<PAGE>
FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
(X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1996
OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number 1-1414
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, 1996, 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 Cash Flows ....... 4
Notes to Condensed Consolidated Financial Statements .. 6
Item 2. Management's Discussion and Analysis of Results of
Operations ............................................ 10
PART II. OTHER INFORMATION
- ---------------------------
Item 6. Exhibits............................................. 24
SIGNATURE......................................................... 25
- ---------
<PAGE>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
REVIEW REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareowner of Pacific Bell:
We have reviewed the accompanying condensed consolidated balance sheet of
Pacific Bell and Subsidiaries (the "Company") as of September 30, 1996 and the
related condensed consolidated statements of income for the three- and nine-
month periods ended September 30, 1996 and 1995, and the condensed
consolidated statements of cash flows for the nine-month periods ended
September 30, 1996 and 1995. These financial statements are the
responsibility of the 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.
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, 1995, 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 22, 1996, we expressed an
unqualified opinion on those consolidated financial statements. In our
opinion, the information set forth in the accompanying condensed consolidated
balance sheet as of December 31, 1995, is fairly stated, in all material
respects, in relation to the consolidated balance sheet from which it has been
derived.
/s/Coopers & Lybrand L.L.P.
San Francisco, California
November 13, 1996
1
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PACIFIC 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) 1996 1995 1996 1995
- --------------------------------------------------------------------------
OPERATING REVENUES
Local service............ $ 1,006 $ 944 $ 2,962 $ 2,803
Network access:
Interstate ............ 448 413 1,338 1,257
Intrastate ............ 176 179 539 522
Toll service ............ 325 306 953 910
Other service revenues .. 422 386 1,220 1,134
------ ------ ------ ------
TOTAL OPERATING REVENUES 2,377 2,228 7,012 6,626
------ ------ ------ ------
OPERATING EXPENSES
Cost of products and
services .............. 450 399 1,287 1,323
Customer operations and
selling expenses ...... 491 476 1,425 1,351
General, administrative,
and other expenses .... 349 340 1,036 959
Property and other taxes. 46 45 132 141
Depreciation and
amortization .......... 462 461 1,370 1,381
------ ------ ------ ------
TOTAL OPERATING EXPENSES. 1,798 1,721 5,250 5,155
------ ------ ------ ------
OPERATING INCOME......... 579 507 1,762 1,471
Interest expense......... 95 110 277 327
Other income
(expense)-net.......... 3 17 4 45
------ ------ ------ ------
INCOME BEFORE INCOME TAXES
AND EXTRAORDINARY ITEM. 487 414 1,489 1,189
Income taxes............. 198 156 606 442
------ ------ ------ ------
INCOME BEFORE EXTRAORDINARY
ITEM .................. 289 258 883 747
Extraordinary item,
net of tax............. - (3,360) - (3,360)
------ ------ ------ ------
NET INCOME (LOSS)........ $ 289 $(3,102) $ 883 $(2,613)
===========================================================================
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) 1996 1995
- ---------------------------------------------------------------------------
ASSETS: (Unaudited)
Cash and cash equivalents........................ $ 78 $ 68
Accounts receivable - (net of allowances for
uncollectibles of $156 and $131 in 1996
and 1995, respectively)........................ 1,563 1,475
Prepaid expenses and other current assets........ 847 802
------- -------
Total current assets............................. 2,488 2,345
------- -------
Property, plant, and equipment - at cost......... 27,808 26,688
Less: accumulated depreciation................ (16,501) (15,608)
------- -------
Property, plant, and equipment - net............. 11,307 11,080
------- -------
Other noncurrent assets.......................... 465 474
------- -------
TOTAL ASSETS..................................... $14,260 $13,899
======= =======
LIABILITIES AND SHAREOWNER'S EQUITY:
Accounts payable and accrued liabilities......... $ 1,953 $ 2,109
Debt maturing within one year.................... 608 781
Other current liabilities........................ 475 552
------- -------
Total current liabilities........................ 3,036 3,442
------- -------
Long-term obligations............................ 5,295 4,608
------- -------
Deferred income taxes............................ 443 321
------- -------
Other noncurrent liabilities and deferred credits 2,124 2,417
------- -------
Commitments and contingencies (Note B)
Common stock ($1.00 stated value, 300,000,000
shares authorized, 224,504,982 shares issued
and outstanding)............................... 225 225
Additional paid-in capital....................... 5,586 5,387
Accumulated deficit.............................. (2,449) (2,501)
------- -------
Total shareowner's equity........................ 3,362 3,111
------- -------
TOTAL LIABILITIES AND SHAREOWNER'S EQUITY........ $14,260 $13,899
==========================================================================
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 CASH FLOWS
(Unaudited)
For the 9 Months Ended
September 30,
----------------------
(Dollars in millions) 1996 1995
- ---------------------------------------------------------------------------
CASH FROM (USED FOR) OPERATING ACTIVITIES:
Net income (loss)................................... $ 883 $(2,613)
Adjustments to reconcile net income (loss) to cash
from operating activities:
Extraordinary item................................. - 3,360
Depreciation and amortization...................... 1,370 1,381
Change in deferred income taxes.................... 133 53
Unamortized investment tax credits................. (35) (37)
Changes in operating assets and liabilities:
Accounts receivable.............................. (107) 49
Prepaid expenses and other current assets........ (37) (22)
Other noncurrent assets.......................... 15 135
Accounts payable and accrued liabilities......... (139) (115)
Other current liabilities........................ (77) 24
Noncurrent liabilities and deferred credits...... (258) (343)
Other adjustments, net........................... 6 8
------- -------
Cash from operating activities...................... 1,754 1,880
------- -------
CASH USED FOR INVESTING ACTIVITIES:
Additions to property, plant, and equipment.......... (1,597) (1,285)
Other investing activities, net...................... (32) (1)
------- -------
Cash used for investing activities................... (1,629) (1,286)
------- -------
CASH FROM (USED FOR) FINANCING ACTIVITIES:
Equity infusion from parent.......................... 198 57
Proceeds from issuance of long-term debt............. 495 -
Dividends paid....................................... (830) (763)
Increase (decrease) in short-term borrowings, net.... (186) 120
Proceeds from sale and leaseback transactions........ 211 -
Other financing activities, net...................... (3) (4)
------- -------
Cash used for financing activities................... (115) (590)
------- -------
(Continued on next page)
4
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PACIFIC BELL AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(Continued)
For the 9 Months Ended
September 30,
----------------------
(Dollars in millions) 1996 1995
- ---------------------------------------------------------------------------
Increase in cash and cash equivalents............... 10 4
Cash and cash equivalents at January 1.............. 68 62
------- -------
Cash and cash equivalents at September 30........... $ 78 $ 66
======= =======
Cash payments for:
Interest.......................................... $ 305 $ 317
Income taxes...................................... $ 253 $ 396
============================================================================
The accompanying Notes are an integral part of the Condensed Consolidated
Financial Statements.
5
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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,
Pacific Bell Information Services, Pacific Bell Mobile Services, Pacific
Bell Internet Services, Pacific Bell Network Integration and others,
hereinafter referred to as the "Company". All significant intercompany
balances and transactions have been eliminated. The Condensed
Consolidated Financial Statements reflect reclassifications made to
conform with the current year presentation. These reclassifications did
not affect net income or shareowner's equity.
The Condensed Consolidated Financial Statements have been prepared in
accordance with the rules and regulations of the Securities and Exchange
Commission ("SEC") applicable to interim financial information. Certain
information and footnote disclosures included in financial statements
prepared in accordance with generally accepted accounting principles have
been condensed or omitted in these interim statements pursuant to such
SEC rules and regulations. Management recommends that these interim
financial statements be read in conjunction with the audited consolidated
financial statements and notes thereto included in the Company's 1995
annual report on Form 10-K.
Effective third quarter 1995, for external financial reporting purposes,
the Company discontinued the application of Statement of Financial
Accounting Standards No. ("SFAS") 71, "Accounting for the Effects of
Certain Types of Regulation," an accounting standard for entities subject
to traditional regulation. As a result, during third quarter 1995 the
Company recorded a non-cash, extraordinary, after-tax charge of
$3.4 billion.
In management's opinion, the Condensed Consolidated Financial Statements
include all adjustments (consisting of only normal recurring adjustments)
necessary to present fairly the financial position and results of
operations for each interim period shown. The Condensed Consolidated
Financial Statements have been reviewed by Coopers & Lybrand L.L.P.,
independent accountants. Their report is on page 1.
Change In Estimates
In March 1996, management amended the salaried pension plan, which
changed from a final pay plan to a cash balance plan. As a result of
the approval of this plan amendment, in second quarter 1996 the Company
updated its actuarial assumptions to reflect changes in market interest
rates and recent experience, including a change in its assumption
concerning future ad hoc increases in pension benefits. These changes in
estimates increased net income by approximately $75 million for the first
nine months of 1996 in comparison to the same period in 1995.
6
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PACIFIC BELL AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
B. COMMITMENTS AND CONTINGENCIES
Merger Agreement
On April 1, 1996, SBC Communications Inc. ("SBC") and Pacific
Telesis, the Company's parent, jointly announced a definitive
agreement whereby Pacific Telesis will become a wholly-owned
subsidiary of SBC. Under terms of the merger agreement, each share
of Pacific Telesis common stock will be exchanged for 0.733 shares
of SBC common stock, subject to adjustment. The transaction is
intended to be accounted for as a pooling of interests and to be a
tax-free reorganization. On July 31, 1996, the shareowners of
Pacific Telesis and SBC approved the transaction, which previously
had been approved by the respective Board of Directors of each
company. On November 5, 1996, the U.S. Department of Justice
announced it had concluded that the merger does not violate the
antitrust laws and accordingly that it was closing its investigation
into the merger. The merger is subject to certain other conditions
and regulatory approvals. The California Public Utilities
Commission ("CPUC") has established a schedule for review of the
transaction with final comments from interested parties due in
January 1997. On September 30, 1996, the Office of Ratepayer
Advocates ("ORA"), the consumer interest branch of the CPUC, filed
testimony in the merger proceeding recommending a $2.1 billion
refund to customers payable over five years. Management does not
agree with the ORA's recommendation and believes no customer rebate
should be required in connection with the merger. The CPUC is
expected to make a final decision on the merger by the end of March
1997. In Nevada, SBC and Pacific Telesis entered into a stipulation
with the staff of the Public Service Commission of Nevada ("PSCN")
and the Office of the Consumer Advocate to refund to customers the
greater of $4 million or 2.0 percent of the amount, if any, ordered
by the CPUC to be refunded to Pacific Bell customers. The refund is
conditioned on approval of the stipulation by the PSCN and closing
of the merger. The PSCN has scheduled hearings for November 25,
1996, and approval is expected in December 1996. If all necessary
approvals are granted, the transaction is expected to close in the
first quarter of 1997.
7
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PACIFIC BELL AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
B. COMMITMENTS AND CONTINGENCIES (Cont'd)
Purchase Commitments
In December 1994, the Company contracted for the purchase of up to
$2 billion of Advanced Communications 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. Management now expects the actual amount of these facilities
purchased in 1998 will be less than $700 million.
As of September 30, 1996, the Company had purchase commitments of about
$212 million remaining in connection with its previously announced
program for deploying an all-digital switching platform with ISDN and
SS-7 capabilities.
Revenues Subject to Refund
In 1992, the CPUC issued a decision adopting, with modification,
SFAS 106, "Employers' Accounting for Postretirement Benefits Other than
Pensions," for regulatory accounting purposes. Annual price cap
decisions by the CPUC granted the Company approximately $100 million in
each of the years 1993-1996 for partial recovery of higher costs under
SFAS 106. However, the CPUC in October 1994 reopened the proceeding to
determine the criteria for exogenous cost treatment and whether 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 plus interest. It is possible that the CPUC could decide this
issue in the near term, and that the decision could have a material
adverse effect on the Company. Related revenues subject to refund
totaled about $197 million at September 30, 1996. Management believes
postretirement benefits costs are appropriately recoverable in the
Company's price cap filings.
8
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PACIFIC BELL AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
B. COMMITMENTS AND CONTINGENCIES (Cont'd)
Property Tax Investigation
In 1992, a settlement agreement was reached between the State Board of
Equalization, all California counties, the State Attorney General, and
28 utilities, including the Company, on a specific methodology for
valuing utility property for property tax purposes for a period of eight
years. The CPUC opened an investigation to determine if any resulting
property tax savings should be returned to customers. Intervenors have
asserted that as much as $20 million of annual property tax savings
should be treated as an exogenous cost reduction in the Company's annual
price cap filings. These intervenors have also asserted that past
property tax savings totaling as much as approximately $66 million as of
September 30, 1996, plus interest should be returned to customers.
Management believes that, under the CPUC's regulatory framework, any
property tax savings should be treated only as a component of the
calculation of shareable earnings not as an exogenous cost. In an
Interim Opinion issued in June 1995, the CPUC decided to defer a final
decision on this matter pending resolution of the criteria for exogenous
cost treatment under its regulatory framework. The criteria are being
considered in a separate proceeding initiated for rehearing of the CPUC's
postretirement benefits other than pensions decision discussed above. It
is possible that the CPUC could decide this issue in the near term, and
that the decision could have a material adverse effect on the Company.
C. DEBT ISSUANCES
The Company issued $500 million of debentures, $250 million in February
1996 at 5.875 percent due February 15, 2006, and $250 million in August
1996 at 6.875 percent due August 15, 2006. Neither issue may be redeemed
prior to maturity. The proceeds from the sale of the debentures were
used to reduce short-term debt incurred to retire the Company's
debentures totaling approximately $500 million called in December 1995.
The Company has remaining CPUC authority, which will expire December 31,
1996, to issue up to $750 million of long- and intermediate-term debt.
The Company plans to make an application to renew this authority. The
proceeds may be used only to redeem maturing debt and to refinance other
debt issues. The Company has remaining authority from the SEC to issue up
to $150 million of long- and intermediate-term debt through a shelf
registration filed in April 1993.
9
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Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
In addition to historical information contained herein, this quarterly report
on Form 10-Q contains certain forward-looking statements that involve
potential risks and uncertainties. Pacific Bell's (the "Company") future
results could differ materially from those discussed herein. Factors that
could cause or contribute to such differences include, but are not limited to,
those discussed herein and those discussed in "Management's Discussion and
Analysis of Results of Operations" included in the Company's December 31, 1995
Form 10-K. Readers are cautioned not to place undue reliance on these
forward-looking statements which speak only as of the date hereof. The
Company undertakes no obligation to revise or update these forward-looking
statements to reflect events or circumstances after the date hereof or to
reflect the occurrence of unanticipated events.
RESULTS OF OPERATIONS
The following discussions and data compare the results of operations of the
Company for the nine-month period ended September 30, 1996 to the
corresponding period in 1995. Results for the first nine months of 1996 may
not be indicative of results for the full year.
A summary of selected operating data is shown below:
For the 9 Months Ended
September 30,
-----------------------
%
Operating Statistics 1996 1995 Change
- ----------------------------------------------------------------------------
Return on shareowner's equity (%)............... 36.4 -57.5 -
Capital expenditures ($mil)..................... 1,596 1,201 32.9
Total employees at September 30................. 46,193 48,359 -4.5
Telephone network employees at September 30*.... 43,444 45,793 -5.1
Telephone network employees per ten thousand
access lines*................................. 27.1 29.8 -9.1
============================================================================
* Excludes Pacific Bell Directory and Pacific Bell Mobile Services
employees.
10
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Earnings
- --------
The Company's earnings continue to reflect revenue growth from increased
customer demand for local telephone products associated with marketing efforts
and California's growing economy, offset by expenses to prepare to enter new
businesses and to comply with local competition mandates. The Company
reported net income of $883 million for the first nine months of 1996, an
18.2 percent increase over the $747 million before extraordinary item reported
for the same period last year. The extraordinary item was a one-time, non-
cash, after-tax charge of $3.4 billion recorded in third quarter 1995. The
extraordinary charge resulted from the discontinued application by the Company
of special accounting rules for entities subject to traditional regulation and
its change to the general accounting rules used by competitive enterprises.
(See "Extraordinary Item" on page 17.)
For the first nine months in 1995, pressure on earnings before extraordinary
item resulted from incremental labor expense associated with the severe storms
in early 1995. These earnings decreases in 1995 were partially offset by the
Company's ongoing cost-reduction efforts.
The California Public Utilities Commission ("CPUC") authorized facilities-
based local services competition effective January 1996, and resale
competition effective March 1996. Certain issues remain open in the local
competition proceedings. (See "CPUC Local Services Competition" on page 22.)
As of September 30, 1996, such competition had not yet had a significant
effect on the Company's earnings. In August 1996, the Federal Communications
Commission ("FCC") released a decision establishing guidelines to implement
the 1996 Telecommunications Act, which sets additional rules for opening local
telecommunications markets to full competition. (See "FCC Interconnection
Order" on page 21.) Management is concerned that final terms set by
regulators could deprive the Company of the opportunity to earn a fair return
on investment.
11
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Volumes
- ------- For the 9 Months Ended
September 30,
-------------------------
%
Volume Indicators 1996 1995 Change
- -----------------------------------------------------------------------------
Switched access lines in service
at September 30 (thousands)..................... 16,018 15,348* 4.4
Residence.................................... 9,979 9,621* 3.7
Business..................................... 5,829 5,521* 5.6
Other........................................ 210 206* 1.9
ISDN access lines (Included in above
access lines).............................. 90 43 109.3
Interexchange carrier access
minutes-of-use (millions)...................... 47,307 43,210 9.5
Interstate................................... 25,961 23,715 9.5
Intrastate................................... 21,346 19,495 9.5
Toll messages (millions)......................... 3,870 3,596 7.6
Toll minutes-of-use (millions)................... 11,521 10,825 6.4
Voice mailbox equivalents at Sept. 30(thousands). 1,649 1,360 21.3
Custom calling services at Sept. 30(thousands)... 7,758 7,037 10.3
============================================================================
* Restated
The total number of access lines in service grew to 16.018 million, an
increase of 4.4 percent for the twelve months ended September 30, 1996. This
is an improvement over the 2.7 percent increase for the same period last year.
The residential access line growth rate increased to 3.7 percent for the
twelve months ended September 30, 1996, from 1.7 percent last year. Changes
in technology, telecommuting, Internet access and the Company's marketing
efforts continue to fuel increased demand for additional telephone lines in
the home. Second access lines in residences grew 14.1 percent from
1.732 million lines to 1.976 million lines for the twelve months ended
September 30, 1996. The growth rate in business access lines was 5.6 percent
for the twelve months ended September 30, 1996, up from 4.4 percent for the
same period last year. The number of ISDN lines in service for the Company
grew to 90 thousand, an increase of 109.3 percent for the twelve months ended
September 30, 1996, as customers increased telecommuting and demanded faster
data transmission and Internet access. Accelerated demand for the Company's
high-speed data transmission continued through the third quarter due to the
Company's intensified marketing efforts.
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, 1996 increased by 9.5 percent over the
same period last year. The increase in access minutes-of-use was primarily
attributable to the continued economic growth in California.
12
<PAGE>
Toll messages and minutes-of-use are comprised of Message Telecommunications
Service and Optional Calling Plans ("local toll") as well as WATS and
terminating 800 services. For the nine months ended September 30, 1996, toll
minutes-of-use increased by 6.4 percent driven by the continued economic
growth in California.
High demand for the Company's voice mail products continued in 1996. Voice
mailbox equivalents in service increased 21.3 percent for the twelve months
ended September 30, 1996 to 1.649 million. Similarly, demand for custom
calling services, such as call waiting, grew 10.3 percent for the twelve
months ended September 30, 1996 due to California's growing economy and the
Company's focused customer retention efforts.
Operating Revenues
- ------------------
For the 9 Months Ended
September 30,
------------------------
($ millions) 1996 1995 Change
- -----------------------------------------------------------------------------
Total operating revenues ....................... $7,012 $6,626 $386
5.8%
- -----------------------------------------------------------------------------
Revenues for the first nine months of 1996 increased from the same period last
year primarily due to increased customer demand for the Company's telephone
services driven by marketing efforts and California's growing economy.
Revenues for the nine-months ended September 30, 1996 were offset by a
$55 million rate reduction due to FCC price cap orders. Revenues for the
six months ended June 30, 1996, decreased $60 million due to the FCC price cap
filing for the twelve months ending June 30, 1996. For the 1996 annual access
tariffs filings effective July 1, 1996, revenues increased approximately
$5 million for the three-month period ending September 30, 1996. (See "FCC
Annual Access Tariff Filing and Regulatory Framework Review" on page 22.) The
CPUC price cap order effective January 1, 1996, had a minimal effect on the
Company's revenues due to an order in December 1995 suspending use of the
"inflation minus productivity" component of the price cap formula for 1996
through 1998. This action freezes the price caps on most of the Company's
regulated services through 1998 except for adjustments due to exogenous costs
or price changes approved through the CPUC's application process. (See "CPUC
Regulatory Framework Review" on page 23.)
13
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Factors affecting revenue changes are summarized in the following table.
Total
Price Change
Cap Customer From
Orders Misc. Demand 1995
- -----------------------------------------------------------------------------
Local service........................ $ - $15 $144 $159
Network access:
Interstate......................... -55 54 82 81
Intrastate......................... - -19 36 17
Toll service......................... - -24 67 43
Other service revenues............... - 10 76 86
----- ----- ----- ----
Total operating revenues............. $-55 $36 $405 $386
=============================================================================
The $144 million increase in customer demand for local service revenues is the
result of the 4.4 percent growth in access lines and the 10.3 percent growth
in custom calling services. These increases were generated by the continuing
growth in the California economy and the Company's focused customer retention
efforts. In addition, the Company introduced a new feature, "Call Return," on
a "pay-per-use" basis in April 1996 that generated revenues of approximately
$30 million for 1996.
The $82 million increase in interstate network access revenues due to customer
demand reflects increased interexchange carrier access minutes-of-use, as well
as increased access lines. The $36 million customer demand-related increase
in intrastate network access revenues also resulted from growth in access
minutes-of-use.
The $67 million increase in toll service revenues due to customer demand was
driven primarily by increased local toll usage resulting from general economic
growth. The customer demand-related increase in local toll service revenues
was partially offset by competitive losses in WATS and 800 services.
Interexchange carriers currently have the competitive advantage of being able
to offer WATS and 800 service both within and between service areas.
The $76 million increase in other service revenues due to customer demand
reflects the continuing success of the Company's voice mail products and
directory operations. In addition, primarily in the second and third quarters
of 1996, customer demand-related revenues increased in the Company's network
integration services.
14
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Operating Expenses
- ------------------
For the 9 Months Ended
September 30,
------------------------
($ millions) 1996 1995 Change
- -----------------------------------------------------------------------------
Total operating expenses....................... $5,250 $5,155 $95
1.8%
- -----------------------------------------------------------------------------
Total operating expenses for the nine-month period ended September 30, 1996
increased when compared with 1995 reflecting costs for increased demand for
products and services, new business initiatives and costs incurred to prepare
for local competition. Increased expenses were partially offset by cost
reductions from the Company's ongoing efficiency efforts and savings due to
changes in employee benefit plans and benefit plan assumptions. Primary
factors affecting expense changes are summarized below.
Total
Change
Salaries Employee Subsi- From
($ millions) & Wages* Benefits* Misc.* diaries 1995
- -----------------------------------------------------------------------------
Cost of products and services.. $6 $-94 $55 $-3 $-36
Customer operations
and selling expenses......... 6 -49 29 88 74
General, administrative
and other expenses........... 5 -12 112 -28 77
Property and other taxes....... - - -9 - -9
Depreciation and amortization.. - - -15 4 -11
---- ---- ---- ---- ----
Total operating expenses....... $17 $-155 $172 $61 $95
=============================================================================
* Excludes Pacific Bell subsidiaries.
Excluding its subsidiaries, the Company's salary and wage expense for the
nine-month period ended September 30, 1996 increased $17 million compared to
the same period in 1995, primarily due to wage increases associated with new
labor agreements effective August 1995 and overtime in the second and third
quarters of 1996 due to increased business volumes. These increases were
mostly offset by force reduction programs. Decreased overtime in first
quarter 1996 due to milder weather when compared to 1995 also partially offset
the increases.
15
<PAGE>
Excluding its subsidiaries, the Company's employee benefits expense for the
nine-month period ended September 30, 1996 decreased $155 million compared to
the same period in 1995 primarily due to changes in employee benefit plans and
a related remeasurement of benefit plan expense. The changes in employee
benefit plans and benefit plan assumptions will continue to produce savings
through year end and are expected to produce savings in future periods. (See
"Change In Estimates" under Note A on page 6.)
Excluding its subsidiaries, the Company's miscellaneous cost of products and
services, and general, administrative and other expenses increased for the
nine-month period ended September 30, 1996 compared to 1995 primarily due to
costs incurred to prepare for local competition and contract services
associated with increased demand for products and services.
Excluding its subsidiaries, the Company's miscellaneous property and other
taxes decreased for the nine-month period ended September 30, 1996 compared to
1995 primarily due to nonrecurring audit adjustments accrued in 1995.
Depreciation expense at the Company, excluding its subsidiaries, decreased
$15 million for the nine-month period ended September 30, 1996 compared to
1995 primarily due to the elimination of the amortization of certain
regulatory assets associated with the discontinued application of Statement of
Financial Accounting Standards No. ("SFAS") 71, "Accounting for the Effects of
Certain Types of Regulation." (See "Extraordinary Item" on page 17.) The
effect of this decrease was partially offset by higher telecommunications
plant balances.
The Company's subsidiaries' customer operations and selling expenses
increased $88 million for the nine-month period ended September 30, 1996
compared to 1995 due to new business initiatives, such as Personal
Communications Services ("PCS"), Internet access and network integration.
The Company's subsidiaries' general, administrative and other expenses
decreased $28 million for the nine-month period ended September 30, 1996
compared to 1995 primarily due to reduced software expenses.
Interest Expense
- ----------------
For the 9 Months Ended
September 30,
------------------------
($ millions) 1996 1995 Change
- -----------------------------------------------------------------------------
Interest expense................................ $277 $327 $-50
-15.3%
- -----------------------------------------------------------------------------
Interest expense decreased for the nine-month period ended September 30, 1996
compared to 1995. This decrease was due to lower interest rates and a change
in classification of interest capitalized during construction from an item of
other income to a reduction in interest expense due to the discontinued
application of SFAS 71.
16
<PAGE>
Other Income (Expense) - Net
- ----------------------------
For the 9 Months Ended
September 30,
-----------------------
($ millions) 1996 1995 Change
- ------------------------------------------------------------------------------
Other income (expense) - net .................. $4 $ 45 $-41
-91.1%
- ------------------------------------------------------------------------------
Other income (expense)-net decreased for the nine-month period ended September
30, 1996 compared to 1995 primarily due to a change in classification of
interest capitalized during construction from an item of other income to a
reduction of interest expense and due to interest income received on a tax
refund in first quarter 1995.
Income Taxes
- ------------
For the 9 Months Ended
September 30,
------------------------
($ millions) 1996 1995 Change
- ------------------------------------------------------------------------------
Income taxes...................................... $606 $442 $164
37.1%
- ------------------------------------------------------------------------------
Income tax expense increased for the nine-month period ended September 30,
1996 compared to 1995 primarily due to higher pre-tax income and tax
adjustments.
Extraordinary Item
- ------------------
Effective third quarter 1995, for external financial reporting purposes, the
Company discontinued the application of SFAS 71, an accounting standard for
entities subject to traditional regulation. As a result, during third quarter
1995 the Company recorded a non-cash, extraordinary, after-tax charge of
$3.4 billion.
17
<PAGE>
Status of Reserves
- ------------------
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 reduction for the Company, excluding its
subsidiaries, was approximately 1,225 employees for the first nine months of
1996. A total of $141 million in cash outlays was charged to the reserve in
the first nine months of 1996. In 1995, the Company charged $219 million to
the restructuring reserve for the cost through 1997 of enhanced retirement
benefits negotiated in the 1995 union contracts. Based on its experience, the
Company this year revised its estimate of these retirement costs.
Consequently, $64 million of these 1995 noncash charges were reversed in
second quarter 1996. There was no effect on net income from either the 1995
charge or the 1996 change in estimate. As of September 30, 1996 $142 million
remained in the restructuring reserve.
Capital Expenditures
- --------------------
The Company invested $1,596 million through September 30, 1996, primarily in
the Company's core telecommunications network and the Pacific Bell Mobile
Services PCS network.
18
<PAGE>
CREDIT RATINGS
In March 1996, Moody's Investors Services, Inc. ("Moody's"), placed the senior
long-term debt ratings of the Company under review for possible downgrade. In
August 1996, Moody's downgraded the Company's debentures and notes to A1 from
Aa3 and the shelf registration of debt securities to (P)A1 from (P)Aa3. The
downgrades were prompted by Moody's concerns about the ability of the Company
to continue to generate the same level of highly predictable cash flows in an
increasingly uncertain competitive and regulatory environment.
In April 1996, reflecting the announcement of the merger agreement with
SBC Communications Inc. ("SBC"), Standard & Poor's Corporation reaffirmed its
rating of Double-A-Minus ("AA-") on the Company's debentures and its credit
rating outlook as negative. (See "Merger Agreement" under Note B on page 7.)
Also reflecting the merger agreement announcement, Duff and Phelps, Inc.
reaffirmed its ratings of Duff 1+ and Double-A-Minus ("AA-") on the Company's
commercial paper and debentures, respectively.
The following are commercial paper and bond ratings for the Company as of
September 30, 1996:
Moody's Investors Standard & Duff and
Services, Inc. Poor's Corp. Phelps, Inc.
----------------- ------------ ------------
Commercial Paper............ Prime-1 A-1+ Duff 1+
Long- and Intermediate-
Term Debt................ A1 AA- AA-
The above ratings reflect the views of the rating agencies and are subject to
change. The ratings should be evaluated independently and are not
recommendations to buy, sell, or hold the securities of the Company.
19
<PAGE>
MERGER AGREEMENT
On April 1, 1996, SBC and Pacific Telesis, the Company's parent, jointly
announced a definitive agreement whereby Pacific Telesis will become a wholly-
owned subsidiary of SBC. Under terms of the merger agreement, each share of
Pacific Telesis common stock will be exchanged for 0.733 shares of SBC common
stock, subject to adjustment. The transaction is intended to be accounted for
as a pooling of interests and to be a tax-free reorganization. On July 31,
1996, the shareowners of Pacific Telesis and SBC approved the transaction,
which previously had been approved by the respective Board of Directors of
each company. On November 5, 1996, the U.S. Department of Justice announced
it had concluded that the merger does not violate the antitrust laws and
accordingly that it was closing its investigation into the merger. The merger
is subject to certain other conditions and regulatory approvals. The
California Public Utilities Commission ("CPUC") has established a schedule for
review of the transaction with final comments from interested parties due in
January 1997. On September 30, 1996, the Office of Ratepayer Advocates
("ORA"), the consumer interest branch of the CPUC, filed testimony in the
merger proceeding recommending a $2.1 billion refund to customers payable over
five years. Management does not agree with the ORA's recommendation and
believes no customer rebate should be required in connection with the merger.
The CPUC is expected to make a final decision on the merger by the end of
March 1997. In Nevada, SBC and Pacific Telesis entered into a stipulation
with the staff of the Public Service Commission of Nevada ("PSCN") and the
Office of the Consumer Advocate to refund to customers the greater of
$4 million or 2.0 percent of the amount, if any, ordered by the CPUC to be
refunded to Pacific Bell customers. The refund is conditioned on approval of
the stipulation by the PSCN and closing of the merger. The PSCN has scheduled
hearings for November 25, 1996, and approval is expected in December 1996. If
all necessary approvals are granted, the transaction is expected to close in
the first quarter of 1997.
PENDING REGULATORY ISSUES
FCC Recommendation on Universal Service
- ---------------------------------------
On November 7, 1996, the Joint Federal-State Board on Universal Service (the
"Board") issued a recommendation on how to implement sections of the 1996
Telecommunications Act regarding universal service. Generally the plan
creates a system that identifies cost subsidies in rural and high-cost areas.
However, the Board deferred a recommendation on how large the subsidy should
be. The Board also recommended creation of a $2.25 billion fund for providing
discounted services to schools and libraries. The FCC has until May 8, 1997
to issue a final decision on this matter.
20
<PAGE>
FCC Interconnection Order
- -------------------------
In August 1996, the FCC released a decision (the "Interconnection Order")
establishing guidelines to implement the 1996 Telecommunications Act, which
sets rules for opening local telecommunications markets to full competition.
The Interconnection Order lays out how long-distance companies and other new
competitors may connect to local networks and sets guidelines and prices for
network components. Management believes that the Interconnection Order
undermines the intent of the 1996 Telecommunications Act by, among other
things, denying states a role in managing and setting prices for local
markets. Management is also concerned that the order requires local telephone
companies to offer wholesale network services at unrealistically low prices.
The Company, along with other local telephone companies, the National
Association of Regulatory Utility Commissioners and state PUCs including the
CPUC, appealed the Interconnection Order to a federal court. On October 15,
1996, the U.S. Court of Appeals for the Eighth Circuit (the "Court of
Appeals") issued a partial stay of the Interconnection Order that stays the
operation and effect of the pricing provisions and the "pick and choose" rule,
but allows the non-pricing elements of the order to go into effect. The U.S.
Supreme Court issued a memorandum decision on November 12, 1996 refusing to
overturn the stay imposed by the Court of Appeals.
The Interconnection Order also addressed the issue of wireless
interconnection, or the arrangements under which local exchange carriers
("LECs") are compensated for interconnecting with and terminating traffic for
commercial mobile radio service ("CMRS") providers (including cellular, PCS
and paging). The Interconnection Order ruled that CMRS providers are entitled
to reciprocal compensation arrangements for transport and termination of local
telecommunications traffic. On November 1, 1996 the Court of Appeals lifted a
part of the stay described above with respect to the non-price aspects of the
FCC's reciprocal compensation rules for CMRS providers. As a result of this
order, the Company is currently renegotiating its CMRS contracts.
21
<PAGE>
FCC Annual Access Tariff Filing and Regulatory Framework Review
- ---------------------------------------------------------------
The Company filed its 1996 annual access tariffs with the FCC, which will
increase annual revenues by approximately $27 million, for the twelve months
beginning July 1, 1996. The revenue increases are under review by the FCC.
The FCC adopted new interim price cap rules in 1995 that govern the prices
that the larger LECs, including the Company, charge interexchange carriers for
access to local telephone networks. The interim rules require the LECs to
adjust their maximum prices for changes in inflation, productivity and certain
costs beyond the control of the LEC. Under the interim plan, LECs may choose
from three productivity factors: 4.0, 4.7 or 5.3 percent. Election of the
5.3 percent productivity factor permits the LEC to retain all of its earnings
whereas the other lower productivity factors require earnings to be shared
with customers. As in 1995, the Company again chose the 5.3 percent
productivity factor that will enable it to retain all of its earnings
effective July 1, 1996. The higher productivity factor was chosen because
management believes that it will be more than offset by elimination of the
sharing mechanism. An FCC ruling on permanent price cap rules has been
delayed until 1997 due to the implementation of the 1996 Telecommunications
Act.
Management continues to believe that the FCC should adopt pure price cap
regulation and eliminate the productivity factor, sharing and earnings cap.
CPUC Local Services Competition
- -------------------------------
The CPUC authorized facilities-based local services competition effective
January 1996 and resale competition effective March 1996. Several issues
still need to be resolved in order to implement competition in all California
telecommunications markets. Issues to be finalized include final rates for
resale and number portability, LEC provisioning and pricing of essential
network functions to competitors and presubscription. The CPUC expects to
issue final rules on presubscription in early 1997 and final rates and rules
for all other issues in late 1997.
Management believes that all markets should be open to all competitors under
the same rules at the same time, and that a truly open competitive market, in
which the Company can compete without restrictions, offers long-term
opportunity to build the business.
22
<PAGE>
CPUC Decision on Universal Service
- ----------------------------------
The CPUC issued its final decision on universal service on October 25, 1996,
establishing an annual California universal service fund of approximately
$352 million. Customers of all telecommunications providers will contribute
to the preservation of affordable telephone service via a 2.87 percent
surcharge on all bills for telecommunications services provided in California.
The new program will go into effect February 1, 1997. Applications for
rehearing are due on December 4, 1996. Management is evaluating whether to
seek rehearing.
Management is concerned that the decision underestimates the true cost of
providing universal telephone service. While $305 million of the total
$352 million is expected to be paid to the Company, this is far short of what
the Company estimates the true cost of providing universal service to be. The
Company developed a Cost Proxy Model to calculate the cost of service in
California. That model estimated the average cost of providing service to be
$27 per line per month. The CPUC uses the model for the new program, but has
determined that the average cost is only $20.30 per line per month.
In order to ensure revenue neutrality, the Company must offset its rates
dollar for dollar for any funds it receives from the newly created universal
service fund. This offset will initially be accomplished by means of an
across-the-board surcredit on all of the Company's products and services
except for residential basic exchange services.
The final decision also establishes a discount program for schools, libraries,
certain community-based organizations and municipal- and county-owned
hospitals and clinics. Carriers providing services at a discounted price will
be reimbursed from a newly created California Teleconnect Fund. This discount
program will be funded by a separate surcharge of 0.41 percent on the bills of
customers of all telecommunications carriers in California.
CPUC Regulatory Framework Review
- --------------------------------
As previously reported, in December 1995, the CPUC issued an order in its
review of the regulatory framework in California. The order suspended use of
the "inflation minus productivity" component of the price cap formula for 1996
through 1998. This action freezes the price caps on most of the Company's
regulated services for the years 1996 through 1998 except for adjustments due
to exogenous costs or price changes approved through the CPUC's application
process. In October 1996, the Company filed an application with the CPUC to
adjust its rates due to exogenous cost changes, proposing an annual revenue
reduction of approximately $65 million effective January 1, 1997. The CPUC is
expected to issue a decision before the end of 1996.
23
<PAGE>
PART II. OTHER INFORMATION
Item 6. Exhibits
(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 1996 Form 10-Q.
The Company will furnish to a security holder upon request a copy of any
exhibit at cost.
24
<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
Date: November 13, 1996
25
<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 1996 Form 10-Q.
26
<PAGE>
EXHIBIT 15
----------
COOPERS & LYBRAND L.L.P.
November 13, 1996
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Ladies and Gentlemen:
Re: Pacific Bell Registration Statement on Form S-3
----------------------------------------------------
We are aware that our report dated November 13, 1996 on our review of the
interim financial information of Pacific Bell and Subsidiaries for the nine-
month period ended September 30, 1996 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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<PAGE>
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<PERIOD-START> JAN-01-1996
<PERIOD-END> SEP-30-1996
<PERIOD-TYPE> 9-MOS
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0
0
<OTHER-SE> 3,137
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