
last year's interest expense associated with a CPUC refund order.
Miscellaneous Income
- --------------------
For the 9 Months Ended
September 30, Change
------------------------ --------------------
($ millions) 1995 1994 Change Percent
- --------------------------------------------------------------------------
Miscellaneous income $45 $1 $44 -
- --------------------------------------------------------------------------
Miscellaneous income for the nine-month period in 1995 compared to 1994
increased primarily due to interest income of $18 million from a tax refund
received in 1995 related to prior years. Also, the late payment charges
penalty recorded in 1994 increased comparative miscellaneous income by $10
million. A change in the FCC calculation of "Allowance for Funds Used During
Construction" also contributed to the increase. In addition, the increase
reflected unrealized gains on trust assets under an executive compensation
deferral plan which will fluctuate throughout the year and may be offset by
unrealized losses depending on market conditions.
17
<PAGE>
Income Taxes
- ------------
For the 9 Months Ended
September 30, Change
------------------------ --------------------
($ millions) 1995 1994 Change Percent
- --------------------------------------------------------------------------
Income taxes $442 $489 -$47 -9.6
- ----------------------------------------------------------------------------
Income tax expense decreased for the nine-month period in 1995 compared to
1994 primarily due to lower pre-tax income partially offset by last year's
accelerated recognition of prior period investment tax credits due to shorter
plant lives.
Extraordinary Item
- -------------------
The Company historically has accounted for the economic effects of regulation
in accordance with the provisions of Statement of Financial Accounting
Standards No. 71 ("SFAS 71"), "Accounting for the Effects of Certain Types of
Regulation." Under SFAS 71, the Company has depreciated telephone plant using
lives prescribed by regulators and, as a result of other actions of
regulators, has deferred recognizing certain costs or has recognized certain
liabilities (referred to as "regulatory assets" and "regulatory liabilities").
Effective third quarter 1995, management determined that, for external
financial reporting purposes, it is no longer appropriate for the Company to
continue 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. Prices for the
Company's products and services are being driven increasingly by market forces
instead of regulation.
The discontinued application of SFAS 71 required the Company, for external
financial reporting purposes, to write down the carrying amount of its
telephone plant and to eliminate its regulatory assets and liabilities. As a
result, the Company recorded in third quarter 1995 a non-cash, extraordinary
charge of $3.4 billion, which is net of a deferred income tax benefit of $2.4
billion. The telephone plant write-down portion of the charge reflects a pre-
tax increase in the Company's accumulated depreciation of approximately $4.8
billion to recognize shorter estimated lives in a competitive market. The
extraordinary charge also includes a pre-tax adjustment of $962 million to
eliminate the Company's regulatory assets and liabilities. The discontinuance
of SFAS 71 was made in accordance with Statement of Financial Accounting
Standards No. 101, "Accounting for the Discontinuance of Application of FASB
Statement No. 71." (See also Note B - "Discontinuation of Regulatory
Accounting - SFAS 71" on page 8.)
In future years, the discontinuance of SFAS 71 by Pacific Bell is not expected
to materially affect depreciation expense, net income or cash flow. This
action will not affect the Company's planned network investments. The
discontinuance of SFAS 71 is a change for external financial reporting
purposes only and has no effect on the Company's customers.
18
<PAGE>
Status of Restructuring Reserve
- -------------------------------
As previously reported, the Company established a restructuring reserve at the
end of 1993 to provide for the incremental cost of force reductions and other
related costs to restructure its internal business processes through 1997.
After new hires, net force loss for Pacific Bell (excluding subsidiaries) was
approximately 1,700 for the first nine months of 1995. A total of $215
million was charged to the reserve in the first nine months of 1995 primarily
for reengineering projects. As of September 30, 1995, a balance of $619
million remained in the restructuring reserve.
The Company continues to refine its reengineering and force reduction plans in
order to maximize cost savings. Management expects fourth quarter 1995
charges to the reserve to exceed the $108 million charged in the third
quarter. Actual charges to the reserve in 1995 are not expected to differ
materially from the previous estimate of $386 million.
During the second quarter of 1995, the Company announced that it will further
consolidate its network operations centers to two by first quarter 1996,
rather than four centers as previously announced. This move is expected to
result in investment savings of $20 million during 1995 without affecting
customer service.
Capital Expenditures
- --------------------
The Company invested about $1.2 billion during the first half of 1995
primarily to modernize and expand the network. The Company now expects to
invest about $1.7 billion in 1995 excluding broadband costs.
BOND RATING
In May 1995, Duff and Phelps, Inc. lowered the rating of the Company's bonds
from Double-A ("AA") to Double-A-Minus ("AA-"). At September 30, 1995, the
Company had approximately $5 billion of long- and intermediate-term debt
outstanding. The rating action reflected price cap revenue reductions, toll
services competition, and proposed interim rules on local services
competition. The rating action also reflected the expected financing
requirements of the Company's broadband and PCS networks. In addition, Moody's
Investors Services, Inc. has changed its outlook on the long-term debt of the
Company to "negative" from "stable," citing concerns about risks associated
with deployment of the broadband network and potential pressure on the
financial profile and performance of the Company. Moody's also expressed
concern about the timetable for introduction of competition for all
telecommunications services in California and the risk that the rules
governing the competitive environment will be unbalanced.
In August 1995, Standard & Poor's Corporation removed bond and commercial
paper ratings of the Company from "CreditWatch," where they were placed in May
1995 following the release by the CPUC of its proposed interim rules on local
services competition. Standard & Poor's Corporation stated that the long-term
rating outlook for the Company is negative.
19
<PAGE>
LABOR AGREEMENT
On August 8, 1995, the Company reached a tentative three-year agreement with
the Communications Workers of America which represents about 33,000 employees.
The agreement was ratified by the union membership in September 1995. The new
agreement features a 10.5 percent wage increase over three years, a 14 percent
pension increase, a $16 million training and retraining program, a new
voluntary early retirement option, continued employment security and improved
health benefits. Agreements were also reached with two other unions.
Management estimates that the agreements will result in increased costs of
approximately $550 million over three years. This estimate does not include
savings which may result from future force reductions. In October 1995, the
Company began offering the new voluntary early retirement option to certain
non-management employees.
PENDING REGULATORY ISSUES
Telecommunications Legislation
- ------------------------------
In June 1995, the U.S. Senate approved a telecommunications bill which would
ease certain restrictions imposed by the Communications Act of 1934, the 1982
Consent Decree and the 1984 Cable Act. Among the provisions, the bill would
allow telephone companies and cable television companies to compete in each
others' markets. In August 1995, similar legislation was passed by the House
of Representatives. In October 1995, the bills went to conference to
reconcile the differences. Management believes that the telecommunications
reform legislation pending before Congress is a balanced plan that, after
reconciliation and if enacted, would begin to offer consumers the benefits of
real competition. The President of the U. S. has indicated that he may veto
the legislation unless certain changes are made.
Calling Party Identification
- ----------------------------
In May 1995, the FCC established national rules affecting how telephone
companies, including the Company, may offer calling party identification
services ("Caller ID"). Caller ID displays the telephone number of the
calling party on a device that attaches to a customer's telephone unless it is
blocked by the calling party. Caller ID is already available in most other
states but has not been offered in California due to CPUC blocking
requirements that make the service uneconomic to provide. The FCC ruling
preempts certain of the CPUC's restrictions which made providing Caller ID
uneconomic. In June 1995, the CPUC appealed the FCC's ruling to the U.S.
Court of Appeals for the Ninth Circuit. The appeal is pending.
20
<PAGE>
FCC Regulatory Framework Review
- --------------------------------
In March 1995, the FCC adopted new interim price cap rules that govern the
prices that the larger local exchange carriers ("LECs"), including the
Company, charge interexchange carriers ("IECs") for access to local telephone
networks.
The interim rules require LECs to adjust their maximum prices for changes in
inflation, productivity and certain costs beyond the control of the LEC.
Under the interim plan, LECs may choose from three productivity factors: 4.0,
4.7, or 5.3 percent. Election of the 5.3 percent productivity factor permits
the LEC to retain all of its earnings whereas the other lower productivity
factors require earnings to be shared with customers. In adopting the interim
plan, the FCC required LECs to prospectively reduce their price caps by 0.7
percent for each year the LEC elected the lower 3.3 percent productivity
factor during 1991-94. For the Company, this resulted in a 2.1 percent
reduction. The Company has formally contested this reduction as well as other
adjustments associated with the interim plan in the U.S. Court of Appeals for
the District of Columbia (the "Court"). In August 1995, the Court agreed to
expedite review of these adjustments.
The FCC plans to adopt permanent rules in 1996 following a rulemaking
proceeding. Management continues to believe that the FCC should adopt pure
price cap regulation and eliminate the productivity factor, sharing, and
earnings caps.
The Company's 1995 annual access filing implementing the interim rules took
effect August 1, 1995. As a result, the Company's revenues were reduced
approximately $123 million through June 30, 1996. Of this amount, $69 million
was reflected in the Company's 1994 financials. The Company chose the 5.3
percent productivity factor that enables it to retain all of its earnings
after July 1, 1995. The higher productivity factor was chosen because
management believes that it will be more than offset by elimination of the
sharing mechanism.
Video Dialtone Applications Approval
- ------------------------------------
In July 1995, the FCC approved the Company's applications for authority to
offer video dialtone services in specific locations in four of its service
areas. The approval allows the Company to begin installing the video-specific
components of its advanced communications network. Construction of the video-
specific elements of the network will give customers access to such
interactive services as movies and television shows on demand, interactive
news, tele-education, home shopping, video games, community information
listings, high-speed Internet access and broadcast programming. Construction
of the telephone portion of the network began in May 1994.
21
<PAGE>
In September 1995, management announced it would concentrate deployment of the
advanced communications network in the San Francisco Bay Area, one of the
Company's most competitive markets. Management had previously planned to build
an advanced communications network simultaneously in Southern California.
Pacific Telesis Group's acquisition of Cross Country Wireless, Inc., a company
with rights to deliver wireless digital television to more than five million
homes, allows the Company to introduce services more rapidly in Southern
California without the immediate deployment of wireline video technology.
The Company's approved video dialtone applications, filed in late December
1993, cover approximately 1.3 million homes throughout California. With this
approval, the Company is on track to be the first company in the United States
to offer a single full service network supporting telephony, data, and video.
Technology trials will be conducted during the second half of 1995 in the San
Francisco Bay Area, with paying customers connected early next year.
Interactive services will be offered to consumers beginning mid-1996.
The Company has selected the state-of-the-art hybrid fiber/coaxial cable
architecture. The technology is cost effective to deploy and operate, and
allows Pacific Bell to achieve significant operational savings. Furthermore,
the architecture is flexible enough to meet customer needs today while network
capacity can be expanded easily as demand grows.
There are still critical regulatory issues to resolve before the Company can
deliver the full benefits of the "communications superhighway". The FCC must
still resolve the issue of whether programming affiliates of the video
dialtone providers will be regulated under cable television rules. While a
cable television system allows the owner sole discretion to determine
programming, a video dialtone platform is a common carrier platform open to
any programmer. Management believes that telephone companies providing video
dialtone should be regulated solely as common carriers even if they provide
some programming on the video dialtone platform.
CPUC Annual Price Cap Filing
- ----------------------------
In October 1995, the Company filed its annual, mandated price cap advice
letter filing for 1996 with the CPUC. However, this year's filing was
complicated by the fact that the CPUC has not adopted a productivity factor
for the Company for 1996 for use in the price cap formula. As a result, and
solely at the CPUC's request, the Company included in its price cap filing,
"for illustrative purposes only", the revenue decrease that would result using
the productivity factor of five percent that had been adopted for use in 1994
and 1995. The resulting "illustrative" revenue decrease from our price cap
filing would be $63 million, consisting of an illustrative revenue reduction
of $116 million due to the "inflation minus productivity" portion of the price
cap formula and a proposed revenue increase of $53 million due to other
partially offsetting items. The CPUC is currently examining whether to modify
or eliminate the "inflation minus productivity" portion of the price cap
formula and has indicated that it could reach a decision by the end of 1995.
(See "CPUC Regulatory Framework Review" below.)
22
<PAGE>
Uniform Systems of Account ("USOA") Turnaround Adjustment
- ---------------------------------------------------------
In May 1995, the Company 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, the Company's revenues have
been reduced by approximately $23 million each year since 1988. 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 September 1995 addressing
whether the USOA Turnaround Adjustment should be eliminated. The Company has
strongly recommended that this adjustment be discontinued effective January 1,
1995, which would result in a one-time revenue increase to Pacific Bell of $23
million for 1995. The CPUC's Division of Ratepayer Advocates has proposed
that the Company be ordered to permanently reduce its revenues by $106 million
effective January 1, 1996. AT&T Corp. has proposed that the Company should be
ordered to reduce its revenues permanently by an $112 million over the next
ten years and reduce its revenues by an additional $43 million on January 1,
1996. Management is unable to predict the outcome of this matter.
Revenue Rebalancing Shortfall Filing
- ------------------------------------
In September 1995, the Company filed for $214 million of revenue increases.
The request was to address the revenue shortfall as a result of the CPUC price
rebalancing decision which was intended to be revenue neutral. Management
cannot predict the outcome of this matter.
CPUC Regulatory Framework Review
- --------------------------------
In June 1995, the Company filed an emergency petition with the CPUC requesting
an expeditious review of its current regulatory framework. In July 1995, the
CPUC granted the Company's request and announced the first phase of the review
which is addressing three issues:
1. Should the inflation minus productivity portion of the price cap formula be
modified or eliminated?
2. Should the price cap formula be applied to all of the services placed in
the categories for non-competitive and partially competitive services or
only to services placed in the category for non-competitive services?
3. Should any modifications to the regulatory framework be ordered in stages,
contingent on reviewing milestones?
Management believes that the inflation minus productivity factor portion of
the price cap formula should be eliminated. As the Company operates under an
increasingly competitive environment, competition itself replaces the need for
formula based adjustments to rates. The CPUC has indicated that it wishes to
conclude the first phase of its review by the end of 1995. Management cannot
predict the future effect of the CPUC's review on revenues.
23
<PAGE>
Depreciation Filing
- -------------------
The CPUC evaluates and prescribes depreciation rates each year. In June 1995,
the Company requested technical changes which would result in a $34 million
decrease in annual depreciation expense. This request was not related to
management's decision to discontinue accounting under SFAS 71 for external
financial reporting purposes. In November 1995, the CPUC granted the Company's
request with new depreciation rates to become effective January 1, 1996.
Local Services Competition
- --------------------------
In July 1995, the CPUC issued initial rules opening the local exchange market
to competition. Facilities-based competitive local carriers ("CLCs") are
authorized to begin providing local phone service beginning January 1, 1996.
Those companies leasing lines for resale will be able to offer phone service
by March 1, 1996. No CLC may begin operating until all certification
requirements are satisfied and the CPUC grants a certificate of public
convenience and necessity. As of October 1995, 67 companies had filed with
the CPUC for authority to offer local phone service in the Company's service
areas.
The CPUC expects to resolve remaining issues and issue final rules for
implementing full competition in all California telecommunications markets by
January 1, 1997. The CPUC has been taking testimony and is holding
evidentiary hearings on specific unresolved issues related to local
competition. These issues include LEC pricing flexibility, resale terms and
conditions including prices, points of network interconnection, prices for
interim number portability and whether the rules provide the LECs with an
opportunity to earn a fair rate of return.
In October 1995 the Company filed proposed guidelines for selling network
services and capabilities to CLCs. The proposal outlines plans for wholesale
pricing, universal service funding, joint marketing and other concerns which
management believes must be addressed before local competition can be
introduced next year. The Company has also filed testimony showing that the
effect of the CPUC's initial local competition rules, taken together with
possible unfavorable decisions on other pending regulatory issues, would
deprive the Company of the opportunity to earn a fair rate of return. The
CPUC denied the Company's Application for Rehearing of the initial rules.
Although management supports the expansion of local telephone competition, it
is concerned that under the CPUC's initial rules competitors will be able to
package and resell local phone service together with long-distance service,
while the Company will still not be able to offer customers the same array of
services. This would be a significant competitive disadvantage to the Company
since it is prohibited by the 1982 Consent Decree from providing long-distance
service between service areas.
24
<PAGE>
Universal Service
- -----------------
In July 1995, in connection with its local services competition decision, the
CPUC affirmed its commitment to universal service, and proposed rules to
assure the continuation of affordable, high quality service in the coming
competitive local phone services market. Universal service issues are
fundamental to the ongoing CPUC proceeding to allow local and long-distance
companies to compete in providing basic local phone services, just as they
already compete in providing local toll services.
The CPUC has stated that companies that want to compete in the local phone
services market will have the opportunities as well as the obligations
associated with universal service. Hearings have been held to seek public
comment on universal service in California. Management believes that universal
service issues should be resolved before resale competition is authorized.
Resale competition is currently scheduled to begin March 1, 1996.
Revenues Subject to Refund
- --------------------------
In 1992, the CPUC issued a decision adopting, with modification, SFAS No. 106,
"Employers' Accounting for Postretirement Benefits Other than Pensions," for
regulatory accounting purposes. Annual price cap decisions by the CPUC
granted the Company $100 million in each of the years 1995 and 1994 for
partial recovery of higher costs under SFAS No. 106. However, the CPUC in
October 1994 reopened the proceeding to determine the criteria for exogenous
cost treatment and whether the Company should continue to recover these costs.
The CPUC's order held that related revenues collected after October 12, 1994
are subject to refund.
Beginning August 1, 1995, approximately $25 million annually of 1993-94
postretirement benefits costs are being recovered subject to potential refund
in the interstate jurisdiction. The FCC is examining the appropriateness of
this cost recovery in a new proceeding. Management believes postretirement
benefits costs are appropriately recoverable in the Company's price cap
filings, but is unable to predict the outcome of the CPUC's or FCC's
proceedings.
25
<PAGE>
Property Taxes
- --------------
In 1992, a settlement agreement was reached between the State Board of
Equalization, all California counties, the State Attorney General, and 28
utilities, including the Company, on a specific methodology for valuing
utility property for property tax purposes. The CPUC opened an investigation
to determine if any resulting property tax savings should be returned to
customers. Intervenors have asserted that as much as $20 million of annual
property tax savings should be treated as an exogenous cost reduction in the
Company's annual price cap filings. These intervenors have also asserted that
past property tax savings totaling as much as $60 million plus interest should
be returned to customers. Management believes that under the CPUC's
regulatory framework, any property tax savings should only be treated as a
component of the calculation of shareable earnings. In an Interim Opinion
issued in June 1995, the CPUC decided to defer a final decision on this matter
pending resolution of the criteria for exogenous cost treatment under its
regulatory framework. The criteria are being considered in a separate
proceeding initiated for rehearing of the CPUC's postretirement benefits other
than pensions decision.
DISPOSITION OF BELLCORE
In April 1995, Bellcore announced a decision by its owners to pursue the
disposition of their interests in Bellcore. Bellcore is a leading provider of
communications software and consulting services. It is owned by Pacific Bell
and six of the telephone regional holding companies formed at the divestiture
of AT&T Corp. in 1984. A final decision regarding the disposition of
interests and the structure of such a transaction has yet to be determined.
Any transaction will be subject to necessary approvals.
COMPETITIVE RISK
Regulatory, legislative and judicial actions, as well as advances in
technology, have expanded the types of available communications products and
services and the number of companies offering such services. Various forms of
competition are growing steadily and are already having an effect on the
Company's earnings. An increasing amount of this competition is from large
companies with substantial capital, technological, and marketing resources.
Currently, competitors primarily consist of interexchange carriers,
competitive access providers and wireless companies. Soon the Company will
also face competition from cable television companies and others.
26
<PAGE>
Effective January 1, 1995, the CPUC authorized toll services competition.
Toll service revenues represented approximately 14 percent of the Company's
total operating revenues for the first nine months of 1995. In May 1995, the
CPUC issued a decision that requires the Company to permit Centrex customers
who purchase certain optional routing features to route intra-service area
calls to the toll carrier of their choice. Since the official introduction of
competition in January 1995, management estimates that the Company lost about
five to six percent of the total local toll services market to other providers
by the end of third quarter 1995. Management estimates that, as a result of
official competition and unofficial competitive losses in prior years, the
Company currently serves less than 60 percent of the business toll market.
Changes contemplated by the CPUC and the effects of pending legislation make
it too early to predict when, or at what level, market share loss will
stabilize.
The CPUC has also ordered the Company 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 the Company's
central offices and long-distance carriers. As a result of the CPUC order,
competitors may choose to locate their transmission facilities within or near
the Company's central offices. Intrastate access revenues subject to increased
competition represent about five percent of the Company's total revenues.
In addition, the CPUC has issued initial rules to open the local exchange
market to competition beginning January 1, 1996. (See "Local Services
Competition" on page 24.) Local service revenues represented approximately 42
percent of the Company's total operating revenues for the first nine months of
1995. Local exchange competition will also affect network access revenues as
CLCs provide access services.
Because of the unique characteristics of the California market, the Company is
vulnerable to competition. The Company's business and residence revenues and
profitability are highly concentrated among a portion of its customer base and
geographic areas. Competitors need only serve portions of our service area to
compete for the majority of the Company's business and residence usage
revenues. High-margin customers are clustered in high density areas such as
Los Angeles and Orange County, the San Francisco Bay Area, San Diego and
Sacramento.
Competitors can be expected to target the high-usage, high-profit customers
and can do this by targeting only a small part of our geographic area and a
small part of our customer base. Large and well-capitalized long-distance
carriers, wireless companies, competitive access providers and cable
television companies are preparing to compete in major local exchange markets.
In some cases they are already deploying switches and other facilities. In
California, cable television companies currently pass more than 90 percent of
the Company's residential customers. Cable television companies have already
announced plans for major build-outs to compete in the local exchange market.
All of the Company's customers have already chosen a long-distance company,
and there is more advertising from long-distance companies than from
traditional local exchange companies including Pacific Bell.
27
<PAGE>
Market research has shown that a substantial majority of residence customers
prefer using one company for all telecommunications services. This is a
significant competitive disadvantage to the Company since it is prohibited by
the 1982 Consent Decree from providing long-distance service between service
areas. Similar market research shows that a substantial majority of business
customers would select one of the major long-distance companies over a
combination of Pacific Bell and a long-distance company because using one
carrier would permit them to apply all of their traffic toward volume discount
plans offered by the long-distance companies.
For these reasons, management believes that implementation of local exchange
competition prior to the Company being allowed to enter the long-distance
market would provide already strong competitors an unfair advantage.
Management also believes that a truly open competitive market would allow for
the simultaneous entry of all telecommunications competitors into each others'
markets on an equal footing. Although the Company is facing increasing
competition for all of its services, management believes that a truly open
competitive market, in which the Company can compete without restrictions,
offers long-term opportunity to grow the business.
28
<PAGE>
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits.
Exhibits identified as on file with the SEC are incorporated herein by
reference as exhibits hereto.
Exhibit
Number Description
- ------- -----------
4 No instrument which defines the rights of holders of long- and
intermediate-term debt of Pacific Bell is filed herewith pursuant to
Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation,
Pacific Bell hereby agrees to furnish a copy of any such instrument to
the SEC upon request.
15 Letter re unaudited interim financial information.
27 Article 5 FDS for 3rd Quarter 1995 Form 10-Q.
The Company will furnish to a security holder upon request a copy of any
exhibit at cost.
(b) Reports on Form 8-K.
Form 8-K, Date of Report September 7, 1995, was filed with the SEC, under Item
5, announcing the discontinuance of SFAS 71.
29
<PAGE>
FORM 10-Q
SIGNATURE
---------
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Pacific Bell
By /s/Peter A. Darbee
---------------------------------------
Peter A. Darbee
Vice President, Chief Financial Officer
and Controller
November 13, 1995
30
<PAGE>
EXHIBIT INDEX
Exhibits identified as on file with the SEC are incorporated herein by
reference as exhibits hereto. All other exhibits are provided as part of the
electronic transmission.
Exhibit
Number Description
- ------- -----------
4 No instrument which defines the rights of holders of long- and
intermediate-term debt of Pacific Bell is filed herewith pursuant to
Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation,
Pacific Bell hereby agrees to furnish a copy of any such instrument to
the SEC upon request.
15 Letter re unaudited interim financial information.
27 Article 5 FDS for 3rd Quarter 1995 Form 10-Q.
31
<PAGE>
Exhibit 15
----------
COOPERS & LYBRAND L.L.P.
November 13, 1995
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Ladies and Gentlemen:
Re: Pacific Bell
Registration Statement on Form S-3
------------------------------------
We are aware that our report dated November 13, 1995 on our review of the
interim financial information of Pacific Bell and Subsidiaries for the three-
and nine-month periods ended September 30, 1995 included in this Form 10-Q is
incorporated by reference in the Company's registration statement as follows:
Form S-3: Pacific Bell $1.575 Billion Debt Securities
Pursuant to Rule 436(c) under the Securities Act of 1933, this report should
not be considered a part of the registration statement prepared or certified
by us within the meaning of Sections 7 and 11 of that Act.
Very truly yours,
/s/Coopers & Lybrand L.L.P.
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