FORM 10-Q
United States
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
(Mark One)
|X| Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the quarterly period ended September 30, 1998
or
|_| Transition Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the transition period from to
Commission File Number 1-1414
PACIFIC BELL
Incorporated under the laws of the State of California
I.R.S. Employer Identification Number 94-0745535
140 New Montgomery Street, San Francisco, California 94105-3705
Telephone Number: (415) 542-9000
THE REGISTRANT, AN INDIRECTLY HELD WHOLLY-OWNED SUBSIDIARY OF SBC COMMUNICATIONS
INC., MEETS THE CONDITIONS SET FORTH IN GENERAL INSTRUCTION H(1)(a) AND (b) OF
FORM 10-Q AND IS THEREFORE FILING THIS FORM WITH REDUCED DISCLOSURE FORMAT
PURSUANT TO GENERAL INSTRUCTION H(2).
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
<PAGE>
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
<TABLE>
PACIFIC BELL
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CONSOLIDATED STATEMENTS OF INCOME
Dollars in millions
(Unaudited)
<CAPTION>
Three months Nine months
ended ended
September 30, September 30,
---------------------------------------
1998 1997 1998 1997
- ----------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Operating Revenues
Local service $ 1,184 $ 1,108 $ 3,469 $ 3,201
Network access:
Interstate 487 456 1,493 1,255
Intrastate 187 194 556 596
Long-distance service 313 299 925 897
Other 238 164 604 504
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Total operating revenues 2,409 2,221 7,047 6,453
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Operating Expenses
Cost of services and products 866 822 2,563 2,458
Selling, general and administrative 440 473 1,310 2,258
Depreciation and amortization 472 441 1,386 1,477
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Total operating expenses 1,778 1,736 5,259 6,193
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Operating Income 631 485 1,788 260
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Other Income (Expense)
Interest expense (104) (116) (320) (342)
Other income (expense) - net - 12 - (16)
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Total other income (expense) (104) (104) (320) (358)
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Income (Loss) Before Income Taxes and Cumulative
Effect of Accounting Changes 527 381 1,468 (98)
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Income Taxes 207 150 575 (5)
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Income (Loss) Before Cumulative Effect of
Accounting Changes 320 231 893 (93)
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Cumulative Effect of Accounting Changes, net of tax - - - 345
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Net Income $ 320 $ 231 $ 893 $ 252
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See Notes to Consolidated Financial Statements.
</TABLE>
<PAGE>
<TABLE>
PACIFIC BELL
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CONSOLIDATED BALANCE SHEETS
Dollars in millions except per share amounts
(Unaudited)
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<CAPTION>
September 30, December 31,
---------------------------------
1998 1997
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<S> <C> <C>
Assets
Current Assets
Cash and cash equivalents $ 48 $ 43
Accounts receivable - net of allowances for
uncollectibles of $168 and $152 1,915 1,782
Prepaid expenses 114 53
Deferred income taxes 333 415
Other current assets 41 44
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Total current assets 2,451 2,337
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Property, Plant and Equipment - at cost 29,810 28,695
Less: Accumulated depreciation and amortization 18,353 17,442
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Property, Plant and Equipment - Net 11,457 11,253
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Other Assets 1,034 749
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Total Assets $14,942 $14,339
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Liabilities and Shareowner's Equity
Current Liabilities
Intercompany loans $ 754 $ 542
Current portion of long-term obligations 104 4
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Total debt maturing within one year 858 546
Accrued taxes 405 334
Accounts payable and accrued liabilities 2,398 2,719
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Total current liabilities 3,661 3,599
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Long-Term Debt 5,281 5,358
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Deferred Credits and Other Noncurrent
Liabilities
Deferred income taxes 992 957
Postemployment benefit obligation 918 881
Unamortized investment tax credits 159 188
Other noncurrent liabilities 629 569
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Total deferred credits and other noncurrent liabilities 2,698 2,595
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Shareowner's Equity
Common shares ($1 par value) 225 225
Capital in excess of par value 4,436 4,814
Retained earnings (deficit) (1,359) (2,252)
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Total shareowner's equity 3,302 2,787
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Total Liabilities and Shareowner's Equity $14,942 $14,339
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See Notes to Consolidated Financial Statements.
</TABLE>
<PAGE>
<TABLE>
PACIFIC BELL
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CONSOLIDATED STATEMENTS OF CASH FLOWS
Dollars in millions, increase (decrease) in cash and cash equivalents
(Unaudited)
- -----------------------------------------------------------------------------
<CAPTION>
Nine months ended
September 30,
---------------------------
1998 1997
- -----------------------------------------------------------------------------
<S> <C> <C>
Operating Activities
Net income $ 893 $ 252
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 1,386 1,477
Provision for uncollectible accounts 116 152
Amortization of investment tax credits (29) (32)
Deferred income tax expense 116 (259)
Cumulative effect of accounting changes, net of tax - (345)
Other - net (795) 469
- -----------------------------------------------------------------------------
Total adjustments 794 1,462
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Net Cash Provided by Operating Activities 1,687 1,714
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Investing Activities
Construction and capital expenditures (1,533) (1,490)
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Net Cash Used in Investing Activities (1,533) (1,490)
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Financing Activities
Net change in short-term borrowings with original
maturities of three months or less 212 (274)
Issuance of other short-term borrowings - 610
Issuance of long-term debt 198 -
Repayment of long-term debt (178) (2)
Equity received from parent 164 9
Dividends paid (545) (569)
- -----------------------------------------------------------------------------
Net Cash Used in Financing Activities (149) (226)
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Net increase (decrease) in cash and cash equivalents 5 (2)
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Cash and cash equivalents beginning of year 43 57
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Cash and Cash Equivalents End of Period $ 48 $ 55
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Cash paid during the nine months ended September 30 for:
Interest $ 357 $ 361
Income taxes, net of refunds $ 463 $ (250)
See Notes to Consolidated Financial Statements.
</TABLE>
<PAGE>
<TABLE>
PACIFIC BELL
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STATEMENTS OF SHAREOWNER'S EQUITY
Dollars in millions
(Unaudited)
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<CAPTION>
Capital in Retained
Common Excess of Earnings
Shares Par Value (Deficit)
- ------------------------------------------------------------------------------------
<S> <C> <C> <C>
Balance, December 31, 1997 $225 $4,814 $(2,252)
Net income - - 893
Dividend to shareowner - (545) -
Net equity from parent - 167 -
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Balance, September 30, 1998 $225 $4,436 $(1,359)
- ------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements.
</TABLE>
* * * *
<TABLE>
SELECTED FINANCIAL AND OPERATING DATA
<CAPTION>
At September 30, or for the nine months then ended: 1998 1997
------------- --------------
<S> <C> <C>
Debt ratio.................................... 65.03% 68.74%
Network access lines in service (000)......... 17,920 17,170
Access minutes of use (000,000)*.............. 54,949 50,929
Resold lines (000)............................ 252 174
Number of employees........................... 45,650 46,400
*Amounts have been restated.
</TABLE>
<PAGE>
PACIFIC BELL
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Dollars in millions
1. BASIS OF PRESENTATION The consolidated financial statements have been
prepared by Pacific Bell (PacBell, which also includes its subsidiary Pacific
Bell Information Services) pursuant to the rules and regulations of the
Securities and Exchange Commission (SEC) and, in the opinion of management,
include all adjustments (consisting only of normal recurring accruals)
necessary to present fairly the results for the interim periods shown.
PacBell is a wholly-owned subsidiary of Pacific Telesis Group (PAC), a
wholly-owned subsidiary of SBC Communications Inc. (SBC). On March 31, 1998,
PacBell distributed the shares of Pacific Bell Directory, Pacific Bell Mobile
Services, Pacific Bell Internet Services and PB COMM Switches, Inc. to PAC.
PacBell has accounted for this distribution as a change in reporting entity.
The financial statements of all periods presented have been restated to show
financial information for the new reporting entity.
Certain information and footnote disclosures, normally included in financial
statements prepared in accordance with generally accepted accounting
principles, have been condensed or omitted pursuant to SEC rules and
regulations. The results for the interim periods are not necessarily
indicative of results for the full year. The consolidated financial
statements contained herein should be read in conjunction with the
consolidated financial statements and notes thereto included in PacBell's
1997 Annual Report on Form 10-K filed with the SEC. Comprehensive income for
PacBell is the same as net income for all periods presented.
2. CONSOLIDATION The consolidated financial statements include the accounts of
PacBell and its subsidiary. All significant intercompany transactions within
PacBell are eliminated in the consolidation process.
3. COMPLETION OF MERGER On April 1, 1997, SBC and PAC completed the merger of an
SBC subsidiary with PAC, in a transaction in which each outstanding share of
PAC common stock was exchanged for 1.4629 shares of SBC common stock
(equivalent to approximately 626 million shares; both the exchange ratio and
shares issued have been restated to reflect SBC's first quarter 1998
two-for-one stock split, effected in the form of a stock dividend). With the
merger, PAC became a wholly-owned subsidiary of SBC. The transaction was
accounted for by SBC as a pooling of interests and a tax-free reorganization.
Conforming accounting changes
PacBell's results include merger transaction costs and the effects of changes
to conform accounting methodologies between PacBell and SBC for, among other
items, pensions and postretirement benefits. These changes were recorded by
PacBell in the second quarter of 1997, retroactive to January 1, 1997, as a
cumulative effect of accounting changes of $345 net of deferred taxes of
$239, and increased income before income taxes and cumulative effect of
accounting changes and net income for the first nine months of 1997 by $63
and $38. The changes in accounting for pension and postretirement benefits
were to adopt SBC's methodology of amortizing gains and losses on assets held
within those benefit plans. Among other costs relating to the close of the
merger, PacBell recorded the present value of amounts to be returned to
California ratepayers as a condition of the merger of $276 ($173 net of tax).
Post-merger initiatives
During the second quarter of 1997, PacBell recorded after-tax charges of $883
related to SBC's June 19, 1997 announcement of several strategic decisions
resulting from the merger integration process that began with the April 1,
1997 closing of its merger with PAC. These charges included $107 ($65 after
tax) of charges related to several regulatory rulings during the second
quarter of 1997 and $276 ($173 after tax) for the merger approval costs. The
decisions resulted from an extensive
<PAGE>
PACIFIC BELL
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)- Continued
Dollars in millions
review of operations throughout the merged company and include significant
integration of operations and consolidation of some administrative and
support functions. The charges related to the strategic decisions totaled
$1 billion ($645 after tax). At September 30, 1998 and December 31, 1997,
remaining accruals for anticipated cash expenditures related to these
decisions were approximately $90 and $202. Following is a discussion of the
most significant of these charges.
Reorganization SBC is centralizing several key functions that will support
the operations of PacBell and two other SBC subsidiaries, Nevada Bell and
Southwestern Bell Telephone Company (SWBell), including network planning,
strategic marketing and procurement. It is also consolidating a number of
corporate-wide support activities, including research and development,
information technology, financial transaction processing and real estate
management. PacBell, Nevada Bell and SWBell will continue as separate legal
entities. These initiatives are resulting in the creation of some jobs and
the elimination and realignment of others, with many of the affected
employees changing job responsibilities and in some cases assuming positions
in other locations.
PacBell recognized a charge of approximately $127 ($80 net of tax) during the
second quarter of 1997 in connection with these initiatives. This charge was
comprised mainly of postemployment benefits, primarily related to severance,
and costs associated with closing down duplicate operations, primarily
contract cancellations. Other charges arising out of the merger related to
relocation, retraining and other effects of consolidating certain operations
are being recognized in the periods those charges are incurred. These charges
totaled $3 ($2 net of tax) in the third quarter of 1997.
Impairments/asset valuation As a result of SBC's merger integration plans,
strategic review of domestic operations and organizational alignments,
PacBell reviewed the carrying values of related long-lived assets. This
review included estimating remaining useful lives and cash flows and
identifying assets to be abandoned. Where this review indicated impairment,
discounted cash flows related to those assets were analyzed to determine the
amount of the impairment. As a result of these reviews, PacBell wrote off
some assets and recognized impairments to the value of other assets with a
combined charge of $341 ($219 after tax) recorded in the second quarter of
1997. These impairments and writeoffs related to certain analog switching
equipment, duplicate or obsolete equipment, cable within commercial
buildings, certain nonoperating plant and other assets.
Video curtailment/purchase commitments SBC also announced it was scaling back
its limited direct investment in video services. As part of this curtailment,
PacBell halted construction on the Advanced Communications Network (ACN) in
California. As part of an agreement with the ACN vendor, PacBell paid the
liabilities of the ACN trust that owned and financed ACN construction,
incurred costs to shut down all construction previously conducted under the
trust and received certain consideration from the vendor. In the second
quarter of 1997, PacBell recognized a net expense of $553 ($346 after tax)
associated with these activities. During the third quarter of 1997 PacBell
recorded the corresponding short-term debt of $610 previously incurred by the
ACN trust on its balance sheet.
4. SOFTWARE COSTS PacBell currently expenses costs as incurred for software
purchased or developed for internal use, except for initial operating
software costs, which are capitalized and amortized over the lives of the
associated hardware. The American Institute of Certified Public Accountants
has issued a Statement of Position (SOP) that will require capitalization of
certain computer software expenditures beginning in 1999, with earlier
adoption permitted.
<PAGE>
PACIFIC BELL
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)- Continued
Dollars in millions
PacBell did not elect to early adopt the provisions of the SOP. Management
is currently evaluating the impact of the change in accounting required by
the SOP and anticipates it will be less than $100. With comparable levels
of software expenditures, the SOP would tend to increase net income in
comparison with PacBell's current method of accounting for software costs.
However, the increases would be largest in the year of adoption with
diminishing levels of increases compared with current accounting throughout
the amortization period. Consequently, given otherwise comparable income
levels excluding software, and otherwise comparable software expenditures,
the effect of the SOP would be to increase income in the first year and
decrease income in each subsequent year until the number of years affected
by the SOP equals the amortization period.
<PAGE>
PACIFIC BELL
Item 2. Management's Discussion and Analysis of Results of Operations
Dollars in millions
RESULTS OF OPERATIONS
Overview Financial results for Pacific Bell (PacBell, which also includes its
subsidiary, Pacific Bell Information Services) for the first nine months of 1998
and 1997 are summarized as follows:
- -------------------------------------------------------------------------------
Nine-Month Period
------------------------------
Percent
1998 1997 Change
- -------------------------------------------------------------------------------
Operating revenues $ 7,047 $ 6,453 9.2%
Operating expenses $ 5,259 $ 6,193 (15.1)%
Income (loss) before cumulative effect of
accounting changes $ 893 $ (93) -
Cumulative effect of accounting changes - $ 345 -
Net income $ 893 $ 252 -
===============================================================================
Net income for the nine months ended September 30, 1997 includes a cumulative
net benefit of $345 resulting from accounting changes related to conforming
accounting methodologies between PacBell and SBC Communications Inc. (SBC) for,
among other items, pensions and postretirement benefits.
PacBell's loss before cumulative effect of accounting changes for the first nine
months of 1997 includes after-tax charges of $884 reflecting strategic
initiatives resulting from SBC's comprehensive review of operations of the
merged company, the impact of several recent regulatory rulings and ongoing
merger integration costs. In addition, the first nine months of 1997 includes an
$87 after-tax settlement gain associated with lump-sum pension payments that
exceeded the projected service and interest costs for 1996 retirements.
Excluding these 1997 one-time charges and gain, PacBell's income before
cumulative effect of accounting changes for the first nine months of 1998
increased by $189, or 26.8%, compared to $704 for the first nine months of 1997.
The primary factor for this increase in income before cumulative effect of
accounting changes during the first nine months of 1998 was growth in demand for
services and products.
Operating Revenues PacBell's operating revenues for the first nine months of
1997 reflect reductions of $114 related primarily to the impact of several
regulatory rulings. Excluding these items, PacBell's operating revenues
increased $480, or 7.3%, for the first nine months of 1998. Components of
operating revenues for the first nine months of 1998 and 1997 are as follows:
- ----------------------------------------------------------------------------
Nine-Month Period
------------------------------
Percent
1998 1997 Change
- ----------------------------------------------------------------------------
Local service $ 3,469 $ 3,201 8.4%
Network access:
Interstate 1,493 1,255 19.0
Intrastate 556 596 (6.7)
Long-distance service 925 897 3.1
Other 604 504 19.8
- -------------------------------------------------------------------
Total $ 7,047 $ 6,453 9.2%
============================================================================
<PAGE>
PACIFIC BELL
Item 2. Management's Discussion and Analysis of Results of Operations
Dollars in millions
RESULTS OF OPERATIONS - Continued
Local service revenues increased $268 in the first nine months of 1998 due
to increases in demand, which accounts for more than 83% of the increase,
including increases in access lines, vertical services and data revenues.
The number of access lines increased by 4.4% since September 30, 1997,
with approximately 42% of access line growth due to the sales of
additional access lines to existing residential customers. Vertical
services revenues, which include custom calling services, call control
options, Caller ID and other services, increased by approximately 30% and
totaled more than $385 for the first nine months of 1998. Local service
revenues also reflect an increase of approximately $21 due primarily to a
July 1998 California Public Utility Commission (CPUC) rate rebalancing
order associated with the implementation of the California universal
service fund that went into effect in February 1997. The rate rebalancing
shifted revenues from long-distance and intrastate access revenues during
the quarter with a neutral impact on total operating revenues.
Additionally, Federal payphone deregulation implemented in April 1997
caused local service to increase by approximately $46 and caused a
decrease in interstate network access of approximately $8, long-distance
service of approximately $9 and other operating revenues of approximately
$7.
Network access The increase in interstate network access revenues for the
first nine months of 1998 reflects second quarter 1997 one-time charges of
$134. These one-time charges included billing claim settlements related to
the effect of the change of the Percentage Interstate Usage (PIU) factor
in California and several Federal regulatory issues including end-user
charges, 800 data base charges, recovery of certain employee-related
expenses and the retroactive effect of the productivity factor adjustment
in the Federal price cap filing. While the 1997 change in the PIU factor,
which is used to allocate network access usage between interstate and
intrastate jurisdictions, also had the effect of increasing intrastate
network access revenues, it resulted in a slight decline in total network
access revenues due to rate differences between the two jurisdictions.
Without these impacts, interstate access revenues increased $104, or 7.5%.
The increase was due primarily to approximately $119 in demand for access
services by interexchange carriers, primarily special access, and growth
in end-user charges attributable to an increasing access line base. Also
contributing to the increase was the absence of the 1997 revenue offset of
approximately $36 required for net payments for long-term support which
were designed to subsidize universal service. This change is discussed
further in operations and support below. Partially offsetting these
increases were the effects of PacBell's annual rate reductions of
approximately $58 related to the Federal productivity factor adjustment,
as discussed in PacBell's 1997 Annual Report on Form 10-K, and payphone
deregulation of approximately $8 referred to above in local service.
Intrastate network access revenues decreased $40 in the first nine months
of 1998 due to the 1997 PIU settlements of $32 described above. Excluding
this impact, intrastate network access revenues decreased slightly,
attributable in part to the July 1998 rate rebalancing order discussed in
local service.
Long-distance service revenues increased $28 in the first nine months of
1998. This increase was due to a higher volume of toll messages due to the
growing California economy and alternative calling plans. As noted in
local service, the increase in long-distance service revenues was
partially offset by payphone deregulation and the rate rebalancing order.
<PAGE>
PACIFIC BELL
Item 2. Management's Discussion and Analysis of Results of Operations
Dollars in millions
RESULTS OF OPERATIONS - Continued
Other operating revenues increased $100 in the first nine months of 1998.
Approximately 83% of this increase was due to increased demand for
nonregulated products and services, voice messaging services and equipment
sales, partially offset by payphone deregulation referred to above in
local service.
Operating Expenses Components of operating expenses for the first nine months of
1998 and 1997 are as follows:
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Nine-Month Period
-----------------------------
Percent
1998 1997 Change
- ---------------------------------------------------------------------------
Operations and support $ 3,873 $ 4,716 (17.9)%
Depreciation and amortization 1,386 1,477 (6.2)
- ------------------------------------------------------------------
Total $ 5,259 $ 6,193 (15.1)%
===========================================================================
PacBell manages its financial and business operations excluding special one-time
or unusual charges and refers to these adjusted results as normalized
operations. As discussed in Note 3 to the Consolidated Financial Statements,
PacBell's operating expenses in the first nine months of 1997 reflect $1.2
billion of adjustments for charges related to SBC's strategic initiatives, a
comprehensive review of operations of the merged company, the impact of several
regulatory rulings and ongoing merger integration costs. In addition, the first
nine months of 1997 include a first quarter settlement gain of $146 associated
with lump-sum pension payments that exceeded the projected service and interest
costs for 1996 retirements. Excluding these 1997 adjustments, PacBell's
normalized operating expenses increased $156, or 3.1%, for the first nine months
of 1998.
Operations and support Components of operations and support and
normalizing adjustments for the first nine months of 1998 and 1997 are as
follows:
- ---------------------------------------------------------------------------
Nine-Month Period
-----------------------------
Percent
1998 1997 Change
- ---------------------------------------------------------------------------
Cost of services and products $ 2,563 $ 2,458 4.3%
Selling, general and administrative 1,310 2,258 (42.0)
- ------------------------------------------------------------------
Total operations and support 3,873 4,716 (17.9)
Adjustments - (963) -
- ------------------------------------------------------------------
Normalized operations and support $ 3,873 $ 3,753 3.2%
===========================================================================
Operations and support consists of all operating expenses except
depreciation and amortization. Operations and support expenses for the
first nine months of 1997 reflect $1.1 billion of the adjustments referred
to above partially offset by the $146 settlement gain described above.
Excluding these adjustments, normalized operations and support increased
$120, or 3.2%, in the first nine months of 1998. The relatively low level
of expense increase has resulted from merger initiatives that have already
been implemented.
<PAGE>
PACIFIC BELL
Item 2. Management's Discussion and Analysis of Results of Operations
Dollars in millions
RESULTS OF OPERATIONS - Continued
The overall increase was due primarily to increases in merger
implementation costs in 1998 of approximately $218, 1997 pension
settlement gains relating to 1997 retirees totaling approximately $96,
increased costs associated with reciprocal compensation for the
termination of Internet traffic of approximately $49, and increases in
universal service fund (USF) charges of approximately $64 that were
previously reported as an offset against network access revenues. The
current USF system assesses charges, recorded as expense, and any amounts
to be received separately. Previously, a net payment or receipt for
long-term support would be recorded as an offset to (or increase in)
revenue. In addition, wages and salaries and materials increased
approximately $38. These increases were partially offset by reductions in
use of contract labor of approximately $136, reduced expenditures for
interconnection and local competition initiatives of approximately $100
and net reductions to benefits, right-to-use fees and research and
development costs totaling approximately $95. Costs incurred for local
number portability were comparable for the first nine months of each year.
Depreciation and amortization Summarization of depreciation and
amortization expense and normalizing adjustments for the first nine months
of 1998 and 1997 is as follows:
- ----------------------------------------------------------------------------
Nine-Month Period
------------------------------
Percent
1998 1997 Change
- ----------------------------------------------------------------------------
Depreciation and amortization $ 1,386 $ 1,477 (6.2)%
Adjustments - (127) -
- -----------------------------------------------------------------
Normalized depreciation and amortization $ 1,386 $ 1,350 2.7%
===========================================================================
Depreciation and amortization for the first nine months of 1997 reflects
charges totaling $127 to record impairment of plant including analog
switching equipment. Excluding these adjustments, depreciation and
amortization increased $36 for the first nine months of 1998. The increase
was primarily due to increased depreciation expense of $72 resulting from
overall higher plant levels. This increase was substantially offset by
reduced depreciation of $42 on analog switching equipment.
Interest expense decreased $22, or 6.4%, for the first nine months of 1998 due
to interest of $27 associated with the second quarter 1997 one-time charges.
Excluding these one-time charges, interest expense increased $5, or 1.6%, due
primarily to increased interest expense resulting from an increase in long-term
debt.
Other income (expense) - net was a net expense of $16 for the first nine months
of 1997 and included a second quarter one-time charge of $30 for SBC's strategic
initiatives, primarily writeoffs of nonoperating plant, partially offset by the
recognition of $11 of investment returns on funds held in trust for deferred
compensation.
Income Taxes for the first nine months of 1997 reflect the tax effect of charges
for strategic initiatives resulting from SBC's comprehensive review of
operations of the merged company and the impact of several regulatory rulings as
well as taxes on the pension settlement gain discussed in operations and
support. Excluding these items, income taxes for the first nine months of 1997
would have been $460. Income taxes for the first nine months of 1998 were higher
due primarily to higher income before income taxes.
<PAGE>
PACIFIC BELL
Item 2. Management's Discussion and Analysis of Results of Operations
Dollars in millions
OPERATING ENVIRONMENT AND TRENDS OF THE BUSINESS - Continued
Cumulative Effect of Accounting Changes, as discussed in Note 3 to the
Consolidated Financial Statements, includes the effect of changes applied
retroactively to conform accounting methodologies between PacBell and SBC
effective January 1, 1997. The cumulative after-tax effect of these one-time
changes is $345.
<PAGE>
PACIFIC BELL
Item 2. Management's Discussion and Analysis of Results of Operations
Dollars in millions
OPERATING ENVIRONMENT AND TRENDS OF THE BUSINESS
COMPETITIVE AND REGULATORY ENVIRONMENT
California Regulation In October 1998, the CPUC issued a final decision
modifying the current regulatory framework for PacBell effective January 1,
1999. The decision adopted PacBell's proposal that the current cap on basic
residential rates be continued for three more years, through 2001, with the CPUC
itself having the ability to adjust basic telephone rates. The final decision
also suspended earnings sharing, rate of return reviews and the use of earnings
caps and floors until the next review in 2001. The decision also adopted
PacBell's proposal to eliminate depreciation reviews and granted PacBell the
freedom to set its own depreciation rates and methodology. It also continued the
suspension of the productivity factor adjustment. In addition, the CPUC decision
eliminated most future exogenous cost adjustments including the recovery of
future costs related to a 1993 accounting change for postretirement benefits
other than pensions. Management currently estimates the items embodied within
the new regulatory framework will have the net effect of reducing revenue by
approximately $100 in 1999.
Telecommunications Act of 1996 In July 1997, SBC brought suit in the United
States District Court for the Northern District of Texas (U.S. District Court),
seeking a declaration that parts of the Telecommunications Act of 1996 (Telecom
Act) are unconstitutional on the grounds that they improperly discriminate
against PacBell by imposing restrictions that prohibit PacBell by name from
offering interLATA long-distance and other services that other Local Exchange
Carriers (LECs) are free to provide. The suit challenged only those portions of
the Telecom Act that exclude PacBell from competing in certain lines of
business. On December 31, 1997, the U.S. District Court ruled in favor of SBC
and declared certain sections of the Telecom Act unconstitutional, thereby
allowing SBC to enter interLATA long-distance in PacBell's operating areas. On
September 4, 1998, the United States Court of Appeals for the Fifth Circuit (5th
Circuit) reversed this decision and ruled that the challenged provisions of the
Telecom Act are constitutional. In October 1998, SBC asked the United States
Supreme Court (Supreme Court) to hear an appeal of the 5th Circuit decision. The
Supreme Court has not yet determined if it will hear this appeal. If it decides
to accept the case, a decision would not likely occur until 1999.
Interconnection Reciprocal compensation is billed to PacBell by Competitive
Local Exchange Carriers (CLECs) for the termination of certain local exchange
traffic to CLEC customers. SBC believes that under the Telecom Act the state
commissions only have authority to order reciprocal compensation for intrastate
or local traffic, while only the Federal Communications Commission (FCC) has
authority over interstate and interexchange traffic, which is where SBC believes
most Internet traffic terminates. In an October 1998 order, the CPUC has taken
the position that Internet communications is intrastate or local traffic and
ordered PacBell to make payment of appropriate reciprocal compensation to
certain CLECs. The question whether Internet communications should be classified
as local/intrastate or interstate traffic for reciprocal compensation purposes
is the subject of pending CPUC and FCC proceedings and the FCC is expected to
rule on this issue in the near future. PacBell has been recording amounts sought
by certain CLECs for the termination of Internet traffic to Internet Service
Providers as they have been billed.
Long-distance Application In October 1998, the CPUC staff released a report on
PacBell's checklist compliance efforts. The CPUC staff concluded that PacBell
has not met all items of the FCC's 14-point checklist required for entry into
in-region interLATA long-distance and made a series of recommendations as to how
PacBell can meet the remaining checklist items. PacBell is working with the CPUC
to address these remaining items. A proposed decision and vote by the CPUC on
whether to recommend PacBell's application to the FCC is expected by late 1998.
<PAGE>
PACIFIC BELL
Item 2. Management's Discussion and Analysis of Results of Operations
Dollars in millions
OPERATING ENVIRONMENT AND TRENDS OF THE BUSINESS - Continued
Uniform System of Accounts Rewrite In a 1988 CPUC decision, PacBell received a
rate increase as a result of an FCC mandated change in accounting which required
the expensing of items that were previously capitalized. The decision required
an annual incremental rate reduction of $23, but did not address a termination
date for the rate reduction. PacBell filed an application in 1995 to terminate
the rate reductions and with subsequent CPUC approval, halted rate reductions
for 1996, 1997 and 1998, pending the outcome of hearings. In September 1998, the
CPUC issued a decision that grants PacBell's request to discontinue the rate
reductions. The decision became final in October 1998.
OTHER BUSINESS MATTERS
New Accounting Standards In June 1998, the Financial Accounting Standards Board
issued Statement No. 133, "Accounting for Derivative Instruments and Hedging
Activities" (FAS 133) which will require all derivatives to be recorded on the
balance sheet at fair value, and will require changes in the fair values of the
derivatives to be recorded in net income or comprehensive income. FAS 133 must
be adopted for years beginning after June 15, 1999 with earlier adoption
permitted. PacBell currently has no derivative financial instruments.
See Note 4 to the Consolidated Financial Statements for a discussion of the new
accounting standard on software costs.
SBC's Year 2000 Project SBC operates numerous date-sensitive computer
applications and systems throughout its businesses. Since 1996, SBC has been
working to upgrade its networks and computer systems to properly recognize the
Year 2000 and continue to process critical operational and financial
information. Companywide teams are in place to address and resolve Year 2000
issues and processes are underway to evaluate and manage the risks and costs
associated with preparing SBC's date-impacted systems and networks for the new
millennium.
SBC is using a four-step methodology to address the issue. The methodology
consists of inventory and assessment, hardware and software fixes, testing and
deployment. SBC measures its progress by tracking the number of completed
hardware and software applications, network components, personal computers and
building facilities that can correctly process Year 2000 dates.
Inventory and assessment is estimated to require 20% of the overall effort and
includes the identification of items (i.e., line-by-line review of software
code, switch generics, vendor products, etc.) that could be impacted by the Year
2000 and the determination of the work effort required to get them ready. The
inventory and assessment phase has been completed. This process involved
reviewing over 300 million lines of software code, 1,100 central office
switches, 6,800 company buildings, conducting an inventory and assessment of
100,000 personal computers, and coordinating with 1,200 suppliers of 12,000
products to obtain adequate assurance they will be compliant with the Year 2000
or determine and address any appropriate contingency plans or back-up systems.
Making the hardware and software fixes is the second phase of the process and is
estimated to require 25% of the overall effort. This activity involves modifying
program code, upgrading computer software and upgrading or replacing hardware.
As of September 30, 1998, more than half of the hardware and software fixes were
accomplished.
<PAGE>
PACIFIC BELL
Item 2. Management's Discussion and Analysis of Results of Operations
Dollars in millions
OPERATING ENVIRONMENT AND TRENDS OF THE BUSINESS - Continued
Testing involves ensuring that hardware and software fixes will work properly in
1999 and beyond and occurs both before and after deployment. Testing is
estimated to comprise 45% of the overall effort. Testing began early in 1998, is
approximately one-third complete, and will continue through 1999 to allow for
thorough testing before the Year 2000. Any need for contingency plans or back-up
systems are being determined and addressed during the testing phase.
Deployment involves placing the "fixed" systems into a live environment to
ensure they are working properly. Additional testing is done after deployment as
well. Deployment is estimated to require 10% of the overall effort. Nearly half
of the deployment phase was completed as of September 30, 1998.
SBC expects to spend less than $250 million on the entire project, with
approximately $89 million spent through September 30, 1998. As testing and
hardware and software fixes are estimated to require most of the expenditures,
there is not a strict correlation between expenditures and project completion.
The activities involved in SBC's Year 2000 project necessarily involve estimates
and projections, as described above, of activities and resources that will be
required in the future. These estimates and projections could change as work
progresses on the project.
Debt Repurchase Offer On October 29, 1998, PacBell issued an offer to repurchase
up to $925 in debentures. PacBell at this time is unable to predict the amount
of debt that will be redeemed by this offer.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Not applicable.
<PAGE>
PACIFIC BELL
PART II - OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit 12 Computation of Ratios of Earnings to Fixed Charges.
Exhibit 27 Financial Data Schedule.
(b) Reports on Form 8-K
There were no reports on Form 8-K filed during the third quarter ended
September 30, 1998.
<PAGE>
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
PACIFIC BELL
November 4, 1998 /s/ Robert B. Pickering
-------------------------
Robert B. Pickering
Vice President and Chief Financial
Officer
<TABLE>
EXHIBIT 12
PACIFIC BELL
COMPUTATION OF RATIOS OF EARNINGS TO FIXED CHARGES
Dollars in Millions
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30, YEAR ENDED DECEMBER 31,
--------------------- -------------------------------------------------------
1998 1997 1997 1996 1995 1994 1993
--------------------- -------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Income (Loss) Before Income Taxes,
Extraordinary Loss and Cumulative
Effect of Accounting Changes $ 1,468 $ (98) $ 34 $ 1,567 $ 1,161 $ 1,276 $ (54)
Add:Interest Expense 320 342 460 379 420 437 429
1/3 Rental Expense 28 33 41 47 29 22 23
--------- ---------- -------- --------- --------- --------- ---------
Adjusted Earnings $ 1,816 $ 277 $ 535 $ 1,993 $ 1,610 $ 1,735 $ 398
========= ========== ======== ========= ========= ========= =========
Total Interest Charges $ 347 $ 360 $ 497 $ 412 $ 420 $ 437 $ 429
1/3 Rental Expense 28 33 41 47 29 22 23
--------- ---------- -------- --------- --------- --------- ---------
Adjusted Fixed Charges $ 375 $ 393 $ 538 $ 459 $ 449 $ 459 $ 452
========= ========== ======== ========= ========= ========= =========
Ratio of Earnings to Fixed Charges 4.84 0.70 * 0.99 ** 4.34 3.59 3.78 0.88 ***
<FN>
* As defined within the computation of earnings to fixed charges, earnings
are $116 less than fixed charges for the first nine months of 1997. See
Management's Discussion and Analysis of Results of Operations in Pacific
Bell's 1997 Annual Report on Form 10-K for a discussion of merger-related
and other unusual items that reduced earnings for 1997.
** As defined within the computation of earnings to fixed charges, earnings
are $3 less than fixed charges for 1997. See Management's Discussion and
Analysis of Results of Operations in Pacific Bell's 1997 Annual Report on
Form 10-K for a discussion of merger-related and other unusual items that
reduced earnings for 1997.
*** As defined within the computation of earnings to fixed charges, earnings
are $54 less than fixed charges for 1993. See Management's Discussion and
Analysis of Results of Operations - Other Business Matters in Pacific
Bell's 1997 Annual Report on Form 10-K for a discussion of the
restructuring charge which reduced earnings for 1993.
</FN>
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM PACIFIC
BELL AND SUBSIDIARIES' SEPTEMBER 30, 1998 CONSOLIDATED FINANCIAL STATEMENTS, AS
RESTATED, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL
STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> SEP-30-1998
<CASH> 48
<SECURITIES> 0
<RECEIVABLES> 2,083
<ALLOWANCES> 168
<INVENTORY> 0<F1>
<CURRENT-ASSETS> 2,451
<PP&E> 29,810
<DEPRECIATION> 18,353
<TOTAL-ASSETS> 14,942
<CURRENT-LIABILITIES> 3,661
<BONDS> 5,281
0
0
<COMMON> 225
<OTHER-SE> 3,077
<TOTAL-LIABILITY-AND-EQUITY> 14,942
<SALES> 0<F2>
<TOTAL-REVENUES> 7,047
<CGS> 0<F3>
<TOTAL-COSTS> 2,563
<OTHER-EXPENSES> 1,386
<LOSS-PROVISION> 116
<INTEREST-EXPENSE> 320
<INCOME-PRETAX> 1,468
<INCOME-TAX> 575
<INCOME-CONTINUING> 893
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 893
<EPS-PRIMARY> 0
<EPS-DILUTED> 0
<FN>
<F1> THIS AMOUNT IS IMMATERIAL.
<F2> NET SALES OF TANGIBLE PRODUCTS IS NOT MORE THAN 10% OF TOTAL OPERATING
REVENUES AND THEREFORE HAS NOT BEEN STATED SEPARATELY IN THE FINANCIAL
STATEMENTS PURSUANT TO REGULATION S-X, RULE 5-03(B). THIS AMOUNT IS
INCLUDED IN THE "TOTAL REVENUES" TAG.
<F3> COST OF TANGIBLE GOODS SOLD IS INCLUDED IN COST OF SERVICES AND PRODUCTS
IN THE FINANCIAL STATEMENTS AND THE "TOTAL COST" TAG, PURSUANT TO
REGULATION S-X, RULE 5-03(B).
</FN>
</TABLE>
