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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
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(X) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
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For The Fiscal Year Ended December 31, 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
A California Corporation I.R.S. Employer Number 94-0745535
140 New Montgomery Street, San Francisco, California 94105
Telephone - Area Code (415) 542-9000
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Securities registered pursuant to Section 12(b) of the Act:
See attached Schedule A.
Securities registered pursuant to Section 12(g) of the Act: None.
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 .
--- ---
THE REGISTRANT, A WHOLLY OWNED SUBSIDIARY OF PACIFIC TELESIS GROUP, MEETS THE
CONDITIONS SET FORTH IN GENERAL INSTRUCTION J (1) (a) AND (b) OF FORM 10-K AND
IS THEREFORE FILING THIS FORM WITH REDUCED DISCLOSURE FORMAT PURSUANT TO
GENERAL INSTRUCTION J(2).
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SCHEDULE A
Securities registered pursuant to Section 12(b) of the Act*:
Name of each exchange
Title of each class on which registered
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7.250% Debenture due 02/01/08 New York Stock Exchange
Pacific Stock Exchange
7.250% Note due 07/01/02 New York Stock Exchange
6.250% Note due 03/01/05 New York Stock Exchange
7.125% Debenture due 03/15/26 New York Stock Exchange
7.500% Debenture due 02/01/33 New York Stock Exchange
6.875% Debenture due 08/15/23 New York Stock Exchange
6.625% Debenture due 10/15/34 New York Stock Exchange
* Pacific Bell has other securities outstanding not registered pursuant
to Section 12(b) of the Act.
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TABLE OF CONTENTS
Item Description Page
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PART I
1. Business (Abbreviated pursuant to General Instruction J(2))... 1
2. Properties....................................................11
3. Legal Proceedings.............................................12
4. Submission of Matters to a Vote of Security Holders (Omitted
pursuant to General Instruction J(2))
PART II
5. Market for Registrant's Common Equity and Related Stockholder
Matters.......................................................12
6. Selected Financial Data (Omitted pursuant to General
Instruction J(2))
7. Management's Discussion and Analysis of Results of Operations.13
8. Financial Statements and Supplementary Data...................33
9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure......................................65
PART III
10. Directors and Executive Officers of Registrant (Omitted
pursuant to General Instruction J(2))
11. Executive Compensation (Omitted pursuant to General
Instruction J(2))
12. Security Ownership of Certain Beneficial Owners and Management
(Omitted pursuant to General Instruction J(2))
13. Certain Relationships and Related Transactions (Omitted
pursuant to General Instruction J(2))
PART IV
14. Exhibits, Financial Statement Schedules and Reports on
Form 8-K......................................................66
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PART I
Item 1. Business.
GENERAL
Pacific Bell(R) (the "Company") was incorporated in 1906 under the laws of the
State of California and has its principal executive offices at 140
New Montgomery Street, San Francisco, California 94105 (telephone number (415)
542-9000).
Through December 31, 1983, the Company was a subsidiary of AT&T Corp.
("AT&T"). Effective January 1, 1984, the Company became a subsidiary of
Pacific Telesis Group(R) ("Pacific Telesis"), one of the seven regional
holding companies ("RHCs") formed in connection with the 1984 divestiture by
AT&T of its 22 wholly owned operating telephone companies ("Bell Operating
Companies" or "BOCs") pursuant to a consent decree settling antitrust
litigation ("Consent Decree") approved by the United States District Court for
the District of Columbia.
PLANNED MERGER WITH SBC COMMUNICATIONS INC.
On April 1, 1996, SBC Communications Inc. ("SBC") and Pacific Telesis 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. The merger is
subject to certain conditions and regulatory approvals. The merger has been
approved by the shareowners of Pacific Telesis and SBC, the Federal
Communications Commission ("FCC") and the Public Service Commission of Nevada
("PSCN"). The U.S. Department of Justice concluded that the merger does not
violate the antitrust laws. In addition, the California State Attorney
General has told the California Public Utilities Commission ("CPUC") that the
merger will not hurt competition in California and is consistent with emerging
trends. On February 21, 1997, two California administrative law judges
("ALJs") issued a proposed decision approving the merger but with a number of
conditions, including payments to customers of up to $750 million and funding
for consumer education efforts and telecommunications services in underserved
California communities (the "community partnership commitment"). An alternate
proposed decision, authored by two Commissioners, which calls for more than
$286 million in payments to California customers and other conditions, was
released on March 17, 1997. A second alternate decision, released by a third
Commissioner later the same day, would reduce the payments called for by the
ALJs' proposal to over $523 million and impose conditions in addition to those
imposed by the ALJs' proposed decision. Both of the proposed alternate
decisions include the $54.7 million community partnership commitment. The
five-member Commission is expected to issue its decision on March 31, 1997 by
adopting one of the proposed decisions. If the Commission determines,
however, to make substantive changes on March 31st, additional CPUC
proceedings would be required, which would have the effect of deferring the
final decision. If approval from the CPUC is granted, the transaction is
expected to close early in the second quarter of 1997. Details of the proposed
merger with SBC appear in "Management's Discussion and Analysis of Financial
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Condition and Results of Operations ("MD&A")."
SBC is a holding, including certain financial information appear in company
whose subsidiaries and affiliates operate predominately in the communications
services industry. SBC's subsidiaries and affiliates provide landline and
wireless telecommunications services and equipment, directory advertising,
publishing and cable television services. Southwestern Bell Telephone Company
is SBC's largest subsidiary, providing telecommunications services in Texas,
Missouri, Oklahoma, Kansas and Arkansas.*
___________________________
* SBC is subject to the informational reporting requirements of the Securities
Exchange Act of 1934, as amended, and in accordance therewith files reports,
including reports on Form 8-K which present proforma combined condensed
financial statements of SBC and Pacific Telesis, proxy statements and other
information with the Securities and Exchange Commission ("SEC"). Such
reports, proxy statements and other information may be inspected and copied
at the public reference facilities maintained by the SEC at Room 1024,
Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549, and at the
SEC's regional offices located at 7 World Trade Center, 13th Floor, New
York, New York 10019 and Northwestern Atrium Center, 500 West Madison
Street, Suite 1400, Chicago, Illinois 60661. Copies of such material may be
obtained by mail from the Public Reference Section of the SEC at Judiciary
Plaza, 450 Fifth Street, N.W. Washington, D.C. 20549, at prescribed rates.
The SEC maintains a World Wide Web site at http://www.sec.gov that contains
reports, proxy and information statements and other information regarding
entities that file electronically with the SEC, including SBC. In addition,
reports, proxy statements and other information concerning SBC may be
inspected at the offices of the following stock exchanges on which the
common stock of SBC is traded: the New York Stock Exchange, 20 Broad
Street, New York, New York 10005; the Chicago Stock Exchange, One Financial
Place, 440 South La Salle Street, Chicago, Illinois 50504; and the Pacific
Stock Exchange, 301 Pine Street, San Francisco, California 94104. Pacific
Telesis does not assume any responsibility for the accuracy or completeness
of the information concerning SBC contained in such documents and does not
warrant that there have not occurred events not yet publicly disclosed
concerning SBC included therein.
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THE COMPANY AND ITS SUBSIDIARIES
The Company 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, provide a
variety of communications and information services in California. These
services include: (1) dialtone and usage services, including local service
(both exchange and private line), message toll services within a service area,
Wide Area Toll Service ("WATS")/800 services within a service area, Centrex
service (a central office-based switching service) and various special and
custom calling services; (2) exchange access to interexchange carriers and
information service providers for the origination and termination of switched
and non-switched (private line) voice and data traffic; (3) personal
communications services ("PCS"), a new generation of wireless services; (4)
billing services for interexchange carriers and information service providers;
(5) various operator services; (6) installation and maintenance of customer
premises wiring; (7) public communications services; (8) directory
advertising; (9) selected information services, such as voice mail; (10)
Internet access; and (11) network integration services.
Pacific Bell Directory ("Directory") publishes the Pacific Bell SMART Yellow
Pages(R). It is the oldest and largest publisher of Yellow Pages in
California and is among the largest Yellow Pages publishers in the United
States. As part of its ongoing small business advocacy efforts, Directory
produces an award-winning publication in partnership with the U.S. Small
Business Administration. "Small Business Success," now in its ninth year,
addresses topics of importance to entrepreneurs.
Pacific Bell Information Services ("PBIS") provides business and residential
voice mail and other selected information services. Current products include
The Message Center(SM) for home use, Pacific Bell Voice Mail(SM) for
businesses and Pacific Bell Call Management(SM), a service that handles
incoming business calls and connects computer databases to answer routine
customer questions.
Pacific Bell Mobile Services ("PBMS") was formed to offer PCS services in
California and Nevada. Unlike cellular service, PCS is a digital wireless
service that is 100 percent digital and offers superior sound quality and
protection from eavesdropping and cloning. The network incorporates the
Global System for Mobile Communications ("GSM") standard which is widely used
internationally. PBMS phones for PCS feature a built-in pager and answering
machine. PBMS began providing service in August 1996 and in Las Vegas, Nevada
in February 1997. The Company expects a widespread offering of PCS service in
most of California and Nevada by mid-1997.
Pacific Bell Internet Services ("PBI") was formed in 1995 to provide Internet
access services to a broad range of customers in California. PBI began
providing Internet access to large businesses in the third quarter of 1995 and
to residential customers in May 1996. PBI was one of the fastest growing
internet service providers in California in 1996.
Pacific Bell Network Integration ("PBNI") began assisting customers with the
implementation of information technology networks in mid-1996. PBNI offers
network design, installation and maintenance, as well as network management
and consulting services. In December 1996, Pacific Bell unveiled its new ISDN
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Home Pack(TM), one of the nation's first fully integrated ISDN and Internet
packages. The package includes Internet access through Pacific Bell's
Internet service network, a terminal adapter and Internet browser software.
PBI is responsible for integrating the whole package and managing delivery of
the hardware and software components.
PRINCIPAL SERVICES
Significant components of the Company's operating revenues are depicted in the
chart below:
% of Total Operating Revenues
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Revenues by Major Category 1996 1995
- ----------------------------------------------------------------------
Local Service
Recurring.............................. 27% 28%
Other Local............................ 15% 15%
Network Access
Carrier Access Charges................. 20% 20%
End User & Other....................... 7% 7%
Toll Service
Message Toll Service................... 12% 12%
Other.................................. 1% 1%
Other Service Revenues
Directory Advertising.................. 11% 11%
Other.................................. 7% 6%
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TOTAL..................................... 100% 100%
The percentages of total operating revenues attributable to interstate and
intrastate telephone operations are displayed below:
% of Total Operating Revenues
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1996 1995
- ----------------------------------------------------------------------
Interstate telephone operations............ 20% 19%
Intrastate telephone operations............ 80% 81%
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TOTAL...................................... 100% 100%
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TELECOMMUNICATIONS ACT OF 1996
The Telecommunications Act became effective on February 8, 1996. The
Telecommunications Act provides that any conduct or activity previously
subject to the Consent Decree occurring after February 8, 1996 will be subject
to the Communications Act of 1934 (the "Communications Act"), as amended by
the Telecommunications Act, not the Consent Decree. (The terms of the Consent
Decree, with certain exceptions, applied generally to all BOCs and their
affiliates.) The Telecommunications Act is the broadest reform of the
telecommunications industry since the Communications Act. The
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Telecommunications Act essentially opens all telecommunications markets and
prohibits the states from continuing or establishing any barriers to entry.
Once the new law is fully implemented, consumers will have many new options
for their local telephone, long-distance, and cable television services. The
Telecommunications Act will affect the Company as described below.
The Company may request authorization from the FCC to provide out-of-region
interLATA service and may provide certain incidental interLATA services
immediately. Before it can provide interLATA service that originates in
California or Nevada, the Company's local markets must be open to competition,
it must unbundle its network to other competitors and comply with the terms
and conditions of a "competitive checklist" specified in the
Telecommunications Act. The Company must request authority to offer in-region
interLATA service from the FCC. This service must initially be offered
through a separate affiliate. The separate affiliate requirement expires
three years after approval, unless extended by the FCC.
The Company may only engage in electronic publishing disseminated by means of
its basic telephone service through a separate affiliate or joint venture.
Joint marketing of electronic publishing services by the electronic publishing
affiliate and the Company is prohibited, with the exception of nonexclusive
inbound telemarketing and nondiscriminatory teaming or business arrangements.
The restrictions on electronic publishing expire in early 2000.
The Telecommunications Act allows for the continued provision by the Company
of intraLATA information services (other than electronic publishing), and
intraLATA Internet access. The Telecommunications Act also allows for the
provision by the Company of interLATA information storage and retrieval
services provided by a separate affiliate to and from the Company's databases.
Full interLATA information services may be provided through a separate
affiliate once the Company obtains authority to provide interLATA services
originating in California.
The Company may provide a variety of video programming services directly to
subscribers in its service areas under regulations that will vary according to
the type of services that are provided. The Company may provide video
services over wireless cable, as a common carrier, as a cable system operator,
as "interactive on-demand services," or as an "open video system."
Interactive on-demand services would allow unscheduled, point-to-point video
programming over the Company's switched networks on an on-demand basis. An
"open video system" would allow the Company to select programming for a
certain number of channels if demand exceeds capacity. An "open video
system" approved by the FCC would be subject to reduced regulatory burdens.
Subject to certain conditions, the Telecommunications Act allows the Company
to collaborate with manufacturers of telecommunications and customer premises
equipment during the design and development phases. The Company may also
engage in research and enter into royalty agreements in connection with the
manufacturing of telecommunications and customer premises equipment. The
Company may manufacture telecommunications and customer premises equipment,
subject to certain restrictions, once it has obtained authority to provide
interLATA services originating in California. Such manufacturing may be done
only through a separate affiliate. The separate affiliate requirement expires
three years after obtaining interLATA authority, unless extended by the FCC.
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FEDERAL REGULATION
The Company is subject to the jurisdiction of the FCC with respect to
interstate access charges and other interstate services. The FCC prescribes a
Uniform System of Accounts and interstate depreciation rates for operating
telephone companies. The FCC also prescribes "separations procedures," which
are used to allocate plant investment, expenses, taxes, and reserves between
interstate services under the jurisdiction of the FCC and intrastate services
under the jurisdiction of state regulatory authorities. The Company is also
required to file tariffs with the FCC for the services it provides. In
addition, the FCC establishes procedures for allocating costs and revenues
between regulated and unregulated activities.
Beginning in 1991, the FCC adopted a price cap system of incentive-based
regulation for Local Exchange Companies ("LECs"), including the Company. The
Company's access rates were retargeted to an 11.25 percent rate of return on
rate base assets. The FCC's price cap system provides a formula for adjusting
rates annually for changes in inflation less a productivity factor and changes
in certain costs that are triggered by administrative, legislative, or
judicial action beyond the control of the LECs.
In March 1995, the FCC adopted new interim price cap rules that govern the
prices that the larger 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 election of the lower productivity
factors requires earnings above certain thresholds to be shared with
customers. The Company has chosen the 5.3 percent productivity factor, which
enables it to retain all of its earnings after July 1, 1996.
The revised FCC price cap plan was intended to be an interim plan that would
be revised in 1996. However, with the passage of the Telecommunications Act
of 1996, the FCC is conducting further proceedings to address various pricing
and productivity issues, and is performing a broader review of price cap
regulation in a competitive environment.
The FCC is also examining universal service and access charge rules during
1997. Although the Joint Federal-State Board on Universal Service has
recently recommended a system that identifies cost subsidies in connection
with implementing a plan for universal service, no recommendation has yet been
issued as to the size or method of recovery of the necessary subsidies. The
Company expects FCC orders on universal service and access reform in May 1997.
In August 1996, the FCC released a decision (the "Interconnection Order")
establishing guidelines to implement certain provisions of the
Telecommunications Act which set rules for opening local telecommunications
markets to full competition. The Interconnection Order laid out how new local
exchange competitors may connect to local networks and set guidelines and
prices for network components and resold services. The Company, along with
other local telephone companies, the National Association of Regulatory
Utility Commissioners and several state PUCs including the CPUC, appealed the
Interconnection Order to a federal court. On October 15, 1996, the U.S.
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Court of Appeals for the Eighth Circuit (the "Eighth Circuit") issued a
partial stay of the Interconnection Order, staying the operation and effect of
the pricing provisions and the so-called "pick and choose" rule (the FCC rule
allowing new entrants to "pick and choose" individual terms from different
existing interconnection agreements), but allowing the non-pricing elements of
the order to go into effect. Upon consideration of a petition filed by the
FCC and certain other parties, the U.S. Supreme Court issued a memorandum
decision on November 12, 1996 refusing to overturn the stay imposed by the
Eighth Circuit.
The Interconnection Order also addressed the issue of wireless
interconnection, or the arrangements under which 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.
In December 1996, the FCC released a decision (the "Non-accounting Safeguards
Order") establishing rules to implement safeguards other than accounting
requirements that will apply when BOCs offer interLATA service that originates
in their regions. Pacific Telesis, together with another RHC, appealed one
aspect of the Non-accounting Safeguards Order to the U.S. Court of Appeals for
District of Columbia Circuit (the "D.C. Circuit"). In February, the parties
to the appeal petitioned the D.C. Circuit to summarily reverse, or expedite
its review of, the Non-accounting Safeguards Order to the extent that the
order prohibits a BOC from providing interLATA facilities or services to its
separate affiliate offering interLATA service within the BOC's region. In
late February the FCC requested that the D.C. Circuit remand the case to the
FCC for further consideration of the issues raised in the appeal. The D.C.
Circuit now has both Pacific Telesis' and the FCC's requests under review.
See "FCC Regulatory Framework Review," "FCC Recommendation on Universal
Service," and "FCC Interconnection Order" on pages 18 through 19 in "Item 7.
MD&A" for additional information on the regulation of the Company by the FCC.
STATE REGULATION
As a provider of telecommunications services in California, the Company is
subject to regulation by the CPUC with respect to intrastate prices and
services, intrastate depreciation rates, the issuance of securities, and other
matters.
The incentive-based regulatory framework adopted by the CPUC in 1989 is a form
of "price cap" regulation, which calls for the Company's sharing of earnings
with customers at certain earnings levels. All earnings below 11.5 percent
are retained by the Company. Earnings between 11.5 percent, which the CPUC
set as the Company's benchmark rate of return, and 15.0 percent are to be
shared equally between the Company and its customers. Earnings above
15.0 percent are to be shared 70.0 percent and 30.0 percent between the
Company and its customers, respectively.
Under "price cap" regulation, the CPUC requires the Company to submit an
annual price cap filing to determine prices for categories of services for
each new year. Price adjustments reflect the effects of any change in
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inflation less a productivity factor as well as adjustments for certain
exogenous cost changes. In December 1995, the CPUC issued an order in its
second review of the incentive-based regulatory framework. 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 three years except for adjustments due to
exogenous cost changes or price changes approved through the CPUC's
application process. The Company continues to believe that the CPUC should
permanently eliminate sharing, earnings caps, and all other vestiges of rate-
of-return regulation.
In December 1996, the CPUC adjusted the Company's rates due to exogenous cost
changes by an annual revenue reduction of approximately $66 million effective
January 1, 1997.
Effective January 1, 1995, the CPUC authorized toll services competition.
Management estimates that, as a result of official competition and unofficial
competitive losses in prior years, the Company currently serves less than 50
percent of the business toll market. 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.
The CPUC authorized facilities-based local competition effective January 1996
and resale competition effective March 1996. Interim rules addressing several
issues, including pricing, resale, interim number portability, interconnection
and the provisioning of essential network functions to competitors have been
adopted by the CPUC. Since the CPUC's authorization of local competition, the
Company has negotiated interconnection agreements with more than twenty
different new entrants by early March 1997, and has completed interconnection
arbitration proceedings with the three largest interexchange carriers, AT&T,
MCI Communications Corp. and Sprint Corp. As a result of these voluntary and
arbitrated agreements, the Company is offering interconnection, unbundled
network elements, and resold services at prices and other terms and conditions
approved by the CPUC. These interconnection agreements allow immediate
competitive entry into the Company's local markets.
In early February 1997, the CPUC had authorized about 90 companies, including
large and well-capitalized long-distance carriers, competitive access
providers, cable television companies and other local exchange providers to
begin providing local phone service in California. All of the Company's
customers have already chosen a long-distance company, and these companies
have established widespread customer awareness through extensive advertising
campaigns over several years. Since customers may select a competitor for all
their telecommunications services, local exchange competition may affect toll
and access revenues as well as local service revenues.
The CPUC issued its final decision on universal service on October 25, 1996,
establishing an annual California universal service fund of approximately $352
million. Customers of all telecommunications providers will contribute to the
preservation of affordable telephone service via a 2.87 percent surcharge on
all bills for telecommunications services provided in California. The new
program went into effect on February 1, 1997. The Company expects to draw
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approximately $305 million annually from the universal service fund. However,
to preserve revenue neutrality, as required by the CPUC decision, the Company
will reduce its prices for certain services to reduce revenues by $305
million. On March 6, 1997, the Company filed its price reduction proposal
with the CPUC. Pending consideration of that proposal by the CPUC, the
Company will reduce its revenues by $305 million by applying a surcredit to
customers' bills.
See "CPUC Local Services Competition", "CPUC Decision on Universal Service,"
"CPUC Regulatory Framework Review" and "Competitive Risk" and "CPUC Revenue
Rebalancing Shortfall" on pages 19 through 22 and page 32 in "Item 7. MD&A"
for additional information on the regulation of the Company by the CPUC. See
also "Item 8", Notes F and K to the 1996 Consolidated Financial Statements on
pages 51 through 53 and 57 through 59 for a discussion of other CPUC
proceedings.
CHANGING INDUSTRY ENVIRONMENT
With increasing competition for existing services and the introduction of
local services competition in California effective January 1, 1996, the
Company faces an increasingly competitive marketplace. In response to the
competitive challenge, management has developed several key strategies
intended to provide a consistent, integrated focus for management's decisions
and actions. These overarching strategies are to strengthen the Company's
core telecommunications business, develop new markets and promote balanced
public policy reform.
A strong core business provides the essential foundation to pursue future-
oriented opportunities. To strengthen the core telecommunications business,
management will continue to upgrade network and systems capability, improve
customer service and efficiency, and retain and expand existing markets
through product and channel innovation. See "Strengthen Core Business" on
pages 14 through 17 in "Item 7. MD&A" for additional information.
As competition increases in its core telecommunications business, the Company
will rely increasingly on developing new markets to create new revenue
sources. Toward that end, the Company is actively creating and pursuing
markets in long-distance services, PCS, Internet access, network integration
and certain new information services. See "New Markets" on pages 17 through
18 in "Item 7. MD&A" for additional information.
Telecommunications policy reform has been, and will continue to be, the
subject of much debate in Congress, the California Legislature, the courts,
the FCC and the CPUC. Management supports public policy reform that promotes
fair competition and ensures that responsibility for universal service is
shared by all who seek to provide telecommunications services. Competition
will bring great benefits to customers by giving them the opportunity to
choose among service providers for their telecommunications needs. See
"Public Policy" on pages 18 through 21 in "Item 7. MD&A", for additional
information.
COMPETITION
Regulatory, legislative, and judicial actions, as well as advances in
technology, have expanded the types of available communications products and
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services and the number of companies offering such services. Various forms of
competition, including price and service 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. The Company also faces competition from cable television companies
and others. Although the Company will face significant competition in its
provision of telephone and new services, management believes that the Company
has a reputation for high quality services and that the key strategies
outlined above will provide an effective competitive response.
TELEPHONE SERVICES COMPETITION
The characteristics of the California market make it attractive to new
competitors. The Company's business and residence revenues and profitability
are concentrated among a small portion of its customer base and geographic
areas. Competitors need only serve selected portions of the Company's service
area to compete for the majority of its business and residence usage revenues.
High-margin customers are clustered in high-density areas such as Los Angeles
and Orange County, the San Francisco Bay Area, San Diego, and Sacramento.
California is also attractive because it has one of the lowest switched
access rates in the country. By combining the low switched access rate and
discounted resale rates, competitors have the ability to price their services
at relatively low rates while maintaining high margins. Reselling,
particularly under the Company's discounted rates, allows competitors to offer
local service with little or no investment.
See "CPUC Local Services Competition" and "Competitive Risk" on pages 19
through 20 and 21 through 22 in "Item 7. MD&A," and "Item 8," Note L to the
1996 Consolidated Financial Statements on pages 60 through 61 for additional
information on current developments in telephone services competition.
Directory Advertising
Other producers of printed directories offer products that compete with
certain Pacific Bell SMART Yellow Pages products. Competition is not limited
to other printed directories, but includes newspapers, radio, television, and,
increasingly, direct mail and directories offered over the Internet. In
addition, new advertising and information products may compete directly or
indirectly with the SMART Yellow Pages. With the introduction of local
exchange competition, Pacific Bell Directory will have to acquire the listings
of other providers for its products, and competing directory publishers may
ally themselves with other telecommunications providers.
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Internet Access
The Company faces competition in the provision of Internet access from
established Internet access providers, cable television, long-distance, and
other telephone companies.
Network Integration
The Company faces competition in the provision of network integration services
primarily from value added distributors with professional services and network
management capability, including large telecommunication services providers.
PCS
The Company faces competition in the provision of PCS services from the
holders of the other licenses in such areas. In addition, the Company must
compete with established providers of cellular service.
FORWARD-LOOKING STATEMENTS
When used in this Form 10-K, the words "expects", "anticipates", "estimates",
"believes" and words of similar import may constitute "forward-looking
statements" within the meaning of Section 17A of the Securities Act of 1933,
as amended. Such statements, which include statements contained in "Business"
and "MD&A" concerning projections of revenue growth and statements of
management's objectives and expectations as to levels of expenditures, are
subject to risks and uncertainties, including those set forth under
"Competitive Risk" and "Regulation" and elsewhere in this Form 10-K, that
could cause actual results to differ materially from those projected. These
forward-looking statements speak only as of the date of this Form 10-K. The
Company expressly disclaims any obligation or undertaking to publicly release
any updates or revisions to any forward-looking statements contained herein to
reflect any change in the Company's expectations with regard thereto or any
change in events, conditions or circumstances on which any such statement is
based.
Item 2. Properties.
The properties of the Company do not lend themselves to description by
character and location of principal units. At December 31, 1996, the
percentage distribution of total telephone plant by major category for the
Company was as follows:
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Telecommunications Property, Plant, and Equipment 1996
- -----------------------------------------------------------------------
Land and buildings (occupied principally by central offices). 10%
Cable and conduit............................................ 40%
Central office equipment..................................... 35%
Other........................................................ 15%
--------
Total........................................................ 100%
=======================================================================
At December 31, 1996 the Company's central office equipment was utilized to
approximately 90 percent of capacity.
Substantially all of the installations of central office equipment and
administrative offices are in buildings and on land owned by the Company. Many
garages, business offices, and telephone service centers are in rented
quarters.
As of December 31, 1996, about 25 percent of the network access lines of the
Company were in Los Angeles and vicinity and about 25 percent were in
San Francisco and vicinity. The Company provided approximately 76 percent of
the total access lines in California as of December 31, 1996. The Company
does not furnish local service in certain sizable areas of California which
are served by non-affiliated telephone companies.
Item 3. Legal Proceedings.
Not Applicable.
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters.
The Company has 224,504,982 shares of common stock outstanding without par
value. There is no public trading market for the Company's common stock.
Pacific Telesis Group, incorporated in 1983 under the laws of the State of
Nevada, holds all the Company's outstanding shares.
12
<PAGE>
Item 7. Management's Discussion and Analysis of Results of Operations
OVERVIEW
Pacific Bell(R) (the "Company,") which when used herein includes its
subsidiaries: Pacific Bell Directory, Pacific Bell Information Services,
Pacific Bell Mobile Services, Pacific Bell Internet Services, Pacific Bell
Network Integration, and others) provides local exchange services, network
access, local toll services, directory advertising, Internet access, Personal
Communications Services ("PCS") and selected information services in
California. The Company is a wholly owned subsidiary of Pacific Telesis(R)
Group ("Pacific Telesis").
The Company's primary financial goal is to build long-term value for Pacific
Telesis' shareowners. Management's business strategies of expanding and
strengthening the core telecommunications business, developing new markets and
promoting public policy reform have returned the Company to solid growth and
continue to build value not only for Pacific Telesis shareowners, but also for
its customers and employees.
To further enhance shareowner, customer and employee value, and to meet the
challenges of our dramatically changing industry, the Board of Directors of
Pacific Telesis announced a plan on April 1, 1996 to merge with SBC
Communications Inc. ("SBC").
PLANNED MERGER
The decision to merge Pacific Telesis with SBC was based on a comprehensive
evaluation of the economic, financial, regulatory and technological factors in
the telecommunications industry. Management believes that the combined
financial resources, access to national and international markets, and
technologies of the combined companies will better enable them to take full
advantage of the growth opportunities provided by the Telecommunications Act
of 1996. This combination will better position Pacific Telesis in today's
competitive telecommunications environment. The merger is based on growth
opportunities which will bring at least 1,000 new jobs to the combined
companies in California, as well as the headquarters of four of the combined
companies' operations.
The merger has been approved by the shareowners of Pacific Telesis and SBC,
the Federal Communications Commission ("FCC") and the Public Service
Commission of Nevada ("PSCN"). The U.S. Department of Justice concluded that
the merger does not violate the antitrust laws. In addition, the California
State Attorney General has told the California Public Utilities Commission
("CPUC") that the merger will not hurt competition in California and is
consistent with emerging trends. On February 21, 1997, two California
administrative law judges issued a proposed decision approving the merger but
with a number of conditions, including payment of up to $750 million.
Management does not agree with the level of payment or the restrictive
conditions and intends to work towards their reduction or elimination. A
proposed decision by the administrative law judges is not binding. The CPUC
is expected to review the full case and the proposed decision and issue a
final decision by March 31, 1997. Depending on the final CPUC decision, the
merger could close in early second quarter. (See "Merger Agreement" under Note
K on page 57.)
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<PAGE>
Management believes the merger will broaden investors' options by creating one
of the nation's largest national and international telecommunications
businesses. The merger will enhance competition in the communications
industry and position the combined companies to continue to grow and pursue
new opportunities in these increasingly competitive markets.
KEY STRATEGIES
With increasing competition for existing services, the opening of local and
toll services competition in California, and the enactment of the
Telecommunications Act of 1996, the Company faces an increasingly competitive
marketplace. Management's key strategies provided a strong response to the
competitive challenge, as reflected by the Company's strong growth in revenues
for 1996. The business strategies of expanding and strengthening the core
telecommunications business, developing new markets and promoting public
policy reform further the Company's goal of being the customers' first choice
for their telecommunications needs.
Strengthen Core Business
- ------------------------
A strong core business provides the essential foundation to pursue future-
oriented opportunities. To strengthen the core telecommunications business,
management will continue to upgrade network and systems capability, improve
customer service and efficiency, and retain and expand existing markets
through product and channel innovation.
Upgrade Network and Systems Capabilities
In order to offer the products and services customers want, now and in the
future, the Company continues to invest heavily in improvements to the core
telecommunications networks. The Company spent a total of $2.4 billion
primarily on the telecommunications networks during 1996. The focus of these
investments has been in the advanced digital technologies discussed below.
These technologies enable the Company to provide new products and services,
increase network quality and reliability, increase transmission speed, and
reduce costs.
December 31
-----------
Technology Deployment 1996 1995
- ------------------------------------------------------------------------
Access lines served by digital switches................ 79% 73%
Access lines with SS-7 capability...................... 99% 98%
Access lines with ISDN accessibility................... 91% 85%
Miles of installed optical fiber (thousands)........... 522 467
- ------------------------------------------------------------------------
Digital switches and optical fiber, a technology using thin filaments of glass
or other transparent materials to transmit coded light pulses, increase the
capacity and reliability of transmitted data while reducing maintenance costs.
Signaling System 7 ("SS-7") permits faster call setup and custom calling
services. Integrated Services Digital Network ("ISDN") allows simultaneous
transmission of voice, data, and video over a single telephone line. In
addition, the Company is deploying Synchronous Optical Network ("SONET")
14
<PAGE>
interfaces within the fiber infrastructure. SONET is an international
standard for high-speed fiber optics transmission.
In December 1994, the Company contracted for the purchase of up to $2 billion
of Advanced Communications Network ("ACN") facilities, which incorporated new
technologies. During 1995, the ability to deploy the facilities outstripped
the ACN vendors' ability to deliver necessary products and software.
Accordingly, management decided to suspend construction at certain sites,
which reduced the expected cost to less than $700 million. If ACN facilities
meet certain quality and performance criteria (the "Network Test"), the
Company is committed to purchase the ACN facilities in 1998. If ACN
facilities fail the Network Test, the Company will not be committed to buy the
ACN facilities but might be liable to reimburse the principal ACN vendor for
some construction costs up to $300 million. If competition or other factors
affect the Company's ability to recover its investment in these facilities,
the value of the ACN facilities could be materially impaired.
Improve Customer Service and Efficiency
The Company also has invested in its networks to enhance service quality, key
to winning and keeping customers in a competitive market. According to a 1996
telecommunications study performed by J. D. Power and Associates, Pacific
Telesis ranked second in customer satisfaction for local residential telephone
service. The Company is in a service industry and the quality of service
provided is still the most essential part of what the Company sells.
In April 1996, the Company introduced a Pacific Bell Awards program, designed
to reward customers for continuing to choose Pacific Bell. The program offers
rewards from more than 20 partners that include airlines, computer companies
and restaurants. The Pacific Bell Awards program helps promote brand name and
also encourages customers to subscribe to Pacific Telesis' new products and
services such as wireless PCS and Digital TV.
Recognizing the diversity of our customers, the Company provides service in
multiple languages to many bilingual or non-English speaking customers in
California, particularly those linked to the Pacific Rim and to Central and
South America. The number of customers whose service was provided in other
languages has grown by 129 percent since 1990, contributing to the Company's
revenues. Strong brand name recognition and an excellent reputation in many
ethnic market segments will enhance opportunity for Pacific Telesis when it
enters the long distance business.
Superior service is delivered by employees in the Company's workforce whose
capabilities and cultures match the diversity and demands of the market. In
1996, the U.S. Department of Labor also recognized this effort and honored
Pacific Telesis with its Opportunity 2000 award for fostering employment
opportunities and employee diversity.
To prosper in a competitive environment, the Company must continue to provide
outstanding customer service while improving efficiency. The Company's core
process reengineering ("CPR") projects have resulted in better, faster
customer service with greater efficiency. CPR is a method for achieving
significant increases in performance by rethinking basic business processes
and systems. For example, the Company reduced the number of network
operations centers from 25 to two. The new centers, which were fully
15
<PAGE>
operational in early 1996, require fewer employees to operate than the old
centers and each serves as a fully operational backup for the other. And in
1995, the Company created customer service centers to improve the response to
service activation and repair calls. With many functions consolidated in the
centers, significant time savings and service improvements have been achieved
by reducing hands-off between functional work groups. Reengineering processes
and other efforts contributed to the improvement in efficiency as measured by
the change in the Company's employees per 10,000 access lines to 26.6 in 1996
from 28.8 in 1995.
Retain and Expand Existing Markets
Stimulating usage of the Company's existing networks is the most cost
effective way to increase revenues. The Company is increasing its use of
alternative sales channels and targeted advertising to stimulate usage. Focus
areas include high-growth data markets, voice mail, additional residential
lines, and custom calling services.
The market for high-speed data transmission, or the Pacific Bell FasTrak(SM)
data services, grew rapidly in 1996 due to focused marketing campaigns and the
improved economy. The Company's ISDN volumes in 1996 increased 94.2 percent
from 1995. Volumes for other FasTrak data services increased as follows for
1996 over the prior year: Frame Relay increased 111.5 percent and Switched
Multimegabit Data Service ("SMDS") increased 60.3 percent. Frame Relay
technology allows a customer to transmit 126 pages of data per second and
enables the customer to move data quickly between widely dispersed local area
networks. SMDS allows users to buy whatever bandwidth they need, and to
upgrade it later if desired.
In December 1996, the Company began testing the delivery of Asynchronous
Transfer Mode ("ATM") high-speed data to the desktop over the telephone
network using Asymmetric Digital Subscriber Line ("ADSL") technology. ATM is
considered the multimedia switching technology of the future. ATM functions
over ADSL, a technology that delivers higher bandwidth over copper telephone
lines. The Company has been conducting a limited ADSL trial in San Ramon,
California since the fall of 1996.
Changes in technology and telecommuting are fueling increased demand for
additional telephone lines in the home. The Company provides approximately 2
million residential access lines that are in addition to the customer's
primary line. Customers want extra lines for data transmission, Internet
access, fax machines, and convenience. Similarly, demand for custom calling
services, such as call waiting, grew more than 11 percent in 1996 as customers
asked for greater convenience and more control over their telephone
communications. Caller ID, another custom calling service, was launched in
July 1996 and displays the telephone number of the calling party on a device
that attaches to, or is part of, a customer's telephone.
The success of the Company's voice mail products continued in 1996. Customers
value such features as the ability of the service to answer the phone even
when they are on the line. They also like remote message retrieval features
and the reliability of the network. Voice mailbox equivalents in service
increased 17.9 percent in 1996 to about 1.7 million.
16
<PAGE>
Capital expenditures for the Company in 1997 are forecast to be about $2.3
billion. This amount includes approximately $2.0 billion primarily for the
cost of upgrading and maintaining the core telecommunications network and
system capabilities. The remainder of this amount includes the cost of
building the PCS network.
New Markets
- -----------
As competition intensifies in its core telecommunications business, the
Company will rely increasingly on developing new products and services to
create new revenue sources. Toward that end, the Company is actively creating
and pursuing markets in PCS, Internet access, network integration, and other
information services.
In November 1996, Pacific Bell Mobile Services ("PBMS") launched PCS in San
Diego, California, and in February 1997, in Las Vegas, Nevada. Unlike most
cellular service, PCS is a digital wireless service, offers superior sound
quality, and protection from eavesdropping and cloning. The network will
incorporate the Global System for Mobile Communications ("GSM") standard which
is widely used in Europe. PBMS phones for PCS feature a built-in pager and
answering machine. PBMS is selling PCS as an off-the-shelf product in
approximately 100 retail stores across San Diego County and about 60 retail
stores in Las Vegas. PBMS plans to offer PCS service in San Francisco and Los
Angeles in the second quarter of 1997. Management expects a widespread
offering of PCS service in most of California and Nevada by mid-1997.
Although management anticipates significant competition, particularly from
established cellular companies, it believes that digital technology and the
Company's reputation for superior service will position our offering well with
the customer.
Pacific Bell Internet Services ("PBI") provides Internet access services to
business customers and in May 1996 rolled out its service to consumers. It is
estimated that between 30 and 40 percent of all Internet traffic originates or
terminates in California. In 1996, PBI added over 65,000 customers in
California and Nevada. Pacific Bell Network Integration ("PBNI"), a new
business initiated in mid-1996, was formed to assist customers with the
implementation of information technology networks by providing state-of-the-
art network management and consulting services. In November 1996, the Company
unveiled its new ISDN Home Pack(TM), the nation's first fully integrated ISDN
and Internet package. The package includes Internet access through the
Company's Internet Service network, a digital modem and Internet browser
software. PBI handles the Internet access and customized software of the
package. PBNI is responsible for integrating the whole package and managing
delivery of the hardware and software components.
In 1996, Pacific Bell Interactive Media ("PBIM") launched Pacific Bell At
Hand(SM), an Internet web site (www.athand.com) designed with focus on
California. California merchants and consumers distribute, receive and
exchange information in one of the Internet's most dynamic markets.
Categories such as Entertainment and Leisure, Sports and the newly released
Real Estate provide users an intimate look at restaurants, golf courses, state
parks, multiple listing entries, and other advertiser provided content. In
1997, PBIM will continue to add to its merchant directory lineup.
17
<PAGE>
Management sees these new markets as attractive investment opportunities even
though substantial start-up costs will be incurred.
Public Policy
- -------------
Telecommunications policy reform has been, and will continue to be, the
subject of much debate in Congress, the California Legislature, the courts,
the FCC and the CPUC. Management supports public policy reform that promotes
fair competition and ensures that the responsibility for universal service is
shared by all who seek to provide telecommunications services.
Telecommunications Legislation
In February 1996, the Telecommunications Act of 1996 was signed into law,
easing certain restrictions imposed by the Communications Act of 1934 and the
1984 Cable Act, and replacing the 1982 Consent Decree. Among the provisions,
the new law allows telephone companies and cable television companies to
compete in each others' markets, and permits the former Bell Operating
Companies to apply to the FCC for authority to offer long-distance service,
subject to certain conditions. Once the new law is fully implemented,
consumers will have many new options for their local telephone, long-distance,
and cable television services. (See "FCC Recommendation on Universal Service"
and "FCC Interconnection Order" below.)
FCC Recommendation on Universal Service
In November 1996, the Joint Federal-State Board on Universal Service (the
"Board") issued a recommendation on how to implement sections of the
Telecommunications Act of 1996 regarding universal service. Generally the
plan creates a system that identifies cost subsidies in rural and high-cost
areas. However, the Board deferred a recommendation on how large the
subsidies should be. The Board also recommended creation of a $2.25 billion
fund for providing discounted services to schools and libraries. The FCC has
until May 1997 to issue a final decision on this matter.
FCC Interconnection Order
In August 1996, the FCC released a decision (the "Interconnection Order")
establishing guidelines to implement the Telecommunications Act of 1996, which
sets rules for opening local telecommunications markets to full competition.
The Interconnection Order lays out how long distance companies and other new
competitors may connect to local networks and sets guidelines and prices for
network components. Management believes that the Interconnection Order
undermines the intent of the Telecommunications Act of 1996 by, among other
things, denying states a role in managing and setting prices for local
markets. Management is also concerned that the order requires local telephone
companies to offer wholesale network services at unrealistically low prices.
Pacific Telesis, 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
18
<PAGE>
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 Court of Appeals is
expected to issue a decision by mid-1997.
The Interconnection Order also addressed the issue of wireless
interconnection, or the arrangements under which local exchange carriers
("LECs") are compensated for interconnecting with and terminating traffic for
commercial mobile radio service ("CMRS") providers (including cellular, PCS
and paging). The Interconnection Order ruled that CMRS providers are entitled
to reciprocal compensation arrangements for transport and termination of local
telecommunications traffic. On November 1, 1996, the Court of Appeals lifted a
part of the stay described above with respect to the non-price aspects of the
FCC's reciprocal compensation rules for CMRS providers. As a result of this
order, the Company is currently renegotiating its CMRS contracts and by early
February 1997, had signed agreements with six CMRS providers, including the
major California providers.
FCC Regulatory Framework Review
The FCC adopted new interim price cap rules in 1995 that govern the prices
that the larger LECs, including the 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.
The revised FCC price cap plan was intended to be an interim plan that would
be revised in 1996. However, with the passage of the Telecommunications Act
of 1996, the FCC is conducting further proceedings to address various pricing
and productivity issues, and is performing a broader review of price cap
regulation in a competitive environment. Additionally, the FCC has indicated
that it will also examine universal service (see "FCC Recommendation on
Universal Service" on page 18) and access charge rules during 1997.
Management continues to believe that the FCC should adopt pure price cap
regulation and eliminate the productivity factor, sharing and earnings cap.
CPUC Local Services Competition
The CPUC authorized facilities-based local services competition effective
January 1996 and resale competition effective March 1996. Several issues
still need to be resolved before the CPUC issues final rules for local
competition. These issues include final rates for resale, presubscription,
implementation of number portability and LEC provisioning and pricing of
essential network functions to competitors. In order to provide services to
19
<PAGE>
resellers, the Company will use operating support systems currently in place,
and it is also building electronic ordering systems and a customer
care/billing center. Costs to implement local competition, especially number
portability, will be material and it is uncertain whether regulators will
allow for recovery of these costs. The CPUC expects to issue final rules on
presubscription in early 1997 and final rates and rules for all other issues
in late 1997.
Management believes that all markets should be open to all competitors under
the same rules at the same time, and that a truly open competitive market, in
which the Company can compete without restrictions, offers long-term
opportunity to build the business and maximizes benefit for the consumer.
CPUC Decision on Universal Service
The CPUC issued its final decision on universal service on October 25, 1996,
establishing an annual California universal service fund of approximately $352
million. Customers of all telecommunications providers will contribute to the
preservation of affordable telephone service via a 2.87 percent surcharge on
all bills for telecommunications services provided in California. The new
program went into effect on February 1, 1997.
Management is concerned that the decision underestimates the true cost of
providing universal telephone service. While $305 million of the total $352
million is expected to be paid to the Company initially, this is far short of
the Company's estimate of the true cost of providing universal service. 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 in a modified form for the
new program, but has determined that the average cost is only $20.30 per line
per month. The universal service fund provides full funding for the
difference between the adopted CPUC cost and price only for those lines with
costs above $20.30. The Company's price for basic service, including federal
charges, is $14.75. Lines that cost more than $14.75, but less than $20.30
will not receive any funding. About 25 percent of the Company's residence
primary lines qualify for funding.
In order to ensure revenue neutrality, the Company must reduce its rates
dollar for dollar for any funds it receives from the newly created universal
service fund. This reduction will initially be accomplished by means of an
across-the-board surcredit on all of the Company's products and services
except for residential basic exchange services. The order allows the Company
to file an application to replace the initial across-the-board surcredit with
permanent price reductions for those services that previously subsidized
universal services.
The final decision also establishes a discount program for schools, libraries,
certain community-based organizations and municipal- and county-owned
hospitals and clinics. Carriers providing services at a discounted price will
be reimbursed from a newly created California Teleconnect Fund. This discount
program will be funded by a separate surcharge of 0.41 percent on the bills of
customers of all telecommunications carriers in California.
20
<PAGE>
CPUC Regulatory Framework Review
In December 1995, the CPUC issued an order in its review of the regulatory
framework in California. The order suspended use of the "inflation minus
productivity" component of the price cap formula for 1996 through 1998. This
action freezes the price caps on most of 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 December
1996, the CPUC adjusted the Company's rates due to exogenous cost changes by
an annual revenue reduction of approximately $66 million effective January 1,
1997.
Management continues to believe that the CPUC should adopt pure price cap
regulation and permanently eliminate sharing, earnings caps, and all other
vestiges of rate-of-return regulation.
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. The Company also faces
competition from cable television companies and others.
Effective January 1, 1995, the CPUC authorized toll services competition.
Management estimates that share losses since January 1, 1995 have been in the
five to six percent range. However, this loss combined with losses prior to
the official opening of this market has resulted in the Company currently
serving less than 50 percent of the business toll market. In April 1995, the
CPUC 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. Competitors may choose to locate their
transmission facilities within or near the Company's central offices.
Effective January 1, 1996, the CPUC authorized local exchange competition. By
early February 1997, the CPUC had authorized about 90 companies, including
large and well-capitalized long distance carriers, competitive access
providers, and cable television companies to begin providing local phone
service in California, and 38 additional applications were pending. These
companies are prepared to compete in major local exchange markets and many
have already deployed switches or other facilities. All of the Company's
customers have already chosen a long distance company, and these companies
have established widespread customer awareness through extensive advertising
campaigns over several years.
Local exchange competition may affect toll and access revenues, as well as
local service revenues, since customers may select a competitor for all their
telecommunications services. Local exchange competition may also affect other
service revenues as Pacific Bell Directory will have to acquire listings from
other providers for its products, and competing directory publishers may ally
21
<PAGE>
themselves with other telecommunications providers. Management estimates the
CPUC's proposed local competition rules could materially reduce revenue growth
for the Company's regulated California operations by late 1997.
The characteristics of the California market make it attractive to new
competitors. The Company's business and residence revenues and profitability
are concentrated among a small portion of its customer base and geographic
areas. Competitors need only serve selected portions of the Company's service
area to compete for the majority of its business and residence usage revenues.
High-margin customers are clustered in high-density areas such as Los Angeles
and Orange County, the San Francisco Bay Area, San Diego, and Sacramento.
California is also attractive because it has one of the lowest switched access
rates in the country. By combining the low switched access rates and
discounted resale rates, competitors have the ability to price their services
below the Company's prices while maintaining high margins. Reselling allows
competitors to offer local services with little or no investment.
Management believes that now that our markets are open to all competitors, the
Company should be granted access to markets that are currently closed to LECs.
A truly open competitive market, in which the Company can compete without
restrictions, offers long-term opportunity to build the business and maximizes
benefits for consumers. Management believes its key strategies of
strengthening the core business by upgrading its network and systems
capabilities, improving customer service and efficiency, expanding existing
markets, developing new markets and promoting public policy reform, will
provide a strong response to its competitive challenge. (See "Key Strategies"
on page 14.)
RESULTS OF OPERATIONS
The following discussions and data summarize the results of operations of the
Company for 1996 compared to 1995.
%
Operating Statistics 1996 Change 1995
- ---------------------------------------------------------------------------
Capital expenditures ($ millions).. 2,419 26.3 1,915
Total employees at December 31..... 45,589 -3.4 47,202
Employees per
ten thousand access lines*....... 26.6 -7.6 28.8
===========================================================================
* Excludes Pacific Bell Directory and Pacific Bell Mobile Services employees.
Earnings for 1996 were $1,255 million. 1996 earnings included a one-time,
non-cash after-tax gain of $85 million associated with a change in accounting
for directory publishing revenues and expenses, which was substantially offset
by a number of other one-time items. (See "Cumulative Effect of Accounting
Change" under Note A on page 43.) Earnings for 1996 reflect the revenue
growth from increased customer demand for local telephone products associated
with marketing efforts and California's growing economy. Earnings remained
stable despite substantial increases in expenditures associated with entering
new businesses, increased demand and regulatory mandates for local
competition.
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<PAGE>
Management cannot predict the effects on earnings for 1997 from competition
and issues remaining to be resolved with the Telecommunications Act of 1996.
Management anticipates earnings dilution from the development of new markets
and increased local competition, but believes that the California economy will
continue to improve and that our history of effective cost controls will
continue. (See "Planned Merger" through "Competitive Risk" on pages 13-22.)
Volume Indicators
- -----------------
%
1996 Change 1995
- ---------------------------------------------------------------------------
Switched access lines at Dec. 31
(thousands)....................... 16,119 4.1 *15,480
Residence....................... 10,029 3.6 *9,677
Business........................ 5,879 5.1 *5,594
Other........................... 211 1.0 209
ISDN access lines at Dec. 31
(thousands, included in above). 101 94.2 52
Total interexchange carrier access
minutes-of-use (millions)........ 63,338 9.2 58,020
Interstate...................... 35,200 11.0 31,712
Intrastate...................... 28,138 7.0 26,308
Toll messages (millions)........... 5,158 7.4 4,802
Toll minutes-of-use (millions)..... 15,876 9.6 14,488
Voice mailbox equivalents at Dec. 31
(thousands)...................... 1,696 17.9 1,438
Custom calling services at Dec. 31
(thousands)...................... 7,936 11.0 *7,152
===========================================================================
* Restated.
The total number of access lines in service at December 31, 1996, grew to
16.119 million, an increase of 4.1 percent for the year, up from 3.0 percent
in 1995. The residential access line growth rate increased to 3.6 percent for
1996, up from 1.9 percent in 1995 reflecting the growing California economy.
The growth rate in business access lines was 5.1 percent in 1996, up from 4.8
percent in 1995. The growth in business access lines reflects increased
employment levels in California. The number of ISDN lines in service grew to
101 thousand, an increase of 94.2 percent for 1996, as customers increased
telecommuting and demanded faster data transmission and Internet access.
Access minutes-of-use represent the volume of traffic carried by interexchange
carriers over the Company's local network. Total access minutes-of-use for
1996 increased by 9.2 percent over 1995. The increase in access minutes-of-
use was primarily attributable to economic growth. The growth rate of 10.8
percent in 1995 was higher than 1996 due to the introduction of toll services
competition in 1995. In California, the official introduction of toll
23
<PAGE>
services competition in January 1995 had the effect of increasing intrastate
access minutes-of-use. This phenomenon occurs because the Company provides
access service to competitors who complete local toll calls over the Company's
network.
Toll messages and minutes-of-use are comprised of Message Telecommunications
Service and Optional Calling Plans ("local toll") as well as WATS and
terminating 800 services. In 1996, toll minutes-of-use increased by
9.6 percent compared to an increase of 4.1 percent for 1995. The increase was
driven primarily by economic growth.
Management cannot predict the effects on volumes for 1997 from competition and
issues remaining to be resolved with the Telecommunications Act of 1996.
However, management believes that the California economy will continue to
improve and that its business strategies will position the Company to compete
effectively in the changing telecommunications industry. (See "Planned
Merger" through "Competitive Risk" on pages 13-22.)
Operating Revenues
- ------------------
($ millions) 1996 Change 1995
- ---------------------------------------------------------------------------
Total operating revenues...... $9,446 $584 $8,862
6.6%
- ---------------------------------------------------------------------------
Revenues for 1996 increased from 1995 primarily due to increased customer
demand driven by the expansion of business data services, strong usage levels
for new custom calling services, increases in access line and minutes-of-use
volumes, and growth in directory advertising. The Company's marketing efforts
and California's growing economy contributed to the increased customer demand.
Increases in 1996 revenues were partially offset by $51 million of rate
reductions due to FCC price cap orders. Revenues for the six months ended June
30, 1996, decreased about $60 million due to the FCC price cap filing for the
twelve months ending June 30, 1996. For the 1996 annual access tariffs filings
effective July 1, 1996, revenues increased approximately $10 million. The CPUC
price cap order effective January 1, 1996, had a minimal effect on the
Company's revenues due to an order in December 1995 suspending use of the
"inflation minus productivity" component of the price cap formula for 1996
through 1998. This action freezes the price caps on most of the Company's
regulated services through 1998 except for adjustments due to exogenous costs
or price changes approved through the CPUC's application process. (See "CPUC
Regulatory Framework Review" on page 21.) Primary factors affecting 1996
revenue changes from 1995 are summarized in the table below.
24
<PAGE>
CHANGE IN 1996 REVENUES FROM 1995:
Total
Price Change
Cap Customer from
($ millions) Orders Misc. Demand 1995
- --------------------------------------------------------------------------
Local service....................... $ - $14 $200 $214
Network access:
Interstate......................... -51 37 137 123
Intrastate......................... - -23 34 11
Toll service........................ - -20 84 64
Other service revenues.............. - 72 100 172
----- ----- ----- -----
Total operating revenues............ $-51 $80 $555 $584
==========================================================================
Local service revenues include basic monthly service fees and usage charges.
Fees and charges for custom calling services, coin phones, installation, and
service connections are also included in this category. The $200 million
increase in customer demand for local service is the result of the 4.1 percent
growth in access lines and the 11.0 percent growth in custom calling services,
such as call waiting, generated by the improved economy in California and
effective marketing.
Network access revenues reflect charges to interexchange carriers and to
business and residential customers for access to the Company's local networks.
The $137 million increase in interstate network access revenues due to
customer demand reflects increased interexchange carrier access minutes-of-
use, as well as increased access lines. The $34 million demand-related
increase in intrastate network access revenues also resulted from growth in
access minutes-of-use.
Toll service revenues include charges for local toll as well as 800 services
within service area boundaries. The increase of $84 million in toll service
revenues due to customer demand was driven primarily by increased local toll
usage resulting from California's growing economy. The customer demand-
related increases in local toll service was partially offset by competitive
losses in 800 services. Interexchange carriers currently have the competitive
advantage of being able to offer these services both within and between
service areas.
Other service revenues are generated from a variety of services including
directory advertising, information services, PCS, Internet services, network
integration and billing and collection services provided by the Company.
Increases in other service revenues reflect growth in the Company's
information services and directory advertising due to continued growth in the
California economy. In addition, other service revenues for Internet and
network integration increased over 1995 primarily due to the introduction of
these new services.
Management cannot predict the effects on revenues for 1997 from competition
and issues remaining to be resolved with the Telecommunications Act of 1996.
However, management believes that the California economy will continue to
improve and that its business strategies will position the Company to compete
effectively in the changing telecommunications industry. (See sections
25
<PAGE>
"Planned Merger" through "Competitive Risk" on pages 13-22.)
Operating Expenses
- ------------------
($ millions) 1996 Change 1995
- ---------------------------------------------------------------------------
Total operating expenses...... $7,142 $203 $6,939
2.9%
- ---------------------------------------------------------------------------
The increase in total operating expenses for 1996 reflects the Company's costs
for increased demand for products and services, new business initiatives and
costs incurred to prepare for local competition. Increased expenses were
partially offset by cost reductions from the Company's ongoing efficiency
efforts and savings due to changes in employee benefit plans and benefit plan
assumptions. Primary factors affecting expense changes are summarized below.
CHANGE IN 1996 OPERATING EXPENSES FROM 1995:
Total
Change
Salaries Employee Subsi- from
($ millions) & Wages* Benefits* Misc.* diaries 1995
- ---------------------------------------------------------------------------
Cost of products and services.. $38 $-121 $55 $ 6 $-22
Customer operations
and selling expenses......... 9 -74 26 89 50
General, administrative
and other expenses........... 27 4 178 -29 180
Depreciation and amortization.. - - -3 -2 -5
---- ---- ---- ---- ----
Total operating expenses....... $74 $-191 $256 $64 $203
===========================================================================
* Excludes Pacific Bell subsidiaries.
Excluding its subsidiaries, the Company's salary and wage expense increased
$74 million in 1996, primarily due to wage increases associated with new labor
agreements effective August 1995 and overtime due to increased business
volumes. These increases were somewhat offset by force reduction programs.
(See "Status of Restructuring Reserve" on page 28.) Due to increased demand
for products and services and entry into new businesses, management
anticipates that the workforce will increase in 1997 and related salary and
wage expense will also increase.
Excluding its subsidiaries, the Company's employee benefits expense decreased
$191 million in 1996. This decrease was due primarily to the net effect of
changes in employee benefit plans and changes in employee benefit plan
assumptions and the discontinued application of Statement of Financial
Accounting Standards No. ("SFAS") 71, "Accounting for the Effects of Certain
Types of Regulation." (See Note B - "Discontinuance of Regulatory Accounting
- - SFAS 71" on page 44, Note E - "Employee Retirement Plans" on page 48 and
Note F - "Other Postretirement Benefits" on page 51.) Despite 1997 expected
force increases, management anticipates that the changes in employee benefit
plans and benefit plan assumptions will continue to produce savings in 1997.
26
<PAGE>
Excluding its subsidiaries, the Company's increase in miscellaneous expenses
in 1996 primarily reflects costs incurred to prepare for local competition,
increased costs for software and contract services associated with increased
demand for products and services.
The Company's subsidiaries' customer operations and selling expenses increased
primarily due to new business initiatives, such as PCS, Internet access and
network integration.
The Company's subsidiaries' general, administrative and other expenses
decreased in 1996 primarily due to reduced software expenses and cost
containment efforts.
Management anticipates total operating expenses to increase in 1997 due to new
business initiatives and increased demand. Also, costs to implement local
competition, especially number portability, will be material and it is
uncertain whether regulators will allow for recovery of these costs. (See
"CPUC Local Services Competition" on page 19.) In addition, over the next few
years, management is expecting to incur additional expenditures to modify its
software to operate correctly for the year 2000.
Interest Expense
- ----------------
($ millions) 1996 Change 1995
- ---------------------------------------------------------------------------
Interest expense ................. $363 $-47 $410
-11.5%
- ---------------------------------------------------------------------------
Interest expense decreased in 1996 due primarily to a change in classification
of interest capitalized during construction from an item of other income to a
reduction in interest expense due to the discontinued application of SFAS 71.
(See Note B - "Discontinuance of Regulatory Accounting - SFAS 71" on page 44.)
Other Income (Expense)-Net
- --------------------------
($ millions) 1996 Change 1995
- ---------------------------------------------------------------------------
Other income (expense)-net........ $4 $-21 $25
-84.0%
- ---------------------------------------------------------------------------
Other income (expense)-net decreased in 1996 primarily due to a change in
classification of interest capitalized during construction from an item of
other income to a reduction of interest expense and interest income from tax
refunds received in 1995. These decreases were partially offset by bond
redemption costs incurred in 1995 associated with redemption of the Company's
debentures.
27
<PAGE>
Income Taxes
- ------------
($ millions) 1996 Change 1995
- ---------------------------------------------------------------------------
Income taxes......................... $775 $206 $569
36.2%
Effective tax rate (%)............... 39.8 37.0
- ---------------------------------------------------------------------------
Income tax expense increased for 1996 primarily due to higher pre-tax income,
tax adjustments and tax refunds received in 1995. Effective January 1, 1997,
California's maximum statutory tax rate will decrease from 9.3 percent to 8.84
percent. Due to this rate reduction, at December 31, 1996, the Company
revalued its net deferred tax assets. This revaluation increased state income
tax expense $10 million for 1996, which contributed to the overall income tax
expense increase for 1996.
Cumulative Effect of Accounting Change
- --------------------------------------
During fourth quarter 1996, Pacific Bell Directory ("Directory") changed its
method of recognizing directory publishing revenues and related expenses
effective January 1, 1996. Directory previously recognized revenues and
expenses related to publishing using the "amortized" method, under which
revenues and expenses were recognized over the lives of the directories,
generally one year. Under the new "issue basis" method, revenues and expenses
will be recognized when the directories are issued. The cumulative after-tax
effect of applying the new method to prior years is recognized as of January
1, 1996 as a one-time, non-cash gain applicable to continuing operations of
$85 million. The gain is net of deferred taxes of $58 million. The first
three quarters of 1996 were restated to reflect the new method. Management
believes this change to the issue basis method is preferable because it is the
method generally followed in the publishing industry and better reflects the
operating activity of the business. This accounting change is not expected to
have a significant net income effect on future periods. (See "Cumulative
Effect of Accounting Change" under Note A on page 43.)
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 1995, the
Company recorded a non-cash, extraordinary, after-tax charge of $3.4 billion.
(See Note B - "Discontinuance of Regulatory Accounting - SFAS 71" on page 44.)
Status of Restructuring Reserve
- -------------------------------
In 1991, a $201 million reserve was established for the cost of management
force reduction programs through 1994. A balance of $77 million remained at
the end of 1993. An additional $1,020 million reserve was established in
December 1993 to record the incremental cost of force reductions associated
with restructuring the Company's business processes through 1997. This
28
<PAGE>
restructuring was expected to allow the Company to eliminate more than
14,000 employee positions from 1994 through 1997. After considering new
positions expected to be created, a net reduction of approximately
10,000 positions was anticipated. In addition, the Company has relocated
employees in conjunction with consolidating business offices, network
facilities, installation and collection centers, and other operations.
The Company's gross force reductions under the restructuring plan, excluding
subsidiaries, totaled 4,142 employees in 1996. Total gross force reductions
for the first three years of the plan, 1994 through 1996, totaled 14,181. Net
force reductions were 1,926 for 1996 and 9,168 for the three-year period 1994
through 1996. The pace of net force loss moderated in 1996 due to strong
volume growth.
Annual cash savings are expected to reach approximately $1 billion when the
restructuring is completed in 1997. In 1996, expense savings due to the
restructuring totaled approximately $757 million primarily from savings in
labor costs due to cumulative force reductions since restructuring began.
Charges to the restructuring reserve in 1996 totaled $126 million, including
cash outlays of $190 million and a $64 million non-cash charge reversal
described below. 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. These costs will be paid
from pension fund assets and do not require current outlays of the Company's
funds. Based on its experience, in 1996 the Company revised its estimate of
these retirement costs. Consequently, $64 million of these 1995 non-cash
charges were reversed in 1996. There was no effect on net income from either
the 1995 charge or the 1996 change in this estimate. Management expects to
use the remaining reserve balance during 1997. (See Note C - "Restructuring
and Curtailment Charges" on page 46.)
The table below sets forth the status and activity in the reserve.
($ millions) 1996 1995 1994
- ---------------------------------------------------------------------------
Reserve for force reductions and restructuring:
Balance - beginning of year.............. $ 219 $ 819 $1,097
Additions................................ - - -
Charges: cash outlays ................... -190 -381 -216
noncash ........................ 64 -219 -62
--------------------------
Balance - end of year.................... $ 93 $ 219 $ 819
===========================================================================
CREDIT RATINGS
In August 1996, Moody's Investors Services, Inc. ("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.
29
<PAGE>
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 K on page 57.)
Also reflecting the merger agreement announcement, Duff and Phelps Credit
Rating Co. 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:
Duff and
Moody's Investors Standard & Phelps Credit
Services, Inc. Poor's Corp. Rating Co.
----------------- ------------ -------------
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.
30
<PAGE>
PENDING REGULATORY ISSUES
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 were
reduced by over $23 million each year from 1988 through 1995. 1996 and 1997
revenues are subject to refund. These adjustments were intended to reflect
annual revenue requirement reductions resulting from the CPUC's adoption of a
capital-to-expense accounting change in 1988. The CPUC held evidentiary
hearings in October 1995 addressing whether the USOA Turnaround Adjustment
should be eliminated. The CPUC's Office of Ratepayer Advocates has proposed
that the Company be ordered to permanently reduce its revenues by $106 million
effective January 1, 1996. Another intervenor has proposed that the Company
should be ordered to reduce its annual revenues by $43 million effective
January 1, 1996, with additional revenue reductions of about $11 million made
on a cumulative basis over the next ten years. After year ten, the proposed
revenue reduction would be about $155 million permanently for each year.
Management cannot predict the outcome of this matter.
Revenues Subject to Refund
- --------------------------
In 1992, the CPUC issued a decision adopting, with modification, SFAS 106,
"Employers' Accounting for Postretirement Benefits Other than Pensions," for
regulatory accounting purposes. Annual price cap decisions by the CPUC
granted 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 $221 million at December 31, 1996. Management believes
postretirement benefits costs are appropriately recoverable in the Company's
price cap filings.
Other Billing and Collecting ("OB&C")
- -------------------------------------
The FCC adopted new rules for recovery of OB&C expenses which will go into
effect mid-March 1997. The new rules shift an additional 25 percent of OB&C
costs from the intrastate to the interstate jurisdiction. The shift could
result in revenue reductions of approximately $40 million a year. Management
is evaluating options to mitigate the effect on revenues.
31
<PAGE>
Property Tax Investigation
- --------------------------
In 1992, a settlement agreement was reached between the State Board of
Equalization, all California counties, the State Attorney General, and
28 utilities, including 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 $70 million as of December 31, 1996, plus interest should be
returned to customers. Management believes that, under the CPUC's regulatory
framework, any property tax savings should be treated only as a component of
the calculation of shareable earnings not as an exogenous cost. In an Interim
Opinion issued in June 1995, the CPUC decided to defer a final decision on
this matter pending resolution of the criteria for exogenous cost treatment
under its regulatory framework. The criteria are being considered in a
separate proceeding initiated for rehearing of the CPUC's postretirement
benefits other than pensions decision discussed above. It is possible that
the CPUC could decide this issue in the near term, and that the decision could
have a material adverse effect on the Company.
CPUC Revenue Rebalancing Shortfall
- ----------------------------------
In September 1995, the Company filed with the CPUC for $214 million of revenue
increases. The request was to compensate the Company for the revenue
shortfall that resulted from the CPUC's price rebalancing plan that
accompanied the official introduction of toll services competition on
January 1, 1995. Revenue reductions due to lower prices were intended to be
offset by other price increases and by increased network usage generated by
the lower prices. Demand growth as a result of local toll price reductions
fell far short of the level anticipated by the CPUC. As a result, the revenue
neutrality intended by the CPUC was not achieved. On February 19, 1997, the
CPUC denied the Company's petition. Management is currently evaluating
whether to appeal the order.
SALE OF BELLCORE
In November 1996, the owners of Bell Communications Research ("Bellcore")
reached an agreement to sell the company to Science Applications International
Corp. Bellcore is a leading provider of communications software and
consulting services. It is owned by the Company and six of the telephone
regional holding companies formed at the divestiture of AT&T Corp. in 1984.
The sale is expected to be finalized by the end of 1997 after obtaining the
necessary regulatory approvals.
32
<PAGE>
Item 8. Financial Statements and Supplementary Data
REPORT OF MANAGEMENT
The management of Pacific Bell is responsible for preparing the accompanying
financial statements and for their integrity and objectivity. The statements
have been prepared in accordance with generally accepted accounting principles
applied on a consistent basis and management believes they are not misstated
due to material fraud or error. In instances where exact measurement is not
possible, the financial statements include amounts based on management's best
estimates and judgments. Management also prepared the other information
contained in this annual financial review and is responsible for its accuracy
and consistency with the financial statements.
The Company's financial statements have been audited by Coopers & Lybrand
L.L.P., independent accountants, whose appointment has been ratified by
Pacific Telesis' shareowners. Management has made available to Coopers
& Lybrand L.L.P. all the Company's financial records and related data, as well
as the minutes of directors' meetings. Furthermore, management believes that
all of its representations made to Coopers & Lybrand L.L.P. during their audit
are valid and appropriate.
Management has established and maintains a system of internal control that
provides reasonable assurance as to the integrity and reliability of the
financial statements, the protection of assets from unauthorized use or
disposition, and the prevention and detection of fraudulent financial
reporting. The system of internal control provides for appropriate division
of responsibility and is documented by written policies and procedures that
are communicated to employees with significant roles in the financial
reporting process and are updated as necessary. Management continually
monitors the system of internal control for compliance, and maintains a strong
internal auditing program that independently assesses the effectiveness of the
internal controls and recommends improvements when necessary. In addition,
as part of their audit of the Company's financial statements, Coopers
& Lybrand L.L.P. have obtained a sufficient understanding of the internal
control structure to determine the nature, timing and extent of audit tests to
be performed. Management has considered the internal auditors' and Coopers
& Lybrand L.L.P.'s recommendations concerning the Company's system of internal
control and has taken actions that it believes are cost-effective under the
circumstances to respond appropriately to these recommendations. Management
believes that the Company's system of internal control is adequate to
accomplish the objectives discussed.
Management also recognizes its responsibility to foster a strong ethical
climate that enables the Company to conduct its affairs according to the
highest standards of personal and corporate conduct. This responsibility is
characterized and reflected in the Company's code of corporate conduct, which
is publicized throughout the Company. The code of conduct addresses, among
other things: potential conflicts of interest; compliance with domestic laws,
including those relating to foreign transactions and financial disclosure; and
the confidentiality of proprietary information. The Company maintains a
systematic program to assess compliance with these policies.
The Audit Committee of the Board of Directors is responsible for overseeing
the Company's financial reporting process on behalf of the Board. In
33
<PAGE>
fulfilling its responsibility, the Committee recommends to the Board, subject
to shareowner ratification, the selection of the Company's independent
accountants. During 1996, the Committee consisted of four members of the
Board who are neither officers nor employees of the Company. It meets
regularly with representatives of management, internal audit and the
independent accountants to review internal accounting controls and accounting,
auditing and financial reporting matters. During 1996, the Committee held
five meetings. The Company's internal auditors and independent accountants
periodically meet alone with the Committee to discuss the matters previously
noted and have direct access to it for private communication at any time.
34
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareowner of Pacific Bell:
We have audited the consolidated financial statements and the financial
statement schedule of Pacific Bell (a wholly owned subsidiary of Pacific
Telesis Group) and Subsidiaries (the "Company") as listed in Item 14(a) of
this Form 10-K. These financial statements and the financial statement
schedule are the responsibility of management. Our responsibility is to
express an opinion on these financial statements and the financial statement
schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform an audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Pacific Bell and
Subsidiaries as of December 31, 1996 and 1995 and the consolidated results of
their operations and their cash flows for each of the three years in the
period ended December 31, 1996 in conformity with generally accepted
accounting principles. In addition, in our opinion, the financial statement
schedule referred to above, when considered in relation to the basic financial
statements taken as a whole, presents fairly, in all material respects, the
information required to be included therein.
As discussed in Note A to the Consolidated Financial Statements, the Company's
Pacific Bell Directory subsidiary changed its method of recognizing directory
publishing revenues and related expenses effective January 1, 1996. Also
discussed in Note A, the Company discontinued its application of Statement of
Financial Accounting Standards No. 71 during 1995.
/s/ Coopers & Lybrand L.L.P.
San Francisco, California
February 27, 1997
35
<PAGE>
PACIFIC BELL AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
For the Year Ended December 31
------------------------------
(Dollars in millions) 1996 1995 1994
- ---------------------------------------------------------------------------
OPERATING REVENUES
Local service................................ $ 3,956 $ 3,742 $ 3,385
Network access:
Interstate................................. 1,805 1,682 1,561
Intrastate................................. 718 707 731
Toll service................................. 1,274 1,210 1,984
Other service revenues....................... 1,693 1,521 1,406
------------------------------
TOTAL OPERATING REVENUES..................... 9,446 8,862 9,067
- ---------------------------------------------------------------------------
OPERATING EXPENSES
Cost of products and services................ 1,788 1,810 1,898
Customer operations and
selling expenses........................... 1,876 1,826 1,846
General, administrative, and other expenses.. 1,652 1,472 1,437
Depreciation and amortization ............... 1,826 1,831 1,758
------------------------------
TOTAL OPERATING EXPENSES..................... 7,142 6,939 6,939
- ---------------------------------------------------------------------------
OPERATING INCOME............................. 2,304 1,923 2,128
Interest expense............................. 363 410 439
Other income(expense)-net.................... 4 25 3
- ---------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES, EXTRAORDINARY
ITEM AND CUMULATIVE EFFECT OF
ACCOUNTING CHANGE.......................... 1,945 1,538 1,692
Income taxes................................. 775 569 621
- ---------------------------------------------------------------------------
INCOME BEFORE EXTRAORDINARY ITEM AND
CUMULATIVE EFFECT OF ACCOUNTING CHANGE..... 1,170 969 1,071
Extraordinary item, net of tax (Note B)...... - (3,360) -
Cumulative effect of accounting change,
net of tax (Note A)........................ 85 - -
------------------------------
NET INCOME (LOSS)............................ $ 1,255 $(2,391) $ 1,071
===========================================================================
The accompanying Notes are an integral part of the Consolidated Financial
Statements.
36
<PAGE>
PACIFIC BELL AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31
-------------------------
(Dollars in millions) 1996 1995
- ---------------------------------------------------------------------------
ASSETS
Cash and cash equivalents......................... $ 58 $ 68
Accounts receivable - net of allowances
for uncollectibles of $161 and $131............. 1,956 1,475
Prepaid expenses and other current assets......... 486 802
-------------------------
Total current assets.............................. 2,500 2,345
-------------------------
Property, plant, and equipment - at cost.......... 28,372 26,688
Less: accumulated depreciation................. (16,699) (15,608)
-------------------------
Property, plant, and equipment - net.............. 11,673 11,080
-------------------------
Other noncurrent assets........................... 476 474
-------------------------
TOTAL ASSETS...................................... $14,649 $13,899
===========================================================================
LIABILITIES AND SHAREOWNER'S EQUITY
Accounts payable and accrued liabilities.......... $ 2,077 $ 2,109
Debt maturing within one year..................... 287 781
Other current liabilities......................... 469 552
-------------------------
Total current liabilities......................... 2,833 3,442
-------------------------
Long-term obligations............................. 5,364 4,608
-------------------------
Deferred income taxes............................. 476 321
-------------------------
Other noncurrent liabilities and deferred credits. 2,049 2,417
-------------------------
Commitments and contingencies (Note K)
Common stock ($1.00 stated value; 300,000,000
shares authorized; 224,504,982 shares issued
and outstanding)................................ 225 225
Additional paid-in capital........................ 6,100 5,387
Accumulated deficit............................... (2,398) (2,501)
-------------------------
Total shareowner's equity......................... 3,927 3,111
-------------------------
TOTAL LIABILITIES AND SHAREOWNER'S EQUITY......... $14,649 $13,899
===========================================================================
The accompanying Notes are an integral part of the Consolidated Financial
Statements.
37
<PAGE>
PACIFIC BELL AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREOWNER'S EQUITY
For the Year Ended December 31
------------------------------
(Dollars in millions) 1996 1995 1994
- ---------------------------------------------------------------------------
COMMON STOCK
Balance at beginning of year................. $ 225 $ 225 $ 225
-----------------------------
Balance at end of year....................... 225 225 225
- ---------------------------------------------------------------------------
ADDITIONAL PAID-IN CAPITAL
Balance at beginning of year................. 5,387 5,169 5,168
Equity investment by parent.................. 713 218 1
-----------------------------
Balance at end of year....................... 6,100 5,387 5,169
- ---------------------------------------------------------------------------
(ACCUMULATED DEFICIT) REINVESTED EARNINGS
Balance at beginning of year................. (2,501) 830 761
Net income (loss)............................ 1,255 (2,391) 1,071
Dividends declared........................... (1,151) (943) (998)
Other changes................................ (1) 3 (4)
-----------------------------
Balance at end of year....................... (2,398) (2,501) 830
- ---------------------------------------------------------------------------
TOTAL SHAREOWNER'S EQUITY.................... $3,927 $3,111 $6,224
===========================================================================
The accompanying Notes are an integral part of the Consolidated Financial
Statements.
38
<PAGE>
PACIFIC BELL AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Year Ended December 31
------------------------------
(Dollars in millions) 1996 1995 1994
- ---------------------------------------------------------------------------
CASH FROM (USED FOR) OPERATING ACTIVITIES
Net income (loss)............................... $ 1,255 $(2,391) $ 1,071
Adjustments to reconcile net income (loss)
to cash from operating activities:
Extraordinary item.......................... - 3,360 -
Cumulative effect of accounting change...... (85) - -
Depreciation and amortization............... 1,826 1,831 1,758
Changes in deferred income taxes............ 251 121 1
Amortization of investment tax credits...... (47) (52) (63)
Changes in operating assets and liabilities:
Accounts receivable....................... (219) 55 (12)
Prepaid expenses and other
current assets.......................... (32) (29) (13)
Other noncurrent assets................... (43) (25) (25)
Accounts payable and accrued
liabilities............................. 14 149 170
Other current liabilities................. (83) (16) 40
Noncurrent liabilities and
deferred credits........................ (321) (367) (7)
Other adjustments, net...................... 6 25 (18)
---------------------------
Cash from operating activities.................. 2,522 2,661 2,902
- ---------------------------------------------------------------------------
CASH FROM (USED FOR) INVESTING ACTIVITIES
Additions to property, plant, and equipment..... (2,334) (1,964) (1,612)
Other investing activities, net................. (29) 19 2
---------------------------
Cash used for investing activities.............. (2,363) (1,945) (1,610)
- ---------------------------------------------------------------------------
(Continued next page)
39
<PAGE>
PACIFIC BELL AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Continued)
For the Year Ended December 31
------------------------------
(Dollars in millions) 1996 1995 1994
- ---------------------------------------------------------------------------
CASH FROM (USED FOR) FINANCING ACTIVITIES
Equity infusion from parent..................... 713 218 1
Proceeds from issuance of long-term debt........ 495 - -
Retirements of long-term debt................... - (514) (11)
Dividends paid.................................. (1,151) (943) (998)
Increase (decrease) in short-term borrowings
with original maturities of 90 days or less,
net........................................... (504) 526 (287)
Other financing activities, net................. 278 3 8
---------------------------
Cash used for financing activities.............. (169) (710) (1,287)
- ---------------------------------------------------------------------------
Increase (decrease) in cash and
cash equivalents.............................. (10) 6 5
Cash and cash equivalents at January 1.......... 68 62 57
---------------------------
Cash and cash equivalents at December 31........ $ 58 $ 68 $ 62
===========================================================================
The accompanying Notes are an integral part of the Consolidated Financial
Statements.
40
<PAGE>
PACIFIC BELL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The Consolidated Financial Statements include the accounts of Pacific 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 (the "Company"). The
Company is a wholly owned subsidiary of Pacific Telesis Group. All
significant intercompany balances and transactions have been eliminated. The
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 Company's principal business, communications and information services,
accounts for substantially all of its revenues. The Company provides local
exchange services, network access, local toll services, directory advertising,
Internet access, and selected information services in California.
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the amounts reported in the financial statements and accompanying
notes. Actual results could differ from those estimates.
Regulatory Accounting
Effective third quarter 1995, for external financial reporting purposes, 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. (See Note B - "Discontinuance of Regulatory Accounting - SFAS
71" on page 44.)
Property, Plant, and Equipment
Property, plant, and equipment (which consists primarily of telecommunications
plant dedicated to providing telecommunications services) is carried at cost.
The cost of self-constructed plant includes employee wages and benefits,
materials, capitalized interest during the construction period, and other
costs. Capital leases are recorded at the present value of future minimum
lease payments. Expenditures in excess of $500 that increase the capacity,
operating efficiency, or useful life of an individual asset are capitalized.
Expenditures for maintenance and repairs are charged to expense.
41
<PAGE>
A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Cont'd)
No gain or loss is recognized on the disposition of depreciable
telecommunications plant. At the time of retirement of telecommunication
property, plant, and equipment, the original cost of the plant retired plus
cost of removal is charged to accumulated depreciation. Accumulated
depreciation is credited with salvage value or insurance recovery, if any.
Depreciation expense is computed using the straight-line method based on
management's estimate of economic lives for various categories of property,
plant, and equipment.
The Company continues to invest heavily in improvements to its core
telecommunications network. The Company has also made investments in Internet
access. These technologies are subject to technological risks and rapid
market changes due to new products and services and changing customer demand.
These changes may result in changes to the estimated economic lives or net
realizable value of these assets.
The Company carries catastrophic insurance coverage with large deductibles on
its telecommunications switching and building assets, and is self-insured for
its outside telecommunications plant.
Cash and Cash Equivalents
Cash equivalents include all highly liquid monetary instruments with
maturities of ninety days or less from the date of purchase. In its cash
management practices, the Company maintains zero-balance disbursement accounts
for which funds are made available as checks are presented for clearance.
Checks outstanding are included in accounts payable.
Income Taxes
Pacific Telesis Group allocates consolidated taxes as if the Company were a
separate taxpayer. The Company records its share of the consolidated taxes as
tax liabilities and pays amounts due to tax authorities through Pacific
Telesis Group.
Deferred income taxes are provided to reflect the tax effects of temporary
differences between the carrying amounts of assets and liabilities for
financial reporting purposes and the amounts used for tax purposes.
Investment tax credits earned prior to their repeal by the Tax Reform Act of
1986 are amortized as reductions in tax expense over the lives of the assets
which gave rise to the credits.
Advertising Costs
Costs for advertising products and services or corporate image are expensed as
incurred.
42
<PAGE>
A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Cont'd)
Computer Software Costs
The costs of computer software purchased or developed for internal use are
expensed as incurred. However, initial operating system software costs are
capitalized and amortized over the lives of the associated hardware.
Change in Accounting for Postretirement Costs
Effective January 1, 1993, the Company adopted SFAS 106, "Employers'
Accounting for Postretirement Benefits Other than Pensions." Annual price cap
decisions by the CPUC granted the Company approximately $100 million for each
of the years 1993-1997 for partial recovery of its higher costs. However, a
CPUC order held that revenues collected after October 12, 1994 are subject to
refund. (See "Revenues Subject to Refund" in Note K on page 59.)
Change in Estimates
In 1996, management amended the salaried pension plan, which changed from a
final pay plan to a cash balance plan. As a result of the approval of this
plan amendment, the Company updated its actuarial assumptions to reflect
changes in market interest rates and recent actuarial experience. (See Note
E - "Employee Retirement Plans" on page 48 and Note F - "Other Postretirement
Benefits" on page 51.)
Cumulative Effect of Accounting Change
Effective January 1, 1996, Pacific Bell Directory ("Directory"), a wholly-
owned subsidiary of the Company, changed its method of recognizing directory
publishing revenues and related expenses. Directory previously recognized
revenues and expenses related to publishing using the "amortized" method,
under which revenues and expenses were recognized over the lives of the
directories, generally one year. Under the new "issue basis" method, revenues
and expenses will be recognized when the directories are issued.
Management believes this change to the issue basis method is preferable
because it is the method generally followed in the publishing industry and
better reflects the operating activity of the business.
The cumulative after-tax effect of applying the new method to prior years is
recognized as of January 1, 1996 as a one-time, non-cash gain applicable to
net income of $85 million. The gain is net of deferred taxes of $58 million.
The effect of applying the new method for the twelve months ended December 31,
1996 is a non-cash gain included in income before extraordinary item
43
<PAGE>
A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Cont'd)
and cumulative effect of accounting change of $3 million. The total effect of
the change is a non-cash gain included in net income of $88 million.
Pro forma results, assuming the issue basis method had been applied during
prior periods, are as follows:
For the year ended December 31
------------------------------
(Dollars in millions) 1996 1995 1994
- ----------------------------------------------------------------------------
Pro Forma (Unaudited)
- --------------------
Income before extraordinary item........... $1,170 $982 $1,057
Net income (loss).......................... $1,170 $(2,378) $1,057
As Reported
- -----------
Income before extraordinary item........... $1,170 $969 $1,071
Net income (loss).......................... $1,255 $(2,391) $1,071
B. DISCONTINUANCE OF REGULATORY ACCOUNTING - SFAS 71
Effective third quarter 1995, for external financial reporting purposes, the
Company discontinued the application of SFAS 71, "Accounting for the Effects
of Certain Types of Regulation," an accounting standard for entities subject
to traditional regulation. As a result, during 1995 the Company recorded a
non-cash, extraordinary, after-tax charge of $3.4 billion, 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.
(Dollars in millions) Pre-Tax After-Tax
- -------------------------------------------------------------------------
Increase in telephone plant and equipment
accumulated depreciation..................... $4,819 $2,842
Elimination of net regulatory assets........... 962 518
------------------
Total.......................................... $5,781 $3,360
=========================================================================
The Company historically accounted for the economic effects of regulation in
accordance with the provisions of SFAS 71. Under SFAS 71, the Company
depreciated telephone plant using lives prescribed by regulators and, as a
result of actions of regulators, deferred recognizing certain costs, or
recognized certain liabilities (referred to as "regulatory assets" and
"regulatory liabilities").
44
<PAGE>
B. DISCONTINUANCE OF REGULATORY ACCOUNTING - SFAS 71 (Cont'd)
Effective third quarter 1995, management determined that, for external
financial reporting purposes, it was 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. The Company's prices for its products
and services are being driven increasingly by market forces instead of
regulation.
In 1995, the $4.8 billion increase in the Company's accumulated depreciation
for its telephone plant reflects the adoption of new, shorter depreciation
lives. The estimated useful lives historically prescribed by regulators did
not keep up with the rapid pace of technology. The Company's previous and new
asset lives are compared in the following table.
Asset Lives (in years) Old New
- ---------------------------------------------------------------------------
Copper cable...................................... 19-26 14
Digital switches.................................. 16.5 10
Digital circuits.................................. 9.6-11.5 8
Fiber optic cable................................. 28-30 20
Conduit........................................... 59 50
- ---------------------------------------------------------------------------
The discontinuance of SFAS 71 for external financial reporting purposes in
1995 by the Company also required the elimination of net regulatory assets
totaling $962 million. Regulators sometimes include costs in allowable costs
for ratemaking purposes in a period other than the period in which those costs
would be charged to expense under general accounting rules. The accounting
for these timing differences created regulatory assets and regulatory
liabilities on the Company's balance sheet.
Significant changes occurred in the Company's balance sheet in 1995 as a
result of the discontinuance of SFAS 71. Details of the Company's net
regulatory assets that have been eliminated are displayed in the following
table.
45
<PAGE>
B. DISCONTINUANCE OF REGULATORY ACCOUNTING - SFAS 71 (Cont'd)
(Dollars in millions)
- ------------------------------------------------------------------------
Regulatory assets/(liabilities) due to:
Deferred pension costs*...................................... $460
Unamortized debt redemption costs**.......................... 337
Deferred compensated absence costs*.......................... 206
Unamortized purchases of property, plant, and
equipment under $500....................................... 82
Deferred income taxes***..................................... (159)
Other........................................................ 36
----
Total........................................................ $962
========================================================================
* Previously included primarily in "Other noncurrent 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."
Due to the discontinued application of SFAS 71, pension costs for both
intrastate and interstate operations are now determined under SFAS 87,
"Employers' Accounting for Pensions," and SFAS 88, "Employers' Accounting for
Settlements and Curtailments of Defined Benefit Pension Plans and for
Termination Benefits." Capitalized interest cost is reported as a cost of
telephone plant and equipment and as a reduction in interest expense, as
required by SFAS 34, "Capitalization of Interest Cost." Prior to the
discontinuance of SFAS 71, 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 in 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. RESTRUCTURING AND CURTAILMENT CHARGES
During 1993, the Company recorded a pre-tax restructuring charge of $977
million to recognize the incremental cost of force reductions associated with
restructuring its internal business processes through 1997. This charge is to
cover the incremental severance costs associated with terminating more than
14,000 employees from 1994 through 1997. It is also to cover the incremental
costs of consolidating and streamlining operations and facilities to support
this downsizing initiative. The remaining reserve balance as of December 31,
1996 and 1995 was $93 and $219 million, respectively.
46
<PAGE>
D. INCOME TAXES
The components of income tax expense for each year are as follows:
(Dollars in millions) 1996 1995 1994
- --------------------------------------------------------------------------
Current:
Federal................................. $442 $406 $549
State and local income taxes............ 130 122 166
----------------------------
Total current.............................. 572 528 715
Deferred:
Federal.................................. 184 66 (24)
State and local income taxes............. 66 27 (7)
----------------------------
Total deferred............................. 250 93 (31)
Amortization of investment
tax credits - net........................ (47) (52) (63)
---------------------------
Total income taxes ........................ $775 $569 $621
==========================================================================
Significant components of the Company's deferred tax assets and liabilities
are as follows:
December 31
-------------------
(Dollars in millions) 1996 1995
- ---------------------------------------------------------------------------
Deferred tax (assets)/liabilities due to:
Depreciation and amortization................. $947 $891
Employee benefits............................. (420) (431)
Restructuring reserve......................... (54) (124)
Customer rate reductions...................... (110) (128)
Other, net.................................... (292) (446)
------ ------
Net deferred tax (assets)/liabilities........... $71 $(238)
====== ======
Amounts recorded in consolidated
balance sheets:
Deferred tax assets*.......................... $405 $ 559
====== ======
Deferred tax liabilities*..................... $476 $ 321
====== ======
===========================================================================
* Reflects reclassification of certain current and noncurrent amounts by
federal and state tax jurisdictions to a net presentation. Amounts include
both current and noncurrent portions. (See Note M - "Additional Financial
Information" on page 62 for current and noncurrent deferred tax assets.)
47
<PAGE>
D. INCOME TAXES (Cont'd)
In 1996 the State of California reduced the corporate tax rate from 9.3
percent to 8.84 percent, effective for taxable years beginning on or after
January 1, 1997. In accordance with generally accepted accounting principles,
deferred tax assets and liabilities at December 31, 1996 were revalued to
reflect the lower tax rate. This revaluation increased state tax expense, net
of federal tax, and decreased net income $10 million in 1996.
An income tax expense related to the cumulative effect of the accounting
change in 1996 for the change in accounting for directory revenue and expenses
is $58 million. (See Note A - "Cumulative Effect of Accounting Change" on page
43.)
An income tax benefit related to the extraordinary charge in 1995 for the
discontinued application of SFAS 71 for depreciated telephone plant is $2.0
billion and for regulatory assets and liabilities is $0.4 billion. (See Note
B - "Discontinuance of Regulatory Accounting - SFAS 71" on page 44.) The
reasons for differences each year between the effective income tax rate and
applying the statutory federal income tax rate to income before income taxes
are provided in the following reconciliation:
1996 1995 1994
- ---------------------------------------------------------------------------
Statutory federal income tax rate (%)......... 35.0 35.0 35.0
Increase (decrease) in taxes resulting from:
Amortization of investment tax credits..... (1.6) (3.4) (3.6)
Plant basis differences - net of
applicable depreciation................. - 2.1 2.0
Interest during construction............... - (1.1) (0.6)
State income taxes - net of federal
income tax benefit...................... 6.5 6.2 6.1
Excess deferred taxes...................... - (2.9) (2.8)
Other ..................................... (0.1) 1.1 0.6
-------------------------
Effective income tax rate (%)................. 39.8 37.0 36.7
===========================================================================
E. EMPLOYEE RETIREMENT PLANS
Defined Benefit Plans
The Company provides pension, death, and survivor benefits to substantially
all of its employees through participation in certain Pacific Telesis Group
defined benefit pension plans. Non-salaried plan benefits are based on a flat
dollar amount and vary according to job classification, age, and years of
service. Salaried plan benefits accrue in a separate account balance based on
a fixed percentage of each employee's monthly salary with interest.
48
<PAGE>
E. EMPLOYEE RETIREMENT PLANS (Cont'd)
The Company is responsible for contributing enough to the pension plans, while
the employee still is working, to ensure that adequate funds are available to
provide the benefit payments upon the employee's retirement. These
contributions are made to an irrevocable trust fund in amounts determined
using the aggregate cost actuarial method, one of the actuarial methods
specified by the Employee Retirement Income Security Act of 1974 ("ERISA"),
subject to ERISA and Internal Revenue Code limitations.
The Company reports pension costs and related obligations under the provisions
of SFAS 87 and SFAS 88. However, prior to discontinuing application of SFAS
71 during 1995, the Company recognized pension costs consistent with the
methods adopted for ratemaking. Pension costs recognized under SFAS 71
reflected a California Public Utilities Commission ("CPUC") order requiring
the continued use of the aggregate cost method for intrastate operations and a
Federal Communications Commission ("FCC") requirement to use SFAS 87 and SFAS
88 for interstate operations. (See Note B - "Discontinuance of Regulatory
Accounting - SFAS 71" on page 44.) As required by regulatory accounting under
SFAS 71, pension cost in the table below excludes the intrastate portion of
the Company's SFAS 87 costs of $79 for 1994.
Annual pension cost recognized in the financial statements during each year
presented is:
Pension Cost 1996 1995 1994
- --------------------------------------------------------------------------
(Dollars in millions)
Current year pension cost................... $(174) $ 76 $ 28
Settlements and curtailments................ - - (10)
-----------------------------
Pension cost (credit) recognized............ $(174) $ 76 $ 18
==========================================================================
49
<PAGE>
E. EMPLOYEE RETIREMENT PLANS (Cont'd)
December 31
-----------------------
Pension Obligation 1996 1995
- --------------------------------------------------------------------------
(Dollars in millions)
Accumulated Benefit Obligation................. $7,443 $8,835
Vested Benefit Obligation...................... $6,904 $7,747
- --------------------------------------------------------------------------
Accrued pension cost liability recognized in
the consolidated balance sheets............. $814 $1,061
- --------------------------------------------------------------------------
Present value discount rate (%)................ 7.5 7.25
Long-term rate of return on plan assets (%).... 9.0 9.0
==========================================================================
Liabilities and expenses for employee benefits are based on actuarial
assumptions. These actuarial assumptions are subject to change over time
which could have a material impact on the Company's financial statements.
The assets of the plans are primarily composed of common stocks, U.S.
Government and corporate obligations, index funds, and real estate
investments. The plans' projected benefit obligations for employee service
to date reflect the Company's expectations of the effects of future salary
progression and benefit increases.
In March 1996, Pacific Telesis Group amended the salaried pension plan from a
final pay plan to a cash balance plan effective July 1, 1996. As a result of
this plan amendment, in second quarter 1996 Pacific Telesis Group updated its
actuarial assumptions to reflect changes in market interest rates and recent
experience, including a change in its assumption concerning future ad hoc
increases in pension benefits. Taken together, the change in plan design,
discount rate, assumed long-term rate of return and other assumptions
increased net income by approximately $150 million during 1996. An enhanced
transition benefit, based on frozen pay and service as of June 30, 1996, was
established to preserve benefits already accrued by salaried employees under
the final pay plan. Effective January 1, 1995, the salaried pension plan was
amended to cap net credited service for pension benefits at 30 years or, if
greater, the amount of the employee's service on January 1, 1995. Upon
adoption, this amendment affected approximately 800 employees.
During 1996, 1995 and 1994, special pension benefits and cash incentives were
offered in connection with the Company's restructuring and related force
reduction program. Effective October 1, 1995, pension benefit increases may
be offered to various groups of non-salaried employees under 1995 plan
amendments which increase benefits for specified groups who elect early
retirement under incentive programs. On March 28, 1994, the Company
50
<PAGE>
E. EMPLOYEE RETIREMENT PLANS (Cont'd)
offered a special pension benefit that removed any age discount from pensions
for management employees who were eligible to retire with a service pension on
that date. Also during 1994, pension benefit increases were offered to
various groups of non-salaried employees under 1992 plan amendments that
increase benefits for specified groups who elect early retirement under
incentive programs. Approximately 1,500, 1,900 and 3,400 employees left the
Company during 1996, 1995 and 1994, respectively, under early retirement or
voluntary and involuntary severance programs. Annual pension cost excludes
($64), $219 and $62 million of additional pension costs charged to the
Company's restructuring reserve in 1996, 1995 and 1994, respectively.
The Company has entered into labor negotiations with union-represented
employees in the past and expects to do so in the future. Pension benefits
have been included in these negotiations, and improvements in benefits have
been made periodically. Additionally, the Company has increased benefits to
pensioners on an ad hoc basis. While no assurance can be offered with respect
to future increases, management's expectations for future benefit increases
other than ad hoc increases have been considered in determining pension costs.
Defined Contribution Plans
The Company also participates in certain Pacific Telesis Group-sponsored
defined contribution retirement plans covering substantially all employees.
These plans include the Pacific Telesis Group Supplemental Retirement and
Savings Plan for Salaried Employees, and the Pacific Telesis Group
Supplemental Retirement and Savings Plan for Nonsalaried Employees
(collectively, the "Savings Plans").
The Company's contributions to the Savings Plans are based on matching a
portion of employee contributions. All matching employer contributions to the
Savings Plans are made through a leveraged employee stock ownership ("LESOP")
trust. Total Company contributions to these plans, including contributions
allocated to participant accounts through the LESOP trust, were $65, $68, and
$64 million in 1996, 1995, and 1994, respectively.
F. OTHER POSTRETIREMENT BENEFITS
Substantially all retirees and their dependents are covered under the
Company's plans for medical, dental and life insurance benefits.
Approximately 43,000 retirees were eligible to receive benefits as of January
1, 1996. Currently, the Company pays the full cost of retiree health
benefits. However, by 1999, all employees retiring after 1990 will pay a share
of the costs of medical coverage that exceeds a defined dollar medical cap.
Such future cost sharing provisions have been reflected in determining the
Company's postretirement benefit costs. The Company retains the right,
subject to applicable legal requirements, to amend or terminate these
benefits.
51
<PAGE>
F. OTHER POSTRETIREMENT BENEFITS (Cont'd)
Effective January 1, 1993, the Company adopted SFAS 106. The standard
requires that the cost of retiree benefits be recognized in the financial
statements from an employee's date of hire until the employee becomes eligible
for these benefits. Previously, the Company expensed these retiree benefits
as they were paid. The Company is amortizing the transition obligation over
20 years from the date of adoption. The transition obligation represents the
unrecognized cost of benefits that had already been earned by retirees and
active employees when the new standard was adopted.
The Company's periodic expense under SFAS 106 in 1996 and 1995, as displayed
in the table below, increased from $103 million in 1992 under the prior
method. Because the Company's higher costs are being partially recovered in
revenues, the increased costs have not materially affected reported earnings.
(See "Change in Accounting for Postretirement Costs" in Note A on page 43.)
However, a CPUC order held that related revenues collected after October 12,
1994 are subject to refund. (See "Revenues Subject to Refund" in Note K on
page 59.)
The components of net periodic postretirement benefit cost are as follows:
(Dollars in millions) 1996 1995
- ---------------------------------------------------------------------------
Service cost.................................. $ 44 $ 49
Interest cost on accumulated postretirement
benefit obligation..........................
232 256
Actual return on plan assets.................. (181) (246)
Net amortization and deferral of items subject
to delayed recognition...................... 162 268
----- -----
Net periodic postretirement benefit cost...... $257 $327
===========================================================================
The Company partially funds the obligation by contributing to Voluntary
Employees' Beneficiary Association trusts. Plan assets are invested primarily
in domestic and international stocks and domestic investment-grade bonds.
In March 1996, in conjunction with a change in the pension plan assumptions,
management revised the assumed discount rate used to measure the accumulated
postretirement benefit obligation and remeasured plan assets. These changes
did not have a material effect on 1996 net income. In addition, in 1996 the
medical trend rate decreased to 6.0 percent, which increased net income by
approximately $17 million during 1996 in comparison to 1995.
52
<PAGE>
F. OTHER POSTRETIREMENT BENEFITS (Cont'd)
The funded status of the plans follows:
December 31
--------------------
(Dollars in millions) 1996 1995
- --------------------------------------------------------------------------
Accumulated postretirement benefit obligation:
Retirees................................... $2,137 $2,250
Eligible active employees................... 246 216
Other active employees...................... 745 769
------ ------
Total accumulated postretirement benefit
obligation.................................. 3,128 3,235
Less:
Fair value of plan assets*.................. (1,508) (1,217)
Transition obligation....................... (1,515) (1,609)
Plus:
Unrecognized net gain**..................... 427 164
Unrecognized prior service cost............. 36 38
------ ------
Accrued net postretirement benefit obligation
recognized in the consolidated
balance sheets.............................. $ 568 $ 611
===========================================================================
* Fair value of plan assets reflects an estimated allocation of the Company's
portion of Pacific Telesis Group plans' assets.
** The unrecognized net gain is amortized over the expected future service
lives of approximately 16 years and reflects differences between actuarial
assumptions and actual experience. It also includes the impact of changes
in actuarial assumptions.
Liabilities and expenses for employee benefits are based on actuarial
assumptions. The assumed discount rate to measure the accumulated
postretirement benefit obligation was 7.50 percent and 7.25 percent at
December 31, 1996 and 1995, respectively. The 1996 expense was calculated at
7.25 percent until March. The remainder of 1996 expense was calculated at
7.75 percent. The 1996 accrued postretirement benefit obligation and the 1997
expense are based on an assumed annual increase in health care costs of 6.0
percent. Increasing the assumed health care cost trend rates by one percent
each year would increase the December 31, 1996 accumulated postretirement
benefit obligation by $402 million and would increase the combined service and
interest cost components of net periodic postretirement benefit cost for 1996
by $35 million. A 9.0 percent long-term rate-of-return on assets is assumed in
calculating postretirement benefit costs. These actuarial assumptions are
subject to change over time, which could have a material impact on the
Company's financial statements.
53
<PAGE>
G. STOCK OPTIONS AND STOCK APPRECIATION RIGHTS
The Company is a wholly owned subsidiary of Pacific Telesis Group ("PTG") and
as such does not issue options or stock appreciation rights ("SARs") on its
own stock. However, key employees of the Company have outstanding options
and SARs that were granted under the PTG 1994 Stock Incentive Plan (the
"Stock Plan") and a previous plan (collectively, the "Plans").
Options granted under the Plans were granted as nonqualified options or as
incentive stock options, and portions were granted in conjunction with SARs.
The original exercise price of each outstanding option and SAR was equal to
the fair market value of PTG's common stock on the date of grant. The
exercise price of each option may be paid in cash or by surrendering shares of
PTG's common stock already owned by the holder, or with a combination of cash
and such shares. Options and associated SARs ordinarily become exercisable at
stated times beginning at least one year after the date of grant. The term of
any option or SAR cannot exceed ten years.
PTG applies Accounting Principles Board Opinion No. 25, "Accounting for Stock
Issued to Employees," and related interpretations in accounting for its plans.
Accordingly, no compensation expense has been recognized by the Company for
options and SARs granted to Company employees resulting from PTG stock-based
compensation plans. Had compensation cost for the PTG's stock option plans
been determined based upon the fair value at the grant date for awards under
these plans consistent with the optional expense measurement method described
in SFAS No. 123, "Accounting for Stock-Based Compensation," the Company's net
income would have been reduced by approximately $1.3 million for 1996 and $0.3
million for 1995. The pro forma effect on net income for 1996 and 1995 is not
representative of the pro forma effect on net income in future years because
it does not take into consideration pro forma compensation expense related to
grants made prior to 1995.
The weighted-average fair value, on the date of grant, of options granted
during 1996 and 1995 is estimated at $2.91 and $2.80, respectively. Fair
value is determined using the Black-Scholes option-pricing model with the
following weighted-average assumptions used for grants in 1996 and 1995,
respectively: dividend yield of 8.0 and 7.2 percent, expected volatility of
23.4 and 17.0 percent, risk-free interest rate of 6.0 and 7.0 percent, and
expected lives of 5 years.
54
<PAGE>
H. DEBT AND LEASE OBLIGATIONS
Long-term obligations as of December 31, 1996 and 1995 consist of debentures
of $4,045 and $3,545 million, respectively, and corporate notes of $1,150
million each year. Maturities and interest rates of long-term obligations are
summarized as follows:
December 31
------------------------
Maturities and Interest Rates 1996 1995
- --------------------------------------------------------------------------
(Dollars in millions)
1999 4.625%.................... $ 100 $ 100
2000 4.625%.................... 125 125
2001 8.700%.................... 200 200
2002-2043 5.875% to 8.500%.......... 4,770 4,270
---------------------
5,195 4,695
Long-term capital lease obligations............. 276 18
Unamortized discount-net of premium............. (107) (105)
---------------------
Total long-term obligations..................... $5,364 $4,608
==========================================================================
In February 1997, the CPUC approved the Company's application to issue up to
$1.75 billion of long- and intermediate-term debt and preferred securities.
The proceeds may be used to redeem maturing debt, to refinance other debt
issues and to finance construction expenditures or acquisition of property.
The CPUC's authorization is in effect until the full $1.75 billion has been
issued. The Company also has remaining authority from the Securities and
Exchange Commission to issue up to $150 million of long- and intermediate-term
debt through a shelf registration filed in April 1993.
During 1996, the Company entered into a leasing arrangement with Pacific
Telesis Group to finance equipment associated with the buildout of the PCS
network. As of December 31, 1996 the obligation remaining is $270 million.
These leases are classified as capital leases and the related assets are
classified as property, plant and equipment.
55
<PAGE>
H. DEBT AND LEASE OBLIGATIONS (Cont'd)
As of December 31, 1996 and 1995, the weighted average interest rate on short-
term borrowings was 6.64 percent and 5.84 percent, respectively. Debt
maturing within one year in the balance sheets consists of short-term
borrowings and the portion of long-term obligations that matures within one
year as follows:
December 31
--------------------
(Dollars in millions) 1996 1995
- -------------------------------------------------------------------------
Commercial paper.......................... $200 $701
Advances from Pacific Telesis Group....... 73 76
---------------------
Total short-term borrowings............... 273 777
Current maturities of
long-term obligations................... 14 4
---------------------
Total debt maturing within one year....... $287 $781
==========================================================================
Lines of Credit
The Company has various uncommitted lines of credit with certain banks. These
arrangements do not require compensating balances or commitment fees and,
accordingly, are subject to continued review by the lending institutions. As
of December 31, 1996 and 1995, the total unused lines of credit available were
approximately $2.8 and $2.7 billion, respectively.
I. FINANCIAL INSTRUMENTS
The following table presents the estimated fair values of the Company's
financial instruments:
December 31
--------------------------------------
1996 1995
--------------------------------------
Estimated Estimated
Carrying Fair Carrying Fair
(Dollars in millions) Amount Value Amount Value
- ----------------------------------------------------------------------------
Cash and cash equivalents........ $ 58 $ 58 $ 68 $ 68
Debt maturing within one year.... 287 287 781 781
Deposit liabilities.............. 268 268 357 357
Long-term debt................... 5,088 5,088 4,590 4,881
============================================================================
56
<PAGE>
I. FINANCIAL INSTRUMENTS (Cont'd)
The following methods and assumptions were used to estimate the fair values of
each category of financial instrument:
The fair values of cash and cash equivalents, debt maturing within one year,
and deposit liabilities approximate their carrying amounts because of the
short-term maturities of these instruments.
The fair value of long-term debt issues was estimated based on the net present
value of future expected cash flows, which were discounted using current
interest rates and current market prices. The carrying amounts of long-term
debt include the unamortized net discount.
J. RELATED PARTY TRANSACTIONS
The Company receives certain services associated with corporate functions,
e.g., legal, financial, external affairs and governmental relations, human
resources and corporate strategy, performed on the Company's behalf by its
parent, Pacific Telesis Group. Costs incurred by Pacific Telesis Group which
are attributable to the Company are charged directly to the Company. The
Company is also charged for its proportionate share of other indirect costs
incurred by Pacific Telesis Group. Total costs charged by Pacific Telesis
Group and included in general, administrative, and other expenses were $141
million, $110 million and $81 million in 1996, 1995 and 1994, respectively.
The Company provides non-telecommunications and telecommunications services
including local, toll and access services to certain Pacific Telesis Group
affiliated companies. Revenues recorded for these services totaled
$68 million, $7 million and $21 million in 1996, 1995 and 1994, respectively.
In 1996, the Company entered into a leasing arrangement with Pacific Telesis
Group. (See Note H - "Debt and Lease Obligations" on page 55.)
K. COMMITMENTS AND CONTINGENCIES
Merger Agreement
On April 1, 1996, SBC Communications Inc. ("SBC") and Pacific Telesis Group,
the Company's parent, jointly announced a definitive agreement whereby Pacific
Telesis Group will become a wholly-owned subsidiary of SBC. Under terms of
the merger agreement, each share of Pacific Telesis common stock will be
exchanged for 0.733 shares of SBC common stock, subject to adjustment. On
July 31, 1996, the shareowners of Pacific Telesis Group and SBC approved the
transaction, which previously had been approved by the respective Board of
Directors of each company.
57
<PAGE>
K. COMMITMENTS AND CONTINGENCIES (Cont'd)
The transaction is intended to be accounted for as a pooling of interests and
to be a tax-free reorganization. Adjustments typically associated with the
pooling of interests method are to conform accounting policies of the merged
entities. Management is unable to determine if these policy changes and other
merger-related adjustments will be material.
The merger is subject to certain conditions and regulatory approvals. On
January 31, 1997, the FCC approved the merger, and in November 1996, the U.S.
Department of Justice announced it had concluded that the merger does not
violate the antitrust laws and accordingly that it was closing its
investigation into the merger. In December 1996, the Public Service
Commission of Nevada ("PSCN") approved the merger with the stipulation that
Nevada Bell customers be paid the greater of $4 million or 2.0 percent of the
amount, if any, ordered by the CPUC to be paid to Pacific Bell customers. The
payment to Nevada Bell customers is conditioned on closing of the merger. In
addition, the California State Attorney General has told the CPUC that the
merger will not hurt competition in California and is consistent with emerging
trends.
On September 30, 1996, the Office of Ratepayer Advocates ("ORA"), the consumer
interest branch of the CPUC, filed testimony in the CPUC merger proceeding
recommending a $2.1 billion rebate to customers payable over five years.
Pacific Telesis Group does not agree with the ORA's recommendation and
believes no customer rebate or payment should be required in connection with
the merger.
On February 21, 1997, two California administrative law judges issued a
proposed decision approving the merger but with a number of conditions,
including payment of up to $750 million. Management does not agree with the
level of payment or the restrictive conditions and intends to work towards
their reduction or elimination. A proposed decision by the administrative law
judges is not binding. The CPUC is expected to review the full case and the
proposed decision and issue a final decision by March 31, 1997. Depending on
the final CPUC decision, the merger could close in early second quarter.
Purchase Commitments
In December 1994, the Company contracted for the purchase of up to $2 billion
of Advanced Communications Network ("ACN") facilities, which incorporated new
technologies. During 1995, the ability to deploy the facilities outstripped
the ACN vendors' ability to deliver necessary products and software.
Accordingly, management decided to suspend construction at certain sites,
which reduced the expected cost to less than $700 million. If ACN facilities
meet certain quality and performance criteria (the "Network Test"), the
Company is committed to purchase the ACN facilities in 1998. If ACN
facilities fail the Network Test, the Company will not be committed to buy the
ACN facilities but might be liable to reimburse the principal ACN vendor for
some construction costs up to $300 million. If competition or other factors
affect the Company's ability to recover its investment in these facilities,
the value of the ACN facilities could be materially impaired.
58
<PAGE>
K. COMMITMENTS AND CONTINGENCIES (Cont'd)
As of December 31, 1996, the Company had purchase commitments of about $208
million remaining in connection with its previously announced program for
deploying an all digital switching platform with ISDN and SS-7 capabilities.
Revenues Subject to Refund
In 1992, the CPUC issued a decision adopting, with modification, SFAS 106 for
regulatory accounting purposes. Annual price cap decisions by the CPUC
granted the Company approximately $100 million in each of the years 1993-1997
for partial recovery of higher costs under SFAS 106. However, the CPUC in
October 1994 reopened the proceeding to determine the criteria for exogenous
cost treatment and whether 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 totaled about
$221 million at December 31, 1996. Management believes postretirement
benefits costs are appropriately recoverable in the Company's price cap
filings.
Property Tax Investigation
In 1992, a settlement agreement was reached between the State Board of
Equalization, all California counties, the State Attorney General, and 28
utilities, including Pacific Bell, on a specific methodology for valuing
utility property for property tax purposes for a period of eight years. The
CPUC opened an investigation to determine if any resulting property tax
savings should be returned to customers. Intervenors have asserted that as
much as $20 million of annual property tax savings should be treated as an
exogenous cost reduction in the Company's annual price cap filings. These
intervenors have also asserted that past property tax savings totaling as much
as approximately $70 million as of December 31, 1996, plus interest should be
returned to customers. Management believes that, under the CPUC's regulatory
framework, any property tax savings should be treated only as a component of
the calculation of shareable earnings not as an exogenous cost. In an Interim
Opinion issued in June 1995, the CPUC decided to defer a final decision on
this matter pending resolution of the criteria for exogenous cost treatment
under its regulatory framework. The criteria are being considered in a
separate proceeding initiated for rehearing of the CPUC's postretirement
benefits other than pensions decision discussed above. It is possible that
the CPUC could decide this issue in the near term, and that the decision could
have a material adverse effect on the Company.
59
<PAGE>
L. 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. The Company also faces
competition from cable television companies and others.
Effective January 1, 1995, the CPUC authorized toll services competition.
Management estimates that share losses since January 1, 1995 have been in the
five to six percent range. However, this loss combined with losses prior to
the official opening of this market has resulted in the Company currently
serving less than 50 percent of the business toll market. In April 1995, the
CPUC 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. Competitors may choose to locate their
transmission facilities within or near the Company's central offices.
Effective January 1, 1996, the CPUC authorized local exchange competition. By
early February 1997, the CPUC had authorized about 90 companies, including
large and well-capitalized long-distance carriers, competitive access
providers, and cable television companies to begin providing local
phone service in California, and 38 additional applications were pending.
These companies are prepared to compete in major local exchange markets and
many have already deployed switches or other facilities. All of the Company's
customers have already chosen a long-distance company, and these companies
have established widespread customer awareness through extensive advertising
campaigns over several years.
Local exchange competition may affect toll and access revenues, as well as
local service revenues, since customers may select a competitor for all their
telecommunications services. Local exchange competition may also affect other
service revenues as Pacific Bell Directory will have to acquire listings from
other providers for its products, and competing directory publishers may ally
themselves with other telecommunications providers. Management estimates the
CPUC's proposed local competition rules could materially reduce revenue growth
for the Company's regulated California operations by late 1997.
The characteristics of the California market make it attractive to new
competitors. The Company's business and residence revenues and profitability
are concentrated among a small portion of its customer base and geographic
areas. Competitors need only serve selected portions of the Company's service
area to compete for the majority of its business and residence usage revenues.
High-margin customers are clustered in high-density areas such as Los Angeles
and Orange County, the San Francisco Bay Area, San Diego, and Sacramento.
California is also attractive because it has one of the lowest switched access
rates in the country. By combining the low switched access rates and
discounted resale rates, competitors have the ability to price their services
below the Company's prices while maintaining high margins. Reselling allows
competitors to offer local services with little or no investment.
60
<PAGE>
L. COMPETITIVE RISK (Cont'd)
Management believes that now that our markets are open to all competitors, the
Company should be granted access to markets that are currently closed to LECs.
A truly open competitive market, in which the Company can compete without
restrictions, offers long-term opportunity to build the business and maximizes
benefits for consumers. Management believes its key strategies of
strengthening the core business by upgrading its network and systems
capabilities, improving customer service and efficiency, expanding existing
markets, developing new markets and promoting public policy reform, will
provide a strong response to its competitive challenge.
61
<PAGE>
M. ADDITIONAL FINANCIAL INFORMATION
December 31
---------------------
(Dollars in millions) 1996 1995
- ---------------------------------------------------------------------------
Prepaid expenses and other current assets:
Prepaid directory expenses................... $ 45 $ 316
Miscellaneous prepaid expenses............... 37 27
Notes and other receivables.................. 92 83
Materials and supplies....................... 34 57
Current deferred tax benefits................ 119 221
Pacific Telesis Group and subsidiaries....... 82 23
Deferred compensation trusts................. 71 63
Other........................................ 6 12
------- -------
Total............................................ $ 486 $ 802
===========================================================================
Property, plant, and equipment - net:
Land and buildings........................... $ 2,870 $ 2,754
Cable and conduit............................ 11,250 10,910
Central office equipment..................... 9,935 9,394
Furniture, equipment, and other.............. 3,020 2,835
Construction in progress..................... 1,297 795
------- -------
28,372 26,688
Less accumulated depreciation................ (16,699) (15,608)
------- -------
Total............................................ $11,673 $11,080
===========================================================================
Other noncurrent assets:
Deferred charges............................. $ 73 $ 30
Investments.................................. 117 105
Deferred tax benefits........................ 286 338
Other........................................ - 1
------- -------
Total............................................. $ 476 $ 474
===========================================================================
62
<PAGE>
M. ADDITIONAL FINANCIAL INFORMATION (Cont'd)
December 31
---------------------
(Dollars in millions) 1996 1995
- ---------------------------------------------------------------------------
Accounts payable and accrued liabilities:
Accounts payable:
Pacific Telesis Group and subsidiaries....... $ 30 $ 37
AT&T and subsidiaries........................ 144 224
Trade........................................ 579 498
Payroll...................................... 24 51
Checks outstanding........................... 396 276
Other:
Incentive awards payable................... 180 187
Other...................................... 340 383
Interest accrued................................ 131 120
Advance billing and customers' deposits......... 253 333
------- -------
Total............................................. $ 2,077 $ 2,109
===========================================================================
Other current liabilities:
Accrued compensated absences.................. $ 258 $ 272
Restructuring reserve......................... 93 219
Other......................................... 118 61
------- ------
Total............................................. $ 469 $ 552
===========================================================================
Other noncurrent liabilities and deferred credits:
Unamortized investment tax credits............ $ 236 $ 283
Accrued pension cost liability................ 814 1,061
Workers' compensation......................... 172 163
Accrued postretirement benefit obligation..... 568 611
Other......................................... 259 299
------- -------
Total.............................................. $ 2,049 $ 2,417
===========================================================================
63
<PAGE>
M. ADDITIONAL FINANCIAL INFORMATION (Cont'd)
For the Year Ended
December 31
---------------------------------
(Dollars in millions) 1996 1995 1994
- --------------------------------------------------------------------------
Other service revenues:
Directory advertising............... $1,051 $1,012 $ 984
Billing and collections............. 90 109 77
Information services................ 178 148 113
Other............................... 374 252 232
------ ------ ------
Total................................... $1,693 $1,521 $1,406
==========================================================================
Interest expense:
Gross interest expense.............. $ 411 $ 421 $ 439
Less capitalized interest........... (48) (11) -
------ ------ ------
Net interest expense................... $ 363 $ 410 $ 439
==========================================================================
Other income(expense) - net:
Allowance for funds used during
construction...................... $ - $ 36 $ 28
Interest income..................... 9 27 5
Other............................... (5) (38) (30)
------ ------ ------
Total................................... $ 4 $ 25 $ 3
==========================================================================
Advertising expense..................... $ 125 $ 93 $ 96
==========================================================================
Cash payments for:
Interest............................ $ 395 $ 410 $ 377
Income taxes........................ $ 574 $ 550 $ 762
==========================================================================
Major Customer
Nearly all of the Company's operating revenues were from telecommunications
and information services. Approximately 7 percent, 10 percent and 11 percent
of these revenues were earned in 1996, 1995 and 1994, respectively, for
services provided to AT&T Corp. No other customer accounted for more than 10
percent of revenues.
64
<PAGE>
QUARTERLY FINANCIAL DATA
(Unaudited)
(Dollars in millions)
------------------------------------------
1996 First* Second*
Third* Fourth**
- ---------------------------------------------------------------------------
Operating revenues.......... $2,327 $2,364 $ 2,315 $2,440
Operating income............ 605 629 530 540
Cumulative effect of
accounting change........ 85 - - -
Net income ................. 393 314 262 286
- ---------------------------------------------------------------------------
1995 First Second Third*** Fourth
- ---------------------------------------------------------------------------
Operating revenues.......... $2,212 $2,186 $ 2,228 $2,236
Operating income............ 470 494 507 452
Extraordinary item.......... - - (3,360) -
Net income (loss)........... 246 243 (3,102) 222
===========================================================================
* During fourth quarter 1996, Pacific Bell Directory changed its method of
recognizing directory publishing revenues and related expenses effective
January 1, 1996 to a preferable method. The cumulative after-tax effect
of applying the new method to prior years is recognized as of January 1,
1996 as a one-time, non-cash gain of $85 million. The first three
quarters of 1996 were restated to reflect the new method. (See
"Cumulative Effect of Accounting Change" under Note A on page 43.)
** Fourth quarter 1996 results reflect a number of one-time items that
reduced earnings by $47 million.
*** Third quarter 1995 results reflect an after-tax extraordinary charge as a
result of the Company's discontinuance of regulatory accounting. (See Note
B - "Discontinuance of Regulatory Accounting - SFAS 71" on page 44.)
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
No disagreements with the Company's independent accountants on any accounting
or financial disclosure matters occurred during the period covered by this
report.
65
<PAGE>
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.
(a) Documents filed as part of the report:
(1) Financial Statements:
Report of Management...............................33
Report of Independent Accountants..................35
Financial Statements:
Consolidated Statements of Income.............36
Consolidated Balance Sheets...................37
Consolidated Statements of Shareowner's
Equity........................................38
Consolidated Statements of Cash Flows.........39
Notes to Consolidated Financial Statements....41
(2) Financial Statement Schedule:
II - Valuation and Qualifying Accounts.............69
Financial statement schedules other than listed above have been
omitted because the required information is contained in the
Consolidated Financial Statements and Notes thereto, or because
such schedules are not required or applicable.
66
<PAGE>
EXHIBIT INDEX
(3) Exhibits:
Exhibits identified in parentheses below 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
------- -----------
3a Articles of Incorporation of Pacific Bell, as amended and restated
to January 11, 1993 (Exhibit (3)a to Form SE filed March 26, 1993 in
connection with the Company's Form 10-K for 1992).
3b By-Laws of Pacific Bell, as amended to February 26, 1996. (Exhibit
3b to Form 10-K for 1995)
4 No instrument which defines the rights of holders of long- and
intermediate-term debt of Pacific Bell and its subsidiaries 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.
12 Computation of Ratio of Earnings to Fixed Charges.
18 Preferability Letter on Discretionary Accounting Change.
23 Consent of Coopers & Lybrand L.L.P.
24 Powers of Attorney executed by Directors and Officers who signed
this Form 10-K.
27 Financial Data Schedule for Pacific Bell Form 10-K.
The Company will furnish to a security holder upon request a copy of any
exhibit at cost.
(b) Reports on Form 8-K:
No reports on Form 8-K were filed in the fourth quarter of 1996.
67
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) 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
(Principal Financial and
Accounting Officer)
DATE: March 28, 1997
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the date indicated.
David W. Dorman,* Chairman of the Board, President and Chief Executive
Officer
/s/ Peter A. Darbee, Vice President, Chief Financial Officer and Controller
Gilbert F. Amelio,* Director Lewis E. Platt,* Director
William P. Clark,* Director Toni Rembe,* Director
Herman E. Gallegos,* Director S. Donley Ritchey,* Director
Frank C. Herringer,* Director Richard M. Rosenberg,* Director
Mary S. Metz,* Director
*BY /s/ Peter A. Darbee
-----------------------
Peter A. Darbee, attorney-in-fact
DATE: March 28, 1997
68
<PAGE>
PACIFIC BELL AND SUBSIDIARIES
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
(Dollars in millions)
- ---------------------------------------------------------------------------
Col. A Col. B Col. C Col. D Col. E
- ---------------------------------------------------------------------------
Allowance for Doubtful Accounts
- -------------------------------
Additions
----------------------
(1) (2)
Charged Charged
Balance at to Costs to Other Balance at
End of Prior and Expenses Accounts Deductions End of
Period (a) (b) (c) Period
- ---------------------------------------------------------------------------
Year 1996 $131 $129 $216 $315 $161
Year 1995 $132 $166 $147 $314 $131
Year 1994 $136 $135 $143 $282 $132
===========================================================================
(a) Provision for uncollectibles as stated in the Consolidated Statements of
Income includes certain direct write-offs which are not reflected in this
account.
(b) Amounts in this column reflect items of uncollectible interstate and
intrastate accounts receivable purchased from and billed for AT&T and
other interexchange carriers under contract arrangements.
(c) Amounts in this column include items written off, net of amounts that had
previously been written off but subsequently recovered.
Reserve for Restructuring
- -------------------------
Additions
----------------------
(1) (2)
Balance at Charged Charged Balance at
End of Prior to Costs to Other Deduction End of
Period and Expenses Accounts (D) Period
- ---------------------------------------------------------------------------
Year 1996 $ 219 $ - $ - $126 $ 93
Year 1995 $ 819 $ - $ - $600 $ 219
Year 1994 $1,097 $ - $ - $278 $ 819
===========================================================================
(d) The 1996, 1995 and 1994 amounts reflect $(64), $219 and $62 million of
costs, respectively, for enhanced retirement benefits paid from pension
fund assets which do not require current outlays of the Company's funds.
The 1996 reversal of $64 million resulted from revised estimates of these
retirement costs.
69
<PAGE>
EXHIBIT INDEX
Exhibits identified in parentheses below 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
------- -----------
3a Articles of Incorporation of Pacific Bell, as amended and restated
to January 11, 1993 (Exhibit (3)a to Form SE filed March 26, 1993 in
connection with the Company's Form 10-K for 1992).
3b By-Laws of Pacific Bell, as amended to February 26, 1996. (Exhibit
3b to Form 10-K for 1995)
4 No instrument which defines the rights of holders of long- and
intermediate-term debt of Pacific Bell and its subsidiaries 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.
12 Computation of Ratio of Earnings to Fixed Charges.
18 Preferability Letter on Discretionary Accounting Change.
23 Consent of Coopers & Lybrand L.L.P.
24 Powers of Attorney executed by Directors and Officers who signed
this Form 10-K.
27 Financial Data Schedule for Pacific Bell Form 10-K.
70
<PAGE>
Exhibit 12
----------
PACIFIC BELL AND SUBSIDIARIES
RATIO OF EARNINGS TO FIXED CHARGES
(Dollars in millions)
-----------------------------------------------
1996 1995 1994 1993 1992
------ ------ ------ ------ ------
1. Earnings
--------
(a) Income before
Interest Expense $1,533 $1,379 $1,510 $ 447 $1,591
(b) Federal Income
Taxes 579 421 462 (68) 458
(c) State and local
Income Taxes 196 148 159 11 149
(d) 1/3 Operating
Rental Expense 46 28 40 37 35
------- ------- ------- ------- ------
Total $2,354 $1,976 $2,171 $ 427 $2,233
2. Fixed Charges
-------------
(a) Total Interest
Deductions $ 411 $ 410 $ 439 $ 429 $ 460
(b) 1/3 Operating
Rental Expense 46 28 40 37 35
------- ------- ------- ------- -------
Total $ 457 $ 438 $ 479 $ 466 $ 495
3. Ratio (1 divided by 2) 5.15 4.51 4.53 .92* 4.51
* This figure reflects the restructuring and curtailment charges totaling
$924 million after taxes taken in the fourth quarter 1993.
<PAGE>
Exhibit 18
----------
PREFERABILITY LETTER
ON DISCRETIONARY ACCOUNTING CHANGE
Pacific Bell
140 New Montgomery
San Francisco, CA 94105
We are providing this letter for inclusion as an exhibit to your Form 10-K
filing pursuant to Item 601 of Regulation S-K.
We have read management's justification for change in accounting from the
"amortization" revenue recognition method to the "point of publication" method
contained in Pacific Bell's Form 10-K for the year ended December 31, 1996.
Based on our reading of the data and discussions with the Company officials of
the business judgment and business planning factors relating to the change, we
believe management's justification is reasonable. Accordingly (in reliance on
management's determination regarding elements of business judgment and
business planning), we concur that the new adopted accounting principle
described above is preferable in Pacific Bell's circumstances to the method
previously applied.
/s/ COOPERS & LYBRAND L.L.P.
San Francisco, California
February 27, 1997
<PAGE>
Exhibit 23
----------
CONSENT OF INDEPENDENT ACCOUNTANTS
We consent to the incorporation by reference of our report dated
February 27, 1997, on our audits of the consolidated financial statements and
the financial statement schedule of Pacific Bell and Subsidiaries as of
December 31, 1996 and 1995, and for each of the three years in the period
ended December 31, 1996, which report is included in this Annual Report on
Form 10-K, and in Pacific Bell's registration statement as follows:
Form S-3: Pacific Bell $1.575 Billion Debt Securities
/s/ COOPERS & LYBRAND L.L.P.
San Francisco, California
March 28, 1997
<PAGE>
Exhibit 24
----------
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS:
WHEREAS, PACIFIC BELL, a California corporation (the "Company"), proposes to
file with the Securities and Exchange Commission (the "SEC"), under the
provisions of the Securities Act of 1934, as amended, an Annual Report on
Form 10-K; and
WHEREAS, each of the undersigned is a director of the Company;
NOW, THEREFORE, each of the undersigned, hereby constitutes and appoints D. W.
Dorman, W. E. Downing, P. A. Darbee and R. W. Odgers, and each of them,
his/her attorney for him/her in his/her stead, in his capacity as a director
of the Company, to execute and to file such Annual Report on Form 10-K, and
any and all amendments, modifications or supplements thereto, and any exhibits
thereto, and granting to each of said attorneys full power and authority to
sign and file any and all other documents and to perform and do all and every
act and thing whatsoever requisite and necessary to be done as fully, to all
intents and purposes, as he/she might or could do if personally present at the
doing thereof, and hereby ratifying and confirming all that said attorneys may
or shall lawfully do, or cause to be done, by virtue hereof in connection with
effecting the filing of the Annual Report on Form 10-K.
IN WITNESS WHEREOF, each of the undersigned has hereunto set his/her hand this
28th day of March, 1997.
/s/ Gilbert F. Amelio /s/ Lewis E. Platt
Director Director
/s/ William P. Clark /s/ Toni Rembe
Director Director
/s/ Herman E. Gallegos /s/ S. Donley Ritchey
Director Director
/s/ Frank C. Herringer /s/ Richard M. Rosenberg
Director Director
/s/ Mary S. Metz
Director
1
<PAGE>
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS:
WHEREAS, PACIFIC BELL, a California corporation (the "Company"), proposes to
file with the Securities and Exchange Commission (the "SEC"), under the
provisions of the Securities Act of 1934, as amended, an Annual Report on
Form 10-K; and
WHEREAS, each of the undersigned is an officer or director, or both, of the
Company, as indicated below his name;
NOW, THEREFORE, each of the undersigned, hereby constitutes and appoints D. W.
Dorman, W. E. Downing, P. A. Darbee and R. W. Odgers, and each of them, his
attorney for him in his stead, in his capacity as an officer or director, or
both, of the Company, to execute and file such Annual Report on Form 10-K, and
any and all amendments, modifications or supplements thereto and any exhibits
thereto, and granting to each of said attorneys full power and authority to
sign and file any and all other documents and to perform and do all and every
act and thing whatsoever requisite and necessary to be done as fully, to all
intents and purposes, as he might or could do if personally present at the
doing thereof, and hereby ratifying and confirming all that said attorneys may
or shall lawfully do, or cause to be done, by virtue hereof in connection with
effecting the filing of the Annual Report on Form 10-K.
IN WITNESS WHEREOF, each of the undersigned has hereunto set his hand this
28th day of March 1997.
/s/ David W. Dorman
Chairman of the Board,
President and Chief Executive Officer
/s/ Peter A. Darbee
Vice President, Chief Financial Officer and Controller
2
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<PAGE>
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<PERIOD-START> JAN-01-1996
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0
0
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