Management's Discussion and Analysis of Financial Condition and Results of
Operations
Dollars in millions except per share amounts
SBC Communications Inc. (SBC) is a holding company whose subsidiaries and
affiliates operate predominantly in the communications services industry. SBC's
subsidiaries and affiliates provide landline and wireless telecommunications
services and equipment, directory advertising and cable television services.
On April 1, 1997, SBC completed a merger which resulted in Pacific Telesis Group
(PAC) becoming a wholly-owned subsidiary of SBC. Among PAC's subsidiaries are
Pacific Bell (PacBell, which also includes its subsidiaries) and Nevada Bell.
The merger was accounted for as a pooling of interests and a tax-free
reorganization. Accordingly, the financial statements for the periods presented
have been restated to include the accounts of PAC (see Note 3 to the Financial
Statements).
SBC's largest telephone subsidiaries are Southwestern Bell Telephone Company
(SWBell), providing landline telecommunications and related services over
approximately 16 million access lines in Texas, Missouri, Oklahoma, Kansas and
Arkansas (five-state area), and PacBell, providing telecommunications and
related services over approximately 17 million access lines in California. SBC
also provides telecommunications and related services through its Nevada Bell
subsidiary over approximately 300 thousand access lines in Nevada. (SWBell,
PacBell and Nevada Bell are collectively referred to as the Telephone
Companies.) The Telephone Companies are subject to regulation by each of the
states in which they operate and by the Federal Communications Commission (FCC).
This discussion should be read in conjunction with the consolidated financial
statements and the accompanying notes. All per share data has been restated to
reflect the two-for-one stock split, effected in the form of a stock dividend,
declared January 30, 1998 (see Note 15 to the Financial Statements).
Results of Operations
Summary
Financial results, including percentage changes from the prior year, are
summarized as follows:
Percent Change
-----------------
1997 1996
1997 1996 1995 vs. vs.
1996 1995
-------------------------------------------------------------------------------
Operating revenues $ 24,856 $ 23,445 $ 21,712 6.0% 8.0%
Operating expenses $ 21,686 $ 17,609 $ 16,592 23.2% 6.1%
Income before
extraordinary loss and
cumulative effect of $ 1,474 $ 3,189 $ 2,958 (53.8)% 7.8%
accounting change
Extraordinary loss - - $ (6,022) - -
Cumulative effect of
accounting change - $ 90 - - -
Net income (loss) $ 1,474 $ 3,279 $ (3,064) - -
===============================================================================
SBC recognized the cumulative effect of a change in accounting in 1996 relating
to recognition of directory publishing revenues and related expenses and an
extraordinary loss in 1995 from the discontinuance of regulatory accounting at
SWBell and PacBell.
SBC's net income for 1997 includes after-tax charges of approximately $2.0
billion reflecting strategic initiatives resulting from a comprehensive review
of operations of the merged company, the impact of several regulatory rulings
during the second quarter of 1997, costs incurred for customer number
portability since the merger and charges for ongoing merger integration costs.
Excluding these items, SBC reported net income of $3,487 for 1997. Net income
for 1997 was also favorably affected by $33 representing SBC's after-tax gain on
the sale of its interests in Bell Communications Research, Inc. (Bellcore) and a
first quarter 1997 $90 after-tax settlement gain at PAC associated with lump-sum
pension payments that exceeded the projected service and interest costs for 1996
retirements. Excluding these additional items, SBC reported an adjusted net
income of $3,364 for 1997, 5.5% higher than 1996 income before cumulative effect
of accounting change of $3,189. The primary factors contributing to this
increase were growth in demand for services and products at the Telephone
Companies and Southwestern Bell Mobile Systems (Mobile Systems), partially
offset by increased expenses at PacBell, including expenses for the introduction
of Personal Communications Services (PCS) operations in California and Nevada.
The primary factors contributing to the increase in income before extraordinary
loss and cumulative effect of accounting change in 1996 were growth in demand
for services and products at the Telephone Companies and Mobile Systems.
Items affecting the comparison of the operating results between 1997 and 1996,
and between 1996 and 1995, are discussed in the following sections.
Operating Revenues
SBC's operating revenues for 1997 reflect reductions of $188 related
primarily to the impact of several regulatory rulings during the second
quarter of 1997. Excluding these reductions, SBC's operating revenues
increased $1,599, or 6.8%, in 1997 and $1,733, or 8.0%, in 1996. Components
of total operating revenues, including percentage changes from the prior year,
are as follows:
-------------------------------------------------------------------------------
Percent Change
----------------
1997 1996
1997 1996 1995 vs. vs.
1996 1995
-------------------------------------------------------------------------------
Local service
Landline $ 9,568 $ 8,754 $ 8,118 9.3% 7.8%
Wireless 3,034 2,635 2,247 15.1 17.3
Network access
Interstate 3,946 4,008 3,770 (1.5) 6.3
Intrastate 1,869 1,823 1,744 2.5 4.5
Long-distance service 2,115 2,240 2,072 (5.6) 8.1
Directory advertising 2,111 1,985 1,984 6.3 0.1
Other 2,213 2,000 1,777 10.7 12.5
================================================================================
$ 24,856 $ 23,445 $ 21,712 6.0% 8.0%
================================================================================
Local Service Landline local service revenues increased in 1997 and 1996
due primarily to increases in demand, including increases in residential
and business access lines and vertical services revenues. Total access
lines increased by 5.0% in both years, of which approximately 50% was due
to growth in California and over 30% was due to growth in Texas. Access
lines in Texas and California account for approximately 80% of the
Telephone Companies' access lines. Approximately 32% of access line growth
in both years was due to sales of additional access lines to existing
residential customers. Vertical services revenues, which include custom
calling options, Caller ID and other enhanced services, increased by
approximately 20% in 1997 and 29% in 1996. Local service revenues also
reflect the implementation of the California High Cost Fund (CHCFB) that
went into effect February 1, 1997. The California Public Utilities
Commission (CPUC) has stated that the CHCFB is intended to directly
subsidize the provision of service to high cost areas and allow PacBell to
set competitive rates for other services. The rebalancing provisions of the
CHCFB resulted in a shift from long-distance revenues of $84 and intrastate
network access revenues of $26 to local service revenues in 1997. For
further information on the operations of the CHCFB, see the discussion
under the heading "Regulatory Environment - California." Additionally,
Federal payphone deregulation in 1997 increased local service revenues and
decreased long-distance service revenues and interstate network access
revenues; the overall impact was a slight increase in total operating
revenues. Rate reductions in 1997 due to CPUC price cap orders partially
offset increases in landline local service revenues.
Wireless local service revenues increased in 1997 and 1996 due primarily to
growth in the number of Mobile Systems' cellular customers of 16.3% and
20.7%, partially offset by declines in average revenue per customer. 1997
wireless local service revenues also include revenues from the introduction
of PCS operations in California, Nevada and Oklahoma. At December 31, 1997,
SBC had 5,068,000 traditional cellular customers, 60,000 resale customers
and 365,000 PCS customers. At December 31, 1996, SBC had 4,398,000
traditional cellular customers and 35,000 resale customers.
Network Access Interstate network access revenues decreased in 1997 due to
$187 in charges. These charges include billing claim settlements related to
the Percentage Interstate Usage (PIU) factor in California and several
Federal regulatory issues including end-user charges, recovery of certain
employee-related expenses and the retroactive effect of the productivity
factor adjustment mandated in the July 1, 1997 Federal price cap filing.
While the change in the PIU factor in California, which is used to allocate
network access revenues between interstate and intrastate jurisdictions,
also had the effect of increasing intrastate network access revenues, it
resulted in a slight decline in total network access revenues. Excluding
these impacts, interstate network access revenues increased in 1997 and
1996 due largely to increases in demand for access services by
interexchange carriers. Growth in revenues from end-user charges
attributable to an increasing access line base also contributed to the
increases in both years. Partially offsetting these increases were the
effects of the rate reductions of approximately $100 in 1997 and $115 in
1996 related to the FCC's productivity factor adjustment.
Intrastate network access revenues in 1997 reflect an increase due to the
PIU settlements and a decrease due to the effects of the CHCFB described
above. Excluding these impacts, intrastate network access revenues
increased slightly in 1997 and 1996 as increases in demand, including usage
by alternative intraLATA toll carriers, were partially offset by state
regulatory rate orders.
Long-Distance Service revenues decreased in 1997 due to the effect of the
CHCFB discussed above, regulatory rate orders, price competition from
alternative intraLATA toll carriers and the introduction and deployment of
extended area local service plans at SWBell. These decreases were somewhat
offset by increases due to growth in wireless revenues and demand resulting
from California's growing economy. Long-distance service revenues increased
in 1996 due principally to increases in demand resulting from California's
growing economy and to growth in Mobile Systems' long-distance revenues,
including interLATA service that began in February 1996. Additionally,
revenues in 1996 increased due to the reduction in 1995 from SWBell
intraLATA toll pool settlement payments and accruals for rate reductions
relating to an appealed 1992 rate order in Oklahoma. The settlement of the
appeals in October 1995 eliminated the need to continue these accruals.
These increases in 1996 revenues were somewhat offset by the impact of
price competition from alternative intraLATA toll carriers.
Directory Advertising revenues increased in 1997 due mainly to increased
demand at Southwestern Bell Yellow Pages, Inc. (Yellow Pages) and Pacific
Bell Directory (PBDirectory) and the publication of directories in 1997
that were not published in 1996. Directory advertising revenues were
relatively unchanged in 1996 as increased revenues were offset by the
decrease resulting from the January 1996 sale of SBC's publishing contracts
for GTE Corporation's service areas to GTE Directories. Excluding the
impact of this sale, revenues increased 5.1% in 1996.
Other operating revenues increased in 1997 and 1996 due primarily to
increased equipment sales at Mobile Systems and Pacific Bell Mobile
Services and revenues from new business initiatives, primarily voice
messaging services and Internet services. Increased demand for PacBell and
SWBell nonregulated services and products also contributed to the increases
in both years.
Operating Expenses
SBC's operating expenses for 1997 reflect approximately $2.9 billion of
charges related to strategic initiatives resulting from a comprehensive
review of operations of the merged company, the impact of several regulatory
rulings during the second quarter of 1997 (see Note 3 to the Financial
Statements), costs incurred for customer number portability since the merger
and charges for ongoing merger integration costs. Excluding these charges,
SBC's operating expenses increased $1,188, or 6.7%, in 1997 and $1,017, or
6.1%, in 1996. Components of total operating expenses, including percentage
changes from the prior year, are as follows:
-------------------------------------------------------------------------------
Percent Change
---------------
1997 1996
1997 1996 1995 vs. vs.
1996 1995
-------------------------------------------------------------------------------
Cost of services and $ 9,488 $ 8,250 $ 7,864 15.0% 4.9%
products
Selling, general and 7,276 5,250 4,694 38.6 11.8
administrative
Depreciation and 4,922 4,109 4,034 19.8 1.9
amortization
----------------------------------------------------------------
$ 21,686 $ 17,609 $ 16,592 23.2% 6.1%
===============================================================================
Cost of Services and Products reflects charges of $334 in 1997 relating to
SBC's strategic initiatives, operational reviews, costs incurred for
customer number portability since the merger and ongoing merger integration
costs; excluding these charges, expenses increased $904, or 11.0%, in 1997.
A significant part of this increase was caused by the introduction of PCS
operations during 1997. Other major factors contributing to the increase
included increases in employee compensation, including increases related to
force additions and contract labor, growth at Mobile Systems, network
expansion and maintenance and interconnection costs. Cost of services and
products increased in 1996 due primarily to increases in employee
compensation, growth at Mobile Systems, network expansion and maintenance,
and expenses related to local competition preparation and new business
initiatives, such as PCS, Internet services and network integration.
Selling, General and Administrative expense in 1997 reflects $1,952 of
charges relating to SBC's strategic initiatives, operational reviews and
ongoing merger integration costs. As discussed in Note 3 to the Financial
Statements, the most significant of these charges included shutdown of the
Advanced Communications Network (ACN), regulatory costs related to the
approval of the merger with SBC by California and Nevada regulators, and
reorganization initiatives. Excluding these charges, expenses increased
$74, or 1.4%, in 1997. Significantly increasing expenses was the
introduction of PCS operations during 1997. Other major factors
contributing to the increase included growth at Mobile Systems, expenses
related to new business initiatives, primarily voice messaging and Internet
services, and increases in employee compensation, sales agents commissions
and uncollectibles. These increases were partially offset by PAC's first
quarter 1997 $152 settlement gain associated with lump-sum pension payments
that exceeded the projected service and interest costs for 1996
retirements. Selling, general and administrative expense increased in 1996
due primarily to growth at Mobile Systems and increases in contracted
services, employee compensation and software costs. Expenses incurred at
PAC to prepare support systems for local competition and for new business
initiatives also contributed to the increase in 1996.
Depreciation and Amortization in 1997 reflects charges totaling $592 to
record impairment of plant and intangibles. As discussed in Note 3 to the
Financial Statements, the most significant of these impairments related to
the wireless digital TV operations in southern California, certain analog
switching equipment in California, certain rural and other
telecommunications equipment in Nevada, selected wireless equipment and
cable within commercial buildings in California. Excluding these charges,
depreciation and amortization increased $221, or 5.4%, in 1997 due
primarily to overall higher plant levels. Reduced depreciation beginning
with the second quarter of 1997 on analog switching equipment in California
at PacBell partially offset this increase. Depreciation and amortization
also increased in 1996 due primarily to overall higher plant levels.
Interest Expense increased $135, or 16.6%, in 1997 and decreased $145, or 15.2%,
in 1996. The 1997 increase was due primarily to increased average debt levels at
SBC. Also contributing to the increase was interest associated with the second
quarter 1997 one-time charges, primarily interest on the merger-approval costs.
The 1996 decrease was due to a change in PAC's capital structure, which replaced
a portion of interest expense with amounts recorded as Other Income (Expense) -
Net (see Note 10 to the Financial Statements), lower long-term debt levels in
SBC subsidiaries other than PAC, and capitalization of interest during
construction required by the discontinuance of regulatory accounting in the
third quarter of 1995. Under regulatory accounting, the Telephone Companies
accounted for capitalization of both interest and equity costs during periods of
construction as other income.
Equity in Net Income of Affiliates decreased $6 in 1997 and increased $87 in
1996. The 1997 decrease reflects decreased income from SBC's investment in
Telefonos de Mexico, S.A. de C.V. (Telmex), Mexico's national telecommunications
company. This lower income resulted from the change in the functional currency
used by SBC to record its interest in Telmex from the peso to the U.S. dollar
beginning in 1997 and SBC's reduced ownership percentage after the sale of
Telmex L shares. Results also reflect preoperating expenses in several
international investments including long-distance in France, Switzerland and
Israel, and cellular communications in Taiwan. These decreases were mainly
offset by income from SBC's May 1997 investment in Telkom SA Limited (Telkom) of
South Africa, whose results reflected strong growth and expense management, and
lower losses resulting from the reduced involvement in Tele-TV.
The 1996 increase reflects increased income from Telmex, due to the relative
stabilization of the peso compared to 1995 and net gains on international
affiliate transactions. Results for 1995 include losses on SBC's United Kingdom
cable television operations, which were accounted for under the equity method
prior to October 1995, and exchange losses on the non-peso denominated debt of
Telmex. Results for 1996 and 1995 also reflect reductions in the translated
amount of U.S. dollar earnings from Telmex's operations. Operational growth at
Telmex in both years somewhat offset these declines.
SBC's earnings from foreign affiliates will continue to be generally sensitive
to exchange rate changes in the value of the respective local currencies. SBC's
foreign investments are recorded under U.S. generally accepted accounting
principles (GAAP), which include adjustments for the purchase method of
accounting and exclude certain adjustments required for local reporting in
specific countries, such as inflation adjustments. SBC's equity earnings in 1998
will reflect SBC's investment in Telkom for a full year of operations (see Note
16 to the Financial Statements for discussion of the Telkom investment).
Other Income (Expense) - Net decreased $5 in 1997 and $276 in 1996. Results for
1997 reflect $26 in second quarter charges related to SBC's strategic
initiatives, primarily writeoffs of nonoperating plant. Other decreases relate
primarily to the market valuation adjustment on certain SBC debt redeemable
either in cash or Telmex L shares and distributions paid on an additional $500
of Trust Originated Preferred Securities (TOPrS) sold by PAC in June 1996.
Partially offsetting these increased expenses were the gain recognized from the
sale of SBC's interests in Bellcore, royalty payments associated with software
developed by an affiliate and the gain on the sale of Telmex L shares. The
decrease in 1996 reflects the inclusion in 1995 of the gain recognized from the
merger of SBC's United Kingdom cable television operations into TeleWest (see
Note 16 to the Financial Statements) and interest income from tax refunds,
somewhat offset by expenses associated with the refinancing of long-term debt by
the Telephone Companies (see Note 9 to the Financial Statements). Additional
decreases in 1996 related to the reclassification of interest during
construction required by the discontinuance of regulatory accounting in the
third quarter of 1995 and the change in PAC's capital structure noted in the
discussion of Interest Expense (see Note 10 to the Financial Statements).
Income Tax expense decreased $1,097, or 56.0%, in 1997 and increased $441, or
29.0%, in 1996. Income taxes for 1997 reflect the tax effect of charges for
strategic initiatives resulting from SBC's comprehensive review of operations of
the merged company, the impact of several regulatory rulings during the second
quarter of 1997, costs incurred for customer number portability since the merger
and charges for ongoing merger integration costs. Excluding these items, income
taxes for 1997 were lower. Contributing to the decrease in income tax expense in
1997 was, among other items, realization of foreign tax credits. Income taxes
paid, net of refunds, reflect the impact of reduced tax payments due to
merger-related and integration costs incurred. The 1996 increase was due
primarily to higher income before income taxes. Taxes also increased in 1996
reflecting a full year's effects of the elimination of excess deferred taxes and
the reduction in the amortization of investment tax credits resulting from the
discontinuance of regulatory accounting, which occurred in the latter part of
1995.
Extraordinary Loss In 1995, SBC recorded an extraordinary loss of $6 billion
from the discontinuance of regulatory accounting. The loss included a reduction
in the net carrying value of telephone plant and the elimination of net
regulatory assets of SWBell and PacBell (see Note 2 to the Financial
Statements).
Cumulative Effect of Accounting Change As discussed in Note 1 to the Financial
Statements, PBDirectory changed its method of recognizing directory publishing
revenues and related expenses effective January 1, 1996. 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 $90, or $0.05 per share. The gain is net of deferred taxes of $53. Management
believes this change to the issue basis method is preferable because it is the
method generally followed in the publishing industry, including Yellow Pages,
and better reflects the operating activity of the business. This accounting
change is not expected to have a significant effect on net income in future
periods.
Operating Environment and Trends of the Business
Regulatory Environment
The telecommunications industry is in transition from a tightly regulated
industry overseen by multiple regulatory bodies, to a more incentive-based,
market driven industry monitored by state and federal agencies. The Telephone
Companies' wireline telecommunications operations remain subject to regulation
by the seven states in which they operate for intrastate services and by the FCC
for interstate services. In 1997, new price cap regulatory plans were
implemented for the Telephone Companies in Missouri and Nevada, and in Oklahoma,
legislation passed allowing alternative regulation. The Telephone Companies
under price cap regulation have the freedom to establish and modify prices for
some services as long as they do not exceed the price caps, as well as the
freedom to change prices for some services without regulatory approval.
Federal Regulation
During 1997, the FCC issued an Access Reform Order restructuring access charges
paid for interexchange carrier access to the Telephone Companies' networks. The
order raises the flat monthly end user charge for primary business lines, and
additional residence and business lines, and lowers the price caps on per minute
access charges for interstate long distance carriers. These changes, which took
effect in 1997 and January 1998, are supposed to shift sources of revenue from
carriers to end users without changing the total amount of revenue received by
the Local Exchange Carriers (LECs).
The FCC's price cap plan for the LECs provides for changes to be made annually
to the price caps for inflation, productivity and changes in other costs. In
1997 the Telephone Companies were ordered to begin using a 6.5% productivity
offset, with no sharing. Prior to 1997, there were three productivity offsets,
two of which provided for a sharing of profits above a specified earnings level
with the Telephone Companies' customers and a higher productivity offset which
did not include sharing. The Telephone Companies had elected the higher 5.3%
productivity offset without sharing.
With the passage of the Telecommunications Act of 1996 (Telecom Act), the FCC
has been conducting further proceedings in conjunction with access reform to
address a number of pricing and productivity issues, and is performing a broader
review of price cap regulation in the context of the increasingly more
competitive telecommunications environment. The Chairman of the FCC has
indicated that the FCC intends to act on these proceedings in 1998. The Telecom
Act and FCC actions taken to implement provisions of the Telecom Act are
discussed further under the heading "Competitive Environment."
Pursuant to the Telecom Act, the local coin rate in the payphone industry was
deregulated by the FCC on October 7, 1997, and LECs were required to remove any
direct or indirect subsidy of payphone service from their regulated
telecommunications operations. Removal of the subsidy caused the Telephone
Companies to raise local coin rates throughout their operating territories in
1997.
State Regulation
With the implementation of Nevada's price cap plan which eliminated the sharing
provision previously in effect, six of the seven state regulatory plans under
which the Telephone Companies operate do not include sharing. The California
price cap plan still includes sharing. However, there has been no sharing in
California in the last two years.
California The California Public Utility Commission's (CPUC) form of price caps
requires PacBell to submit an annual price cap filing to determine prices for
categories of services for each new year. The productivity factor used in
calculating price caps has been set equal to the inflation factor for the period
1996-1998. The price cap plan includes a sharing mechanism that requires PacBell
to share its earnings with customers above certain earnings levels. In December
1997, the CPUC adopted a decision on PacBell's 1997 price cap filing resulting
in a revenue reduction in 1998 of approximately $86 effective January 1, 1998.
The reduction reflects items accrued in the 1997 results of operations,
including, among other things, the rate reduction ordered in the CPUC decision
approving the SBC/PAC merger and the gain on the sale of PacBell's interest in
Bellcore. Because of these accruals, the order will not materially affect SBC's
results of operations in 1998.
In an April 1997 ruling, the CPUC reaffirmed that postretirement benefit costs
were appropriately recoverable in PacBell's price cap filings as exogenous
costs. The CPUC continued to allow recovery in 1998 consistent with the amount
requested by PacBell in an October 1997 filing. The CPUC also ordered a further
proceeding to address future procedures and amounts for recovery.
In May 1997, the FCC adopted new separations rules that shifted recovery of a
substantial amount of billing and collection costs to the interstate
jurisdiction. PacBell filed for a waiver of the requirement and was denied the
waiver in December 1997. As a result, PacBell could be required to refund an
annualized amount of approximately $21 to customers since July 1997, with
refunds commencing in 1999.
In 1996, the CPUC issued an order on universal service and established the CHCFB
to subsidize telephone service in California's high cost areas. The estimated
$352 cost of the program is expected to be collected from customers of all
telecommunications providers who will contribute to the fund through a 2.87%
surcharge on all bills for telecommunications services provided in California.
The surcharge became effective February 1, 1997. To maintain revenue neutrality,
PacBell will reduce its revenues dollar for dollar for amounts it will receive
from the fund. This reduction will occur through an across the board surcredit
on all products and services (except for residential basic exchange services and
contracts) or through permanent rate reductions for those services that
previously subsidized universal service. PacBell filed to reduce permanently
certain toll and access rates. Hearings were held in October 1997, and a
decision is expected in the second or third quarter of 1998.
PacBell expects to receive approximately $305 annually from the CHCFB fund based
on CPUC estimates of the cost of providing universal service. PacBell believes
the new program underestimates the cost of providing universal service and that
the average cost of providing service is up to 33% higher per line, per month
than the CPUC estimate. As a result, subsidies for universal service will remain
in the prices for PacBell's competitive services, which may place it at a
competitive disadvantage.
In 1992, PacBell entered into a settlement with tax authorities and others which
fixed a specific methodology for valuing utility property for tax purposes for a
period of eight years. As a result, the CPUC opened an investigation to
determine if any resulting property tax savings should be returned by PacBell to
its customers. Intervenors have asserted that as much as $20 of annual property
tax savings should be treated as an exogenous cost reduction in PacBell's annual
price cap filings and that as much as $90 in past property tax savings as of
December 31, 1997, plus interest, should be returned to customers. PacBell
believes that, under the CPUC's regulatory framework, any property tax savings
qualify only as a component of shareable earnings and not as an exogenous cost.
In an interim opinion issued in June 1995, the CPUC ruled in favor of
intervenors, but decided to defer a final decision on the matter pending
resolution in a separate proceeding of the criteria for exogenous cost treatment
under its regulatory framework. To date, the CPUC has taken no further action on
the issue.
More than 120 applications for certification to provide competitive local
service have been approved by the CPUC, with over 25 more applications pending
approval. As a result, PacBell expects competition to continue to develop for
local service, but the financial impact of this competition cannot be reasonably
estimated at this time.
Texas The Public Utility Regulatory Act, which became effective in May 1995
(PURA), allows SWBell and other LECs to elect to move from rate of return
regulation to price regulation with elimination of earnings sharing. In
September 1995, SWBell notified the Texas Public Utility Commission (TPUC) that
it elected incentive regulation under the new law. Basic local service rates are
capped at existing levels for four years following the election. The TPUC is
prohibited from reducing switched access rates charged by LECs to interexchange
carriers while rates are capped.
LECs electing price regulation must commit to network and infrastructure
improvement goals, including expansion of digital switching and advanced
high-speed services to qualifying public institutions, such as schools,
libraries and hospitals, requesting the services. PURA also established an
infrastructure grant fund for use by public institutions in upgrading their
communications and computer technology. PURA provided for a total fund
assessment of $150 annually on all telecommunications providers in Texas for a
ten-year period. The 1997 Texas legislative session changed the funding for the
infrastructure grant from annually collecting $150 for ten years to a flat rate
(1.25%) applied to all telecommunications providers' sales taxable revenues. The
law also provides a cap of $1,500 for the life of the fund. SWBell's annual
payments will increase from the current level in 1997 of $36 per year to
approximately $50 for each of the next three years. Due to the industry's growth
in revenues, the fund should be completely funded before the original ten years.
PURA establishes local exchange competition by allowing other companies that
desire to provide local exchange services to apply for certification by the
TPUC, subject to certain build-out requirements, resale restrictions and minimum
service requirements. PURA provides that SWBell will remain the default carrier
of "1 plus" intraLATA long-distance traffic until SWBell is allowed to carry
interLATA long-distance. In 1996, MCI Communications Corporation (MCI) and AT&T
Corp. (AT&T) sued the state of Texas, alleging that PURA violates the Texas
state constitution, and claiming that PURA establishes anticompetitive barriers
designed to prevent MCI, AT&T and Sprint Corporation (Sprint) from providing
local services within Texas. The FCC, also in response to petitions filed by
AT&T and MCI, preempted and voided portions of PURA that required certain new
entrants to build telephone networks to cover a 27-square-mile area in any
market they entered. Furthermore, the FCC also preempted rules that excluded
competitors from entering markets with fewer than 31,000 access lines and which
made resale of Centrex phone services subject to a limited property restriction.
AT&T and MCI have dismissed their suits regarding this matter. In October 1997,
SWBell filed with the FCC a Petition for Reconsideration regarding the
preemption of the property restriction for Centrex services.
More than 170 applications for certification to provide competitive local
service have been approved by the TPUC, with over 25 more applications pending
approval. As a result, SWBell expects competition to continue to develop for
local service, but the financial impact of this competition cannot be reasonably
estimated at this time.
Missouri Effective September 26, 1997, the Missouri Public Service Commission
(MPSC) determined that SWBell is now subject to price cap regulation. Prices in
effect as of December 31, 1996 are the initial maximum allowable rates for
services and cannot be adjusted until January 1, 2000 for basic and access
services and until January 1, 1999 for non-basic services. On an exchange basis
where a competitor begins operations, the January 1, 1999 freeze on maximum
allowable rates for non-basic services is removed. After those dates, caps for
basic and access services may be adjusted based on one of two government indices
while caps for non-basic services may be increased up to 8% per year. In an
exchange where competition for basic local service exists for five years,
services will be declared competitive and subject to market pricing unless the
MPSC finds effective competition does not exist. The Office of Public Counsel
and MCI have sought judicial review of the MPSC determination.
Oklahoma Oklahoma enacted legislation, effective July 1, 1997, which allows for
alternative regulation in Oklahoma for telecommunications providers. Key
provisions of the new law allow SWBell to apply for alternative regulation at
any time, impose a restriction against the Oklahoma Corporation Commission (OCC)
initiating a rate case until February 5, 2001, establish a Universal Service
Fund (USF), and require SWBell to keep intrastate access rates at parity with
interstate rates. SWBell is allowed to seek partial recovery of the access rate
reductions from the USF. In addition, the new law allows for streamlined tariff
processing procedures and establishes a framework to have services declared
competitive and eventually deregulated.
Competitive Environment
Competition continues to increase for telecommunication and information
services. Recent changes in legislation and regulation have increased the
opportunities for alternative service providers offering telecommunications
services. Technological advances have expanded the types and uses of services
and products available. As a result, SBC faces increasing competition in
significant portions of its business.
Domestic
On February 8, 1996, the Telecom Act was enacted into law. The Telecom Act is
intended to address various aspects of competition within, and regulation of,
the telecommunications industry. The Telecom Act provides that all
post-enactment conduct or activities which were subject to the consent decree
issued at the time of AT&T divestiture of the Regional Holding Companies (RHCs),
referred to as the Modification of Final Judgment (MFJ), are now subject to the
provisions of the Telecom Act. In April 1996, the United States District Court
for the District of Columbia issued its Opinion and Order terminating the MFJ
and dismissing all pending motions related to the MFJ as moot. This ruling
effectively ended 13 years of RHC regulation under the MFJ. Among other things,
the Telecom Act also defines conditions SBC must comply with before being
permitted to offer interLATA long-distance service within California, Texas,
Missouri, Kansas, Oklahoma, Arkansas and Nevada (regulated operating areas) and
establishes certain terms and conditions intended to promote competition for the
Telephone Companies' local exchange services.
Under the Telecom Act, SBC may immediately offer interLATA long-distance outside
the regulated operating areas and over its wireless network both inside and
outside the regulated operating areas. Before being permitted to offer landline
interLATA long-distance service in any state within the regulated operating
areas, SBC must apply for and obtain state-specific approval from the FCC. The
FCC's approval, which involves consultation with the United States Department of
Justice and appropriate state commissions, requires favorable determinations
that the Telephone Companies have entered into interconnection agreement(s) that
satisfy a 14-point "competitive checklist" with predominantly facilities-based
carrier(s) that serve residential and business customers or, alternatively, that
the Telephone Companies have a statement of terms and conditions effective in
that state under which they offer the "competitive checklist" items. The FCC
must also make favorable public interest and structural separation
determinations in connection with such applications.
In July 1997, SBC brought suit in the U.S. District Court for the Northern
District of Texas (U.S. District Court), seeking a declaration that parts of the
Telecom Act are unconstitutional on the grounds that they improperly
discriminate against the Telephone Companies by imposing restrictions that
prohibit the Telephone Companies by name from offering interLATA long-distance
and other services that other LECs are free to provide. The suit challenged only
those portions of the Telecom Act that exclude the Telephone Companies 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 the
Telephone Companies' operating areas. If upheld, this ruling is expected to
speed competition in the interLATA long-distance markets in SBC's regulated
operating areas. The FCC and competitor intervenors have sought and received a
stay of the decision by the U.S. District Court.
In August 1996, the FCC issued rules by which competitors could connect with
LECs' networks, including those of the Telephone Companies. Among other things,
the rules addressed unbundling of network elements, pricing for interconnection
and unbundled elements (Pricing Provisions), and resale of retail
telecommunications services. The FCC rules were appealed by numerous parties,
including SBC.
In July 1997, the United States Court of Appeals for the Eighth Circuit in St.
Louis (8th Circuit) held that the FCC did not have authority to promulgate rules
related to the pricing of local intrastate telecommunications and that its rules
in that regard were invalid. The 8th Circuit also overturned the FCC's rules
which allowed competitors to "pick and choose" among the terms and conditions of
approved interconnection agreements. In October 1997, the 8th Circuit issued a
subsequent decision clarifying that the Telecom Act does not require the
incumbent LECs to deliver network elements to competitors in anything other than
completely unbundled form.
In September 1997, a number of parties including SBC, filed petitions to enforce
the July 1997 ruling of the 8th Circuit that the right to set local exchange
prices, including the pricing methodology used, is reserved exclusively to the
states. The petitions responded to the FCC's rejection of Ameritech
Corporation's interLATA long-distance application in Michigan in which the FCC
stated it intended to apply its own pricing standards to RHC interLATA
applications. The petitioners asserted the FCC was violating state authority. On
January 22, 1998 the 8th Circuit ordered the FCC to abide by the July 1997
ruling and reiterated that the FCC cannot use interLATA long-distance
applications made by SBC and other RHC wireline subsidiaries wishing to provide
interLATA long-distance to attempt to re-impose the pricing standards ruled
invalid in July 1997 by the 8th Circuit. On January 26, 1998, the U.S. Supreme
Court agreed to hear all appeals of the July 1997 8th Circuit decision.
The effects of the FCC rules are dependent on many factors including, but not
limited to: the ultimate resolution of the pending appeals; the number and
nature of competitors requesting interconnection, unbundling or resale; and the
results of the state regulatory commissions' review and handling of related
matters within their jurisdictions. Accordingly, SBC is not able to assess the
impact of the FCC rules at this time.
Landline Local Service
Recent state legislative and regulatory developments also allow increased
competition for local exchange services. Companies wishing to provide
competitive local service have filed numerous applications with state
commissions throughout the Telephone Companies' regulated operating areas, and
the commissions of each state have been approving these applications since late
1995. Under the Telecom Act, companies seeking to interconnect to the Telephone
Companies' networks and exchange local calls must enter into interconnection
agreements with the Telephone Companies. These agreements are then subject to
approval by the appropriate state commissions. SBC has reached over 250
interconnection and resale agreements with competitive local service providers,
and most have been approved by the relevant state commissions. AT&T and other
competitors are reselling SBC local exchange services, and as of December 31,
1997, there were approximately 500,000 SBC access lines supporting services of
resale competitors throughout the Telephone Companies' regulated operating
areas, most of them in Texas and California. Many competitors have placed
facilities in service and have begun advertising campaigns and offering
services. Beginning in 1996, SWBell was also granted facilities-based and resale
operating authority in territories served by other LECs. SWBell began local
exchange service offerings to these areas during 1997.
The CPUC authorized facilities-based local services competition effective
January 1996 and resale competition effective March 1996. While the CPUC has
established local competition rules and interim prices, several issues still
remain to be resolved, including final rates for resale and LEC provisioning and
pricing of certain network elements to competitors. In order to provide services
to resellers, PacBell uses established operating support systems and has
implemented electronic ordering systems and a customer care/billing center.
Costs to implement local competition, especially number portability, are
substantial. The CPUC has set a schedule to review PacBell's recovery of its
local competition implementation costs incurred since January 1, 1996.
The CPUC has issued orders regarding the implementation of competition in 1997.
Some of the key ones include permitting the resale of Centrex services to
businesses only, prohibiting aggregation of customers to obtain toll discounts,
enforcing optional calling plans retail tariff restrictions on resale,
prohibiting sharing of certain Centrex features to route intraLATA calls,
adopting no discount on private line resale, ordering resale of voice mail to
competitors, and allowing collection of intrastate access charges on unbundled
network elements. The CPUC order on resale of voice mail service was stayed and
is being reviewed.
In December 1997, the TPUC set rates that SWBell may charge for access and
interconnection to its telephone network. The TPUC decision sets pricing for
dozens of network components and completes a consolidated arbitration between
SWBell and six of its competitors, including AT&T and MCI. SWBell has
TPUC-approved resale and interconnection agreements with approximately 80 local
service providers, with approximately 15 pending approval.
In Missouri, the MPSC issued orders on a consolidated arbitration hearing with
AT&T and MCI and on selected items with Metropolitan Fiber Systems (MFS). Among
other terms, the orders established discount rates for resale of SWBell services
and prices for unbundled network elements. SWBell appealed the interconnection
agreement resulting from the first arbitration proceeding on November 5, 1997; a
decision is still pending. A second arbitration process to address other
interconnection issues with AT&T has concluded, and the MPSC ordered that an
agreement be filed. SWBell has sought reconsideration of this order.
As a result of the Telecom Act and conforming interconnection agreements, the
Telephone Companies expect increased competitive pressure in 1998 and beyond
from multiple providers in various markets including facilities-based
Competitive Local Exchange Carriers (CLECs), interexchange carriers (IXCs) and
resellers. At this time, management is unable to assess the effect of
competition on the industry as a whole, or financially on SBC, but expects both
losses of market share in local service and gains resulting from new business
initiatives, vertical services and new service areas.
Wireless Local Service
In 1993, the FCC adopted an order allocating radio spectrum and licenses for
PCS. PCS utilizes wireless telecommunications digital technology at a higher
frequency radio spectrum than cellular. Like cellular, it is designed to permit
access to a variety of communications services regardless of subscriber
location. In an FCC auction, which concluded in March 1995, PCS licenses were
awarded in 51 major markets. SBC or affiliates acquired PCS licenses in the
Major Trading Areas (MTAs) of Los Angeles-San Diego, California; San
Francisco-Oakland-San Jose, California; Memphis, Tennessee; Little Rock,
Arkansas; and Tulsa, Oklahoma. The California licenses cover substantially all
of California and Nevada. SBC is currently operational in all of its major
California-Nevada markets and Tulsa, Oklahoma. During 1996, SBC received several
AT&T cellular networks in Arkansas in exchange for SBC's PCS licenses in
Memphis, Tennessee and Little Rock, Arkansas and other consideration.
In November 1996, Pacific Bell Mobile Services (PBMS) conducted an extensive PCS
trial in San Diego, California. Service was formally launched in San Diego,
California in January 1997, in Las Vegas, Nevada in February 1997, in
Sacramento, California in March 1997, in San Francisco in May 1997, in Los
Angeles in July 1997 and in Bakersfield, California in October 1997. The network
incorporates the Global System for Mobile Communications (GSM) standard which is
widely used in Europe. PBMS is selling PCS as an off-the-shelf product in retail
stores across California and Nevada. Significant competition exists,
particularly from the two established cellular companies in each market.
In an FCC auction which concluded in January 1997, SBC acquired eight additional
PCS licenses for Basic Trading Areas (BTAs) that are within the five-state area.
SBC also has state approved interconnection agreements to receive reciprocal
compensation from interexchange carriers and other local service providers
accessing its wireless networks in all states where it provides wireless
services.
Companies granted licenses in MTAs and BTAs where SBC also provides service
include subsidiaries and affiliates of AT&T, Sprint and other RHCs. Significant
competition from PCS providers exists in SBC's major markets. Competition has
been based upon both price and product packaging and has contributed to SBC's
decline in average subscriber revenue per wireless customer.
Long-Distance
Competition continues to intensify in the Telephone Companies' intraLATA
long-distance markets. It is estimated that providers other than PacBell now
serve more than half of the business intraLATA long-distance customers in
PacBell's service areas.
The OCC recommended that SBC be allowed to offer interLATA long-distance in
Oklahoma. Notwithstanding that recommendation, the FCC denied SBC such authority
and SBC has appealed the decision in the D.C. Court of Appeals where the case is
pending.
Since the Telecom Act, SBC has entered the wireless long-distance markets, and
offers wireless long-distance service in all of its wireless service areas. In
addition, through affiliates SBC also offers landline interLATA long-distance
services to customers in selected areas outside the Telephone Companies'
operating areas.
Other
In the future, it is likely that additional competitors will emerge in the
telecommunications industry. Cable television companies and electric utilities
have expressed an interest in, or already are, providing telecommunications
services. As a result of recent and prospective mergers and acquisitions within
the industry, SBC may face competition from entities offering both cable TV and
telephone services in the Telephone Companies' regulated operating areas.
Interexchange carriers have been certified to provide local service, and a
number of other major carriers have publicly announced their intent to provide
local service in certain markets, some of which are in the Telephone Companies'
regulated operating areas. Public communications services such as public
payphone services will also face increased competition as a result of federal
deregulation of the payphone industry.
SBC is aggressively representing its interests regarding competition before
federal and state regulatory bodies, courts, Congress and state legislatures.
SBC will continue to evaluate the increasingly competitive nature of its
business, and develop appropriate competitive, legislative and regulatory
strategies.
International
Telmex was granted a concession in 1990, which expired in August 1996, as the
sole provider of long-distance services in Mexico. In 1995, the Mexican Senate
and Chamber of Deputies passed legislation providing for the introduction of
competition into the Mexican long-distance market. This legislation specified
that there would be an unlimited number of long-distance concessions and that
Telmex was required to provide 60 interconnection points by January 1, 1997, and
more than 200 interconnection points by the year 2000. Several large competitors
have received licenses to compete with Telmex and begun operations, including a
joint venture between AT&T and Alfa S.A. de C.V., a Mexican consortium, and
Avantel, S.A., a joint venture between MCI and Grupo Financiero Banamex-Accival,
Mexico's largest financial group. Balloting for presubscription of long-distance
service is currently occurring among Telmex's customers in selected areas. At
the end of 1997, Telmex had retained about 75% of its long-distance customers in
areas that had completed balloting.
Other Business Matters
Merger Agreement On January 5, 1998, SBC and Southern New England
Telecommunications Corporation (SNET) jointly announced a definitive agreement
to merge an SBC subsidiary with SNET, in a transaction in which each share of
SNET common stock will be exchanged for 1.7568 shares of SBC common stock
(equivalent to approximately 120 million shares, or 6.5% of SBC's outstanding
shares at December 31, 1997). After the merger, SNET will be a wholly-owned
subsidiary of SBC. 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 regulatory approvals as well as approval by the shareowners of SNET at a
special meeting expected to be held on March 27, 1998. If approvals are granted,
the transaction is expected to close by the end of 1998.
Restructuring Reserve In December 1993, PAC established a reserve to record the
incremental cost of force reductions associated with restructuring PAC's
business processes, of $1,431 in expenses, which impacted net income by $861.
This restructuring was expected to allow PacBell to eliminate approximately
10,000 employee positions through 1997, net of approximately 4,000 new positions
expected to be created. For the three-year period 1994 through 1996, net force
reductions totalled 9,168.
This table sets forth the status and activity of this reserve during that
three-year period:
-------------------------------------------------------------------------
1996 1995 1994
-------------------------------------------------------------------------
Balance - beginning of year $ 228 $ 819 $ 1,097
Charges: cash outlays (195) (372) (216)
non-cash 64 (219) (62)
-------------------------------------------------------------------------
Balance - end of year $ 97 $ 228 $ 819
=========================================================================
The remaining 1996 reserve of $97 was used during 1997. As a result of the new
initiatives arising from the merger with PAC, net force changes during 1997 are
not meaningful to the restructuring reserve.
Acquisitions and Dispositions In addition to the items discussed in Note 16 to
the Financial Statements, SBC has made several acquisitions and dispositions
since 1995.
In 1995, SBC made the following acquisitions: a wireless system serving
Watertown, New York, and 100% of the stock of Cross Country Wireless (CCW), a
wireless cable television operator providing service to 40,000 customers in
Riverside, California and with licenses to provide service in Los Angeles,
Orange County and San Diego. The CCW acquisition involved the issuance of stock
valued at approximately $120 and assumption of $55 in debt. Additionally, SBC
made the following equity investments in 1995: a $317 investment to acquire 40%
of VTR S.A. (VTR), a privately owned Chilean telecommunications holding company
which was 51% owned by Grupo Luksic (Luksic), a large Chilean conglomerate, and
an investment in a South African wireless company.
In 1996, SBC made the following additional investments: an investment to
maintain its indirect 10% ownership in a French cellular company to offset
dilution of its interest resulting from other equity sales, and an increase in
its holding in VTR to 49% through the purchase of shares from another minority
shareholder. Also in 1996, SBC and the other RHCs reached an agreement to sell
Bellcore. This sale was finalized in 1997.
During 1997, SBC contributed its French cellular holdings and an additional $240
to acquire a 15% interest in Cegetel, S.A, a newly formed company which is
intended to provide a broad base of telecommunications services throughout
France. Luksic exercised an option to purchase shares of VTR from SBC, reducing
SBC's ownership to 44%; in December 1997, VTR sold its wireless services
operations. SBC also sold its interests in an Australian directory publisher in
1997.
During the third quarter of 1997, SBC reached agreement to sell its cable
television properties in Montgomery County, Maryland and Arlington, Virginia, as
well as its purchase option to invest in cable television operations in Chicago,
Illinois. These transactions are expected to close during 1998.
Throughout 1997 and in February 1998, SBC sold portions of its Telmex L shares
so that SBC's total equity investment remained below 10% of Telmex's total
equity capitalization.
None of these transactions had a material effect on SBC's financial results in
1997, 1996 or 1995, nor does management expect them to have a material effect on
SBC's financial position or results of operations in 1998.
Strategic Realignment In July 1995, SBC announced a strategic realignment of
functions, and recognized $139 in selling, general and administrative expenses.
These expenses include postemployment benefits for approximately 2,400 employees
arising from the future consolidation of operations, streamlining support and
administrative functions and integrating financial systems. Full implementation
of the realignment had been delayed due to the merger with PAC, and the
realignment plans and all remaining liabilities were either integrated with or
superseded by the post-merger initiatives. The charge reduced net income for
1995 by approximately $88.
Liquidity and Capital Resources
Capital Expenditures and Other Commitments
To provide high-quality communications services to its customers, SBC,
particularly its landline and wireless operations, must make significant
investments in property, plant and equipment. The amount of capital investment
is influenced by demand for services and products, continued growth and
regulatory commitments.
SBC's capital expenditures totaled $5,766, $5,481 and $4,338 for 1997, 1996 and
1995. The Telephone Companies' capital expenditures increased 7% in 1997 and 26%
in 1996 due primarily to demand-related growth, network upgrades,
customer-contracted requirements, ISDN projects, PCS build-out and SWBell's
regulatory commitments.
In 1998, management expects total capital spending to decrease slightly from
1997, to between $5,500 and $5,700. Capital expenditures in 1998 will relate
primarily to the continued evolution of the Telephone Companies' networks,
including amounts agreed to under regulation plans at SWBell, and continued
build-out of Mobile Systems' markets and PBMS. SBC expects to fund ongoing
capital expenditures with cash provided by operations.
SWBell continues to make additional network and infrastructure improvements over
periods ranging through 2001 to satisfy regulatory commitments. Total capital
expenditures under these commitments will vary based on actual demand of
potential end users. SWBell anticipates spending approximately $100 in 1998
associated with these commitments.
PacBell has purchase commitments of approximately $190 remaining in connection
with its previously announced program for deploying an all-digital switching
platform with ISDN and SS-7 capabilities.
Over the next few years, SBC expects to incur significant capital and software
expenditures for customer number portability, which allows customers to switch
to new local competitors and keep the same phone number, and interconnection.
SBC expects capital costs and expenses associated with customer number
portability to total up to $1.2 billion on a pre-tax basis over the next four
years. Full recovery of customer number portability costs is required under the
Telecom Act; however, the FCC has not yet determined when or how those
significant costs will be recovered. SBC has filed a tariff for recovery of
these costs. No action has been taken by the FCC on this tariff, pending the
issuance of its order on customer number portability. SBC is unable to predict
the likelihood of the FCC permitting the tariffs to become effective. Capital
costs and expenses associated with interconnection will vary based on the number
of competitors seeking interconnection, the particular markets entered and the
number of customers served by those competitors. Accordingly, SBC is currently
unable to reasonably estimate the future costs that will be incurred associated
with interconnection.
SBC currently operates numerous date-sensitive computer applications and systems
throughout its business. As the century change approaches, it will be essential
for SBC to ensure that these systems properly recognize the year 2000 and
continue to process critical operational and financial information. SBC has
established processes for evaluating and managing the risks and costs associated
with preparing its systems and applications for the year 2000 change. Total
expenses for this project have been estimated to be less than $250 over the next
three years. SBC expects to substantially complete modifications and incur most
of these costs during 1998 to allow for thorough testing before the year 2000.
Dividends Declared
Dividends declared by the Board of Directors of SBC (Board) were $0.895 per
share in 1997, $0.86 per share in 1996, and $0.825 per share in 1995. These per
share amounts do not include dividends declared and paid by PAC prior to the
merger. The total dividends paid by SBC and PAC were $1,638 in 1997, $1,680 in
1996 and $1,933 in 1995. Pursuant to the terms of the merger agreement, PAC
reduced its dividend beginning in the second quarter of 1996. The lower second
and third quarter dividends paid in 1996 improved 1996 cash flow by
approximately $195. SBC's dividend policy considers both the expectations and
requirements of shareowners, internal requirements of SBC and long-term growth
opportunities. On January 30, 1998, the Board declared a first quarter 1998
dividend of $0.23375 per share.
Cash, Lines of Credit and Cash Flows
SBC had $398 of cash and cash equivalents available at December 31, 1997.
Commercial paper borrowings as of December 31, 1997, totaled $1,268. SBC has
entered into agreements with several banks for lines of credit totaling $2,475,
all of which may be used to support commercial paper borrowings (see Note 9 to
the Financial Statements). SBC had no borrowings outstanding under these lines
of credit as of December 31, 1997.
During 1997, as in 1996 and 1995, SBC's primary source of funds continued to be
cash generated from operations, as shown in the Consolidated Statements of Cash
Flows. Net cash provided by operating activities exceeded SBC's construction and
capital expenditures during 1997, as in 1996 and 1995; this excess is referred
to as free cash flow, a supplemental measure of liquidity. SBC generated free
cash flow of $1,204, $1,935 and $2,452 in 1997, 1996 and 1995.
During 1996 PAC issued $1,000 of TOPrS, $500 at 7.56% in January 1996 and $500
at 8.5% in June 1996 (see Note 10 to the Financial Statements). The proceeds
were used to retire outstanding short-term debt, primarily commercial paper that
had increased significantly during 1995.
During 1997, 1996 and 1995, the Telephone Companies refinanced long-term debt
with an aggregate principal amount of $964.
Total Capital
SBC's total capital consists of debt (long-term debt and debt maturing within
one year), TOPrS and shareowners' equity. Total capital increased $958 in 1997
and $1,844 in 1996. The increase in 1997 was due to higher debt levels and 1997
earnings. The increase in 1996 was due to PAC's increased financing requirements
and the reinvestment of earnings, partially offset by the acquisition of
treasury shares.
Debt Ratio
SBC's debt ratio was 56.2%, 55.5% and 61.7% at December 31, 1997, 1996 and 1995.
The debt ratio is affected by the same factors that affect total capital. For
1995, the decrease in equity caused by the discontinuance of regulatory
accounting increased the debt ratio by 13.2 percentage points.
Employee Stock Ownership Plans
See Note 13 to the Financial Statements.
SBC Communications Inc.
Consolidated Statements of Shareowners' Equity
Dollars in millions except per share amounts
Notes to Consolidated Financial Statements
Dollars in millions except per share amounts
Note 1. Summary of Significant Accounting Policies
Basis of Presentation - The consolidated financial statements include the
accounts of SBC Communications Inc. and its majority-owned subsidiaries
(SBC). SBC's subsidiaries and affiliates operate predominantly in the
communications services industry, providing landline and wireless
telecommunications services and equipment, directory advertising and cable
television services both domestically and worldwide.
SBC's largest subsidiaries are Southwestern Bell Telephone Company
(SWBell) providing telecommunications services in Texas, Missouri,
Oklahoma, Kansas and Arkansas (five-state area), and Pacific Telesis Group
(PAC), providing telecommunications services in California and Nevada.
PAC's subsidiaries include Pacific Bell (PacBell, which also includes its
subsidiaries) and Nevada Bell. (SWBell, PacBell and Nevada Bell are
collectively referred to as the Telephone Companies.)
All significant intercompany transactions are eliminated in the
consolidation process. Investments in partnerships, joint ventures and
less than majority-owned subsidiaries are principally accounted for under
the equity method. Earnings from certain foreign investments accounted for
under the equity method are included for periods ended within three months
of SBC's year end.
Financial information has been restated to reflect the two-for-one stock
split, effected in the form of a stock dividend, declared January 30, 1998
(see Note 15). Certain amounts in prior period financial statements have
been reclassified to conform to the current year's presentation.
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.
Income Taxes - Deferred income taxes are provided for 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 income tax expense over the lives
of the assets which gave rise to the credits.
Cash Equivalents - Cash equivalents include all highly liquid investments
with original maturities of three months or less.
Deferred Charges - Directory advertising costs are deferred until the
directory is published and advertising revenues related to these costs are
recognized.
Cumulative Effect of Accounting Change - Prior to January 1, 1996, Pacific
Bell Directory (a subsidiary of PacBell) recognized revenues and expenses
related to publishing directories in California using the "amortization"
method, under which revenues and expenses were recognized over the lives
of the directories, generally one year. Effective January 1, 1996, Pacific
Bell Directory changed to the "issue basis" method of accounting, which
recognizes the revenues and expenses at the time the related directory is
published. The change in methodology was made because the issue basis
method is generally followed in the publishing industry, including
Southwestern Bell Yellow Pages, and better reflects the operating activity
of the business.
The cumulative after-tax effect of applying the change in method to prior
years is recognized as of January 1, 1996 as a one-time, non-cash gain
applicable to continuing operations of $90, or $0.05 per share. The gain
is net of deferred taxes of $53. Had the current method been applied
during 1995, income before extraordinary loss and accounting change would
not have been materially affected.
Property, Plant and Equipment - Property, plant and equipment is stated at
cost. The cost of additions and substantial betterments of property, plant
and equipment is capitalized. The cost of maintenance and repairs of
property, plant and equipment is charged to operating expenses. Property,
plant and equipment is depreciated using straight-line methods over their
estimated economic lives, generally ranging from 3 to 50 years. Prior to
the discontinuance of regulatory accounting in the third quarter of 1995,
SWBell and PacBell computed depreciation using certain straight-line
methods and rates as prescribed by regulators. In accordance with
composite group depreciation methodology, when a portion of the Telephone
Companies' depreciable property, plant and equipment is retired in the
ordinary course of business, the gross book value is charged to
accumulated depreciation; no gain or loss is recognized on the disposition
of this plant.
Intangible Assets - Intangible assets consist primarily of wireless
cellular and Personal Communications Services (PCS) licenses, television
licenses, customer lists and the excess of consideration paid over net
assets acquired in business combinations. These assets are being amortized
using the straight-line method, over periods generally ranging from 5 to
40 years. At December 31, 1997 and 1996, amounts included in net
intangible assets for licenses were $2,625 and $2,695. Management
periodically reviews the carrying value and lives of all intangible assets
based on expected future cash flows.
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.
Advertising Costs - Costs for advertising products and services or
corporate image are expensed as incurred.
Foreign Currency Translation - Local currencies are generally considered
the functional currency for SBC's share of foreign operations, except in
countries considered highly inflationary. SBC translates its share of
foreign assets and liabilities at current exchange rates. Revenues and
expenses are translated using average rates during the year. The ensuing
foreign currency translation adjustments are recorded as a separate
component of Shareowners' Equity. Other transaction gains and losses
resulting from exchange rate changes on transactions denominated in a
currency other than the local currency are included in earnings as
incurred.
Earnings Per Common Share - In 1997, Statement of Financial Accounting
Standards No. 128, "Earnings per Share" (FAS 128) replaced the calculation
of primary and fully diluted earnings per share with basic and diluted
earnings per share. Basic earnings per share excludes any dilutive effects
of options and other stock-based compensation. All earnings per share
amounts for all periods have been presented and, where appropriate,
restated to conform to FAS 128 requirements.
Derivative Financial Instruments - SBC does not invest in any derivatives
for trading purposes. From time to time SBC invests in immaterial amounts
of interest rate swaps in order to manage exposure to interest rate risk
and foreign currency forward exchange contracts in order to manage
exposure to changes in foreign currency rates. Amounts related to
derivative contracts are recorded using the hedge accounting approach. SBC
currently does not recognize the fair values of these derivative financial
investments or their changes in fair value in its financial statements.
PAC has entered into an equity swap contract to hedge exposure to risk
associated with its recorded liability for certain outstanding employee
stock options relating to stock of AirTouch Communications Inc. (see Note
10). The equity swap contract and its liability are recorded at fair value
in the balance sheet as other assets or liabilities.
Note 2. Discontinuance of Regulatory Accounting
In the third quarter of 1995, SWBell and PacBell discontinued their
application of Statement of Financial Accounting Standards No. 71,
"Accounting for the Effects of Certain Types of Regulation" (FAS 71). FAS
71 requires depreciation of telephone plant using lives set by regulators
which are generally longer than those established by unregulated companies
and the deferral of certain costs and obligations based on regulatory
actions (regulatory assets and liabilities). As a result of the adoption
of price-based regulation for most of SWBell's revenues and the
acceleration of competition in the California and five-state area
telecommunications markets, management determined that SWBell and PacBell
no longer met the criteria for application of FAS 71.
Upon discontinuance of FAS 71 by SWBell and PacBell, SBC recorded a
non-cash, extraordinary charge to net income of $6,022 (after a net
deferred tax benefit of $4,037). This charge was comprised of an after-tax
charge of $5,739 to reduce the net carrying value of telephone plant, and
an after-tax charge of $283 for the elimination of net regulatory assets.
The components of the charge were as follows:
----------------------------------------------------------------------
Pre-tax After-tax
----------------------------------------------------------------------
Increase telephone plant accumulated $ 9,476 $ 5,739
depreciation
Elimination of net regulatory assets 583 283
======================================================================
Total $ 10,059 $ 6,022
======================================================================
The increase in accumulated depreciation of $9,476 reflected the effects
of adopting depreciable lives for SWBell's and PacBell's plant categories
which more closely reflect the economic and technological lives of the
plant. The adjustment was supported by discounted cash flow analyses, that
estimated amounts of telephone plant that may not be recoverable from
discounted future cash flows. These analyses included consideration of the
effects of anticipated competition and technological changes on plant
lives and revenues.
Following is a comparison of new lives to those prescribed by regulators
for selected plant categories:
------------------------------------------------------------------------
Average Lives (in Years)
------------------------------------------------------------------------
Regulator- Estimated
Prescribed Economic
------------------------------------------------------------------------
Digital switch 17 10-11
Digital circuit 10-12 7-8
Copper cable 19-26 14-18
Fiber cable 27-30 20
Conduit 57-59 50
========================================================================
The increase in accumulated depreciation at SWBell also included an
adjustment of approximately $450 to fully depreciate analog switching
equipment scheduled for replacement. Remaining analog switching equipment
is being depreciated using an average remaining life of four years.
The discontinuance of FAS 71 for external financial reporting purposes
also required the elimination of net regulatory assets of $583. Regulatory
assets and liabilities are related primarily to accounting policies used
by regulators in the ratemaking process which are different from those
used by non-regulated companies. The differences arose predominantly in
the accounting for income taxes, deferred compensated absences, and in
California, pension costs and debt redemption costs. These items were
required to be eliminated with the discontinuance of accounting under FAS
71. SWBell and PacBell accounting and reporting for regulatory purposes
are not affected by the discontinuance of FAS 71 for external financial
reporting purposes.
With the discontinuance of FAS 71, SWBell and PacBell began accounting for
interest on funds borrowed to finance construction as an increase in
property, plant and equipment and a reduction of interest expense. Under
the provisions of FAS 71, both companies capitalized both interest and
equity costs allowed by regulators during periods of construction as other
income and as an addition to the cost of plant constructed. Additionally,
PacBell began accounting for pension costs under Statement of Financial
Accounting Standards No. 87, "Employers' Accounting for Pensions," (FAS
87) and Statement of Financial Accounting Standards No. 88, "Employers'
Accounting for Settlements and Curtailments of Defined Benefit Pension
Plans and for Termination Benefits" (FAS 88).
Note 3. Merger with PAC
On April 1, 1997, SBC and PAC completed the merger of an SBC subsidiary
with PAC, in a transaction in which each 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 the two-for-one stock split declared
January 30, 1998). With the merger, PAC became a wholly-owned subsidiary
of SBC. The transaction has been accounted for as a pooling of interests
and a tax-free reorganization. Accordingly, the financial statements for
the periods presented prior to the merger have been restated to include
the accounts of PAC.
Operating revenues, income before extraordinary loss and cumulative effect
of accounting change and net income (loss) of the separate companies for
the pre-merger periods of the last three years were as follows:
-----------------------------------------------------------------------
Three
months
ended
March 31, Year Ended December 31,
-----------------------------------------------------------------------
1997 1996 1995
-----------------------------------------------------------------------
Operating revenues:
SBC $ 3,456 $ 13,857 $ 12,670
PAC 2,535 9,588 9,042
-----------------------------------------------------------------------
Combined $ 5,991 $ 23,445 $ 21,712
-----------------------------------------------------------------------
Income before extraordinary loss and
cumulative effect of accounting
change:
SBC $ 517 $ 2,101 $ 1,889
PAC 352 1,057 1,048
Adjustments (12) 31 21
-----------------------------------------------------------------------
Combined $ 857 $ 3,189 $ 2,958
-----------------------------------------------------------------------
Net income (loss):
SBC $ 517 $ 2,101 $ (930)
PAC 352 1,142 (2,312)
Adjustments (12) 36 178
-----------------------------------------------------------------------
Combined $ 857 $ 3,279 $ (3,064)
-----------------------------------------------------------------------
The combined results include the effect of changes applied retroactively
to conform accounting methodologies between PAC and SBC for, among other
items, pensions, postretirement benefits, sales commissions and merger
transaction costs as well as certain deferred tax adjustments resulting
from the merger. In each case, SBC believes the new methods are more
prevalent and better reflect the operations of the business. Transaction
costs and one-time charges relating to the closing of the merger were $359
($215 net of tax) including, among other items, the present value of
amounts to be returned to California ratepayers as a condition of the
merger and expenses for investment banker and professional fees. Of this
total, $287 ($180 net of tax) is included in expenses in 1997, and $72
($35 net of tax) in 1996.
Post-merger initiatives
During the second quarter of 1997, SBC announced after-tax charges of $1.6
billion related to several strategic decisions resulting from the merger
integration process that began with the April 1 closing of its merger with
PAC, which included $165 ($101 after tax) of charges related to several
regulatory rulings during the second quarter of 1997 and $281 ($176 after
tax) for merger approval costs. The decisions resulted from an extensive
review of operations throughout the merged company and include significant
integration of operations and consolidation of some administrative and
support functions. Following is a discussion of the most significant of
these charges.
Reorganization SBC is centralizing several key functions that will support
the operations of the Telephone Companies, 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. The Telephone Companies will continue as separate legal
entities. These initiatives will result in the creation of some jobs and
the elimination and realignment of others, with many of the affected
employees changing job responsibilities and in some cases assuming
positions in other locations.
SBC recognized a charge of approximately $338 ($213 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. During the second half of 1997, SBC incurred $501 ($304 net of
tax) of merger-related charges.
Impairments/asset valuation As a result of SBC's merger integration plans,
strategic review of domestic operations and organizational realignments,
SBC 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, SBC wrote off some assets
and recognized impairments to the value of other assets with a combined
charge of $965 ($667 after tax) recorded in the second quarter of 1997.
These impairments and writeoffs related to the wireless digital TV
operations in southern California, certain analog switching equipment in
California, certain rural and other telecommunications equipment in
Nevada, selected wireless equipment, duplicate or obsolete equipment,
cable within commercial buildings in California, certain nonoperating
plant and other assets.
Video curtailment/purchase commitments SBC also announced that it is
scaling back its limited direct investment in video services. As a result
of this curtailment, SBC has halted construction on the Advanced
Communications Network (ACN) in California. As part of an agreement with
the ACN vendor, SBC 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, SBC recognized its net
expense of $553 ($346 after tax) associated with these activities.
Additionally, SBC curtailed several other video-related activities
including discontinuing its broadband network video trials in Richardson,
Texas and San Jose, California, substantially scaling back its involvement
in the Tele-TV joint venture and withdrawing from the Americast venture.
Americast partners are disputing the withdrawal in arbitration and
litigation, the outcome of which cannot be predicted. The collective
impact of these decisions resulted in a charge of $145 ($92 after tax) in
the second quarter of 1997.
Note 4. Merger Agreement with Southern New England Telecommunications
Corporation (SNET)
On January 5, 1998, SBC and SNET jointly announced a definitive agreement
to merge an SBC subsidiary with SNET, in a transaction in which each share
of SNET common stock will be exchanged for 1.7568 shares of SBC common
stock (equivalent to approximately 120 million shares, or 6.5% of SBC's
outstanding shares at December 31, 1997; both the exchange ratio and
shares to be issued have been restated to reflect the two-for-one stock
split declared January 30, 1998). After the merger, SNET will be a
wholly-owned subsidiary of SBC. 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 regulatory approvals as
well as approval by the shareowners of SNET at a special meeting expected
to be held on March 27, 1998. If approvals are granted, the transaction is
expected to close by the end of 1998.
Note 5. Pacific Telesis Group Financial Information
The following table presents summarized financial information for Pacific
Telesis Group at December 31, or for the year then ended:
SBC has not provided separate financial statements and other disclosures
for PAC as management has determined that such information is not material
to the holders of the Trust Originated Preferred Securities (TOPrS) (see
Note 10). On January 30, 1998, SBC guaranteed payment of the obligations
of the TOPrS.
Note 6. Earnings Per Share
A reconciliation of the numerators and denominators of basic earnings per
share and diluted earnings per share for income before extraordinary loss
and cumulative effect of accounting change for the years ended December
31, 1997, 1996 and 1995 are shown in the table below. Per share amounts
have been restated to reflect the two-for-one stock split declared January
30, 1998.
--------------------------------------------------------------------
Year Ended December 31, 1997 1996 1995
--------------------------------------------------------------------
Numerators
Numerator for basic earnings per share:
Income before extraordinary loss
and cumulative effect of accounting
change $ 1,474 $ 3,189 $ 2,958
--------------------------------------------------------------------
Dilutive potential common shares:
Other stock-based compensation 3 2 2
--------------------------------------------------------------------
Numerator for diluted earnings
per share $ 1,477 $ 3,191 $ 2,960
--------------------------------------------------------------------
Denominators
Denominator for basic earnings per share:
Weighted average number of common
shares outstanding (000) 1,828,395 1,841,240 1,840,861
--------------------------------------------------------------------
Dilutive potential common shares (000):
Stock options 11,791 6,783 4,910
Other stock-based compensation 4,443 3,410 2,936
--------------------------------------------------------------------
Denominator for diluted
earnings per share 1,844,629 1,851,433 1,848,707
--------------------------------------------------------------------
Basic earnings per share:
Income before extraordinary loss
and cumulative effect of accounting
change $ 0.81 $ 1.73 $ 1.61
Extraordinary loss - - (3.27)
Cumulative effect of accounting
change - 0.05 -
--------------------------------------------------------------------
Net income (loss) $ 0.81 $ 1.78 $ (1.66)
--------------------------------------------------------------------
Diluted earnings per share:
Income before extraordinary loss
and cumulative effect of accounting
change $ 0.80 $ 1.72 $ 1.60
Extraordinary loss - - (3.26)
Cumulative effect of accounting
change - 0.05 -
--------------------------------------------------------------------
Net income (loss) $ 0.80 $ 1.77 $ (1.66)
--------------------------------------------------------------------
Note 7. Property, Plant and Equipment
Property, plant and equipment is summarized as follows at December 31:
---------------------------------------------------------------------
1997 1996
---------------------------------------------------------------------
Telephone Companies plant
In service $ 60,122 $ 56,638
Under construction 1,147 1,614
---------------------------------------------------------------------
61,269 58,252
Accumulated depreciation and
amortization (36,384) (34,515)
---------------------------------------------------------------------
Total Telephone Companies 24,885 23,737
---------------------------------------------------------------------
Other 4,017 3,534
Accumulated depreciation and
amortization (1,563) (1,191)
---------------------------------------------------------------------
Total other 2,454 2,343
---------------------------------------------------------------------
Property, plant and equipment-net $ 27,339 $ 26,080
=====================================================================
SBC's depreciation expense as a percentage of average depreciable plant
was 7.4% for 1997, 6.9% for 1996 and 7.0% for 1995.
Certain facilities and equipment used in operations are under operating or
capital leases. Rental expenses under operating leases for 1997, 1996 and
1995 were $390, $324 and $231. At December 31, 1997, the future minimum
rental payments under noncancelable operating leases for the years 1998
through 2002 were $168, $171, $113, $86 and $66, and $238 thereafter.
Capital leases were not significant.
Note 8. Equity Investments
Investments in affiliates accounted for under the equity method include
SBC's investment in Telefonos de Mexico, S.A. de C.V. (Telmex), Mexico's
national telecommunications company. SBC is a member of a consortium that
holds all of the AA shares of Telmex stock, representing voting control of
the company. The consortium is controlled by a group of Mexican investors
led by an affiliate of Grupo Carso, S.A. de C.V. SBC also owns L shares
which have limited voting rights. Throughout 1997 and in February 1998,
SBC sold portions of its L shares so that its total equity investment
remained below 10% of Telmex's total equity capitalization.
Other major equity investments held by SBC include a 1997 investment of
$760 in South African telecommunications (see Note 16), an indirect 15%
ownership in Cegetel, a joint venture providing a broad range of
telecommunications offerings in France, investments in Chilean
telecommunications operations and minority ownership of several domestic
wireless properties.
The following table is a reconciliation of SBC's investments in equity
affiliates:
---------------------------------------------------------------------
1997 1996 1995
---------------------------------------------------------------------
Beginning of year $ 1,964 $ 1,616 $ 1,776
Additional investments 1,076 337 447
Equity in net income 201 207 120
Dividends received (90) (70) (62)
Currency translation adjustments (135) (94) (268)
Reclassifications and other
adjustments (276) (32) (397)
=====================================================================
End of year $ 2,740 $ 1,964 $ 1,616
=====================================================================
Currency translation adjustments for 1997 primarily reflect the effect of
the exchange rate fluctuations on SBC's investments in South African and
French telecommunications.
The currency translation adjustment for 1995 primarily reflects the effect
on SBC's investment in Telmex of the decline in the value of the Mexican
peso relative to the U.S. dollar during 1995. In 1997, SBC used the U.S.
dollar, instead of the peso, as the functional currency for its investment
in Telmex due to the Mexican economy becoming highly inflationary.
Other adjustments for 1997 reflect the sale of portions of SBC's Telmex L
shares and the change to the cost method of accounting in 1997 for SBC's
1995 investment in South African wireless operations. Other adjustments
for 1995 reflect the change in October 1995 to the cost method of
accounting for SBC's United Kingdom cable television operations (see Note
16).
Undistributed earnings from equity affiliates were $862 and $762 at
December 31, 1997 and 1996.
Note 9. Debt
In February 1998, SBC called $630 of debentures and notes of SWBell,
PacBell and SBC Communications Capital Corporation (included in Other
notes). Estimated net income impact from unamortized discounts and call
premiums is $(8). During 1995, SBC refinanced long-term debentures of
SWBell and PacBell. Costs of $36 associated with refinancing are included
in other income (expense) - net, with related income tax benefits of $14
included in income taxes in SBC's Consolidated Statements of Income.
At December 31, 1997, the aggregate principal amounts of long-term debt
scheduled for repayment for the years 1998 through 2002 were $336, $500,
$469, $986 and $879. As of December 31, 1997, SBC was in compliance with
all covenants and conditions of instruments governing its debt.
Debt maturing within one year consists of the following at December 31:
----------------------------------------------------------------------
1997 1996
----------------------------------------------------------------------
Commercial paper $ 1,268 $ 1,848
Current maturities of long-term debt 336 487
Other short-term debt 349 -
======================================================================
Total $ 1,953 $ 2,335
======================================================================
The weighted average interest rate on commercial paper debt at December
31, 1997 and 1996 was 6.0%. SBC has entered into agreements with several
banks for lines of credit totaling $1,000. All of these agreements may be
used to support commercial paper borrowings and are on a negotiated fee
basis with interest rates negotiable at time of borrowing. There were no
borrowings outstanding under these lines of credit at December 31, 1997.
Another group of uncommitted lines of credit with banks that do not
require compensating balances or commitment fees, and accordingly are
subject to continued review, amounted to approximately $1,475 at December
31, 1997.
Note 10. Financial Instruments
The carrying amounts and estimated fair values of SBC's long-term debt,
including current maturities and other financial instruments, are
summarized as follows at December 31:
-----------------------------------------------------------------------
1997 1996
-----------------------------------------------------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
----------------------------------------------------------------------
SWBell debentures $3,764 $3,828 $3,271 $3,208
SWBell notes 1,230 1,271 1,112 1,115
PacBell debentures 4,055 4,337 3,955 3,917
PacBell notes 1,282 1,342 1,132 1,171
Other notes 1,577 1,768 1,436 1,478
TOPrS 1,000 1,034 1,000 990
Guaranteed obligations of
employee stock ownership
plans(1) 153 159 208 219
----------------------------------------------------------------------
(1) See Note 13.
The fair values of SBC's long-term debt were estimated based on quoted
market prices, where available, or on the net present value method of
expected future cash flows using current interest rates. The fair value of
the TOPrS was estimated based on quoted market prices. The carrying
amounts of commercial paper debt approximate fair values.
SBC does not hold or issue any financial instruments for trading purposes.
SBC's cash equivalents and short-term investments are recorded at
amortized cost. The carrying amounts of cash and cash equivalents and
short-term investments and customer deposits approximate fair values.
Pacific Telesis Financing I and II (the Trusts) were formed for the
exclusive purpose of issuing preferred and common securities representing
undivided beneficial interests in the Trusts and investing the proceeds
from the sales of TOPrS in unsecured subordinated debt securities of PAC.
Under certain circumstances, dividends on TOPrS could be deferred for up
to a period of five years. PAC sold $1 billion of TOPrS, $500 at 7.56% in
January 1996 through Pacific Telesis Financing I and $500 at 8.5% in June
1996 through Pacific Telesis Financing II. As of December 31, 1997, the
Trusts held subordinated debt securities of PAC in principal amounts of
$516 and $514 with interest rates of 7.56% and 8.5%. Both issues of TOPrS
were priced at $25 per share, have an original 30-year maturity that may
be extended up to 49 years, and are callable five years after date of sale
at par and are included on the balance sheet as corporation-obligated
mandatorily redeemable preferred securities of subsidiary trusts. The
proceeds were used to retire short-term indebtedness, primarily commercial
paper. On January 30, 1998, SBC guaranteed payment of the obligations of
the TOPrS.
Derivatives
PAC has entered into an equity swap contract to hedge exposure to risk of
market changes related to its recorded liability for outstanding employee
stock options for common stock of AirTouch Communications, Inc. (spun-off
operations) and associated stock appreciation rights (SARs)(see Note 14).
PAC plans to make open market purchases of the stock of spun-off
operations to satisfy its obligation for options that are exercised.
Off-balance-sheet risk exists to the extent the market price of the stock
of spun-off operations rises above the market price reflected in the
liability's current carrying value. The equity swap was entered into to
hedge this exposure and minimize the impact of market fluctuations. The
contract entitles PAC to receive settlement payments to the extent the
price of the common stock of spun-off operations rises above the notional
value of $23.74 per share, but imposes an obligation to make payments to
the extent the price declines below this level. The swap also obligates
PAC to make a monthly payment of a fee based on LIBOR. The total notional
amount of the contract, $32 and $60 as of December 31, 1997 and 1996
covers the approximate number of the outstanding options and SARs of
spun-off operations on that date. PAC plans to periodically adjust
downward the outstanding notional amount as the options and SARs are
exercised. The equity swap contract expires April 1999.
Both the equity swap and PAC's liability for the stock options and SARs of
spun-off operations are carried in the balance sheet at their market
values, which were immaterial as of December 31, 1997 and 1996. Gains and
losses from quarterly market adjustments of the carrying amounts
substantially offset. As of December 31, 1997 and 1996, the accounting
loss that would be incurred from nonperformance by the counterparty to the
equity swap was $14 and $4. However, management does not expect to realize
any loss from counterparty nonperformance.
Note 11. Income Taxes
Significant components of SBC's deferred tax liabilities and assets are as
follows at December 31:
------------------------------------------------------------------
1997 1996
------------------------------------------------------------------
Depreciation and amortization $ 3,648 $ 3,283
Other 2,255 1,017
------------------------------------------------------------------
Deferred tax liabilities 5,903 4,300
------------------------------------------------------------------
Employee benefits 2,391 2,221
Unamortized investment tax credits 169 195
Other 2,394 1,328
------------------------------------------------------------------
Deferred tax assets 4,954 3,744
------------------------------------------------------------------
Deferred tax assets valuation allowance 68 96
------------------------------------------------------------------
Net deferred tax liabilities $ 1,017 $ 652
==================================================================
The decrease in the valuation allowance is the result of an evaluation of
the uncertainty associated with the realization of certain deferred tax
assets. The valuation allowance is maintained in deferred tax assets for
certain unused federal and state loss carryforwards.
The components of income tax expense are as follows:
A reconciliation of income tax expense and the amount computed by applying
the statutory federal income tax rate (35%) to income before income taxes,
extraordinary loss and cumulative effect of accounting change is as
follows:
Note 12. Employee Benefits
Pensions - Substantially all employees of SBC are covered by one of three
noncontributory pension and death benefit plans. The pension benefit
formula used in the determination of pension cost for nonmanagement
employees is based on a flat dollar amount per year of service according
to job classification. For PAC managers, benefits accrue in separate
account balances based on a fixed percentage of each employee's monthly
salary with interest. For all other managers, benefits accrue in separate
account balances based on a fixed percentage of each employee's monthly
salary plus interest or are determined based upon a stated percentage of
adjusted career income.
SBC's objective in funding the plans, in combination with the standards of
the Employee Retirement Income Security Act of 1974 (as amended), is to
accumulate funds sufficient to meet its benefit obligations to employees
upon their retirement. Contributions to the plans are made to a trust for
the benefit of plan participants. Plan assets consist primarily of stocks,
U.S. government and domestic corporate bonds, index funds and real estate.
Net pension cost is composed of the following:
-----------------------------------------------------------------------
1997 1996 1995
-----------------------------------------------------------------------
Service cost--benefits earned during
the period $ 278 $ 297 $ 311
Interest cost on projected benefit
obligation 1,146 1,131 1,161
Actual return on plan assets (3,775) (2,919) (4,232)
Other--net 2,161 1,270 2,813
-----------------------------------------------------------------------
Net pension cost (benefit) $ (190) $ (221) $ 53
-----------------------------------------------------------------------
The following table sets forth the pension plans' funded status and the
amounts included in SBC's Consolidated Balance Sheets at December 31:
--------------------------------------------------------------------
1997 1996
--------------------------------------------------------------------
Fair value of plan assets $23,092 $ 20,738
Less: Actuarial present value of projected
benefit obligation 16,746 15,006
--------------------------------------------------------------------
Plan assets in excess of projected benefit
obligation 6,346 5,732
Unrecognized prior service cost 1,108 845
Unrecognized net gain (6,564) (6,072)
Unamortized transition asset (811) (973)
--------------------------------------------------------------------
Prepaid (accrued) pension cost $ 79 $ (468)
====================================================================
The projected benefit obligation was increased $202 at December 31, 1996,
for the cost of force reductions anticipated to take place in 1996 and
1997 and recognized in SBC's financial statements under FAS 88.
Significant weighted average assumptions used in developing pension
information include:
--------------------------------------------------------------------------
1997 1996 1995
--------------------------------------------------------------------------
Discount rate for determining projected
benefit obligation 7.25% 7.5% 7.25%
Long-term rate of return on plan assets 8.5% 8.55% 8.0%
Composite rate of compensation increase 4.3% 4.3% 4.3%
--------------------------------------------------------------------------
The projected benefit obligation is the actuarial present value of all
benefits attributed by the pension benefit formula to previously rendered
employee service. It is measured based on assumptions concerning future
interest rates and employee compensation levels. Should actual experience
differ from the actuarial assumptions, the benefit obligation will be
affected.
In April 1997 management amended the pension plan for non-PAC managers to
a cash balance pension plan effective June 1, 1997. Under the new plan,
participants accrue benefits based on a percentage of pay plus interest.
In addition, a transition benefit is phased in over five years. The new
plan also requires computation of a grandfathered benefit using the old
formula for five years. Participants receive the greater of the cash
balance benefit or the grandfathered benefit. The new cash balance plan
allows lump sum benefit payments in addition to annuities. This change did
not have a significant impact on SBC's net income for 1997.
In March 1996, management amended the pension plan for PAC managers from a
final pay plan to a cash balance plan effective July 1, 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 and resulted in an increase in earned benefits
for most employees. SBC also updated the actuarial assumptions used in
valuing the PAC plans 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, these changes
increased net income by approximately $125 during 1996.
The actuarial estimate of the accumulated benefit obligation does not
include assumptions about future compensation levels. The accumulated
benefit obligation as of December 31, 1997 was $15,565, of which $14,404
was vested. At December 31, 1996 these amounts were $13,965 and $12,376.
Approximately 4,200 and 2,200 employees left PacBell during 1996 and 1995
under retirement or voluntary and involuntary severance programs and
received special pension benefits and cash incentives in connection with
the PacBell restructuring and related force reduction programs. Annual
pension cost excludes $(64) and $219 of additional pension costs charged
to PacBell's restructuring reserve in 1996 and 1995.
During 1997, the significant amount of lump sum pension payments resulted
in a partial settlement of PAC's pension plans. In accordance with FAS 88,
net settlement gains in the amount of $299 were recognized in 1997. Of
this amount, $152 was recognized in the first quarter of 1997 and related
primarily to managers who terminated employment in 1996. These gains are
not included in the net pension cost shown in the preceding table.
In December 1996, under the provisions of Section 420 of the Internal
Revenue Code, SBC transferred $73 in pension assets to a health care
benefit account for the reimbursement of retiree health care benefits paid
by SBC. No additional pension assets were transferred to the health care
benefit account in 1997.
Supplemental Retirement Plans - SBC also provides senior and middle
management employees with nonqualified, unfunded supplemental retirement
and savings plans. These plans include supplemental defined pension
benefits as well as compensation deferral plans, some of which include a
corresponding match by SBC based on a percentage of the compensation
deferral. Expenses related to these plans were $89, $88 and $91 in 1997,
1996 and 1995. Liabilities of $892 and $758 related to these plans have
been included in other noncurrent liabilities in SBC's Consolidated
Balance Sheets at December 31, 1997 and 1996.
Postretirement Benefits - SBC provides certain medical, dental and life
insurance benefits to substantially all retired employees under various
plans and accrues actuarially determined postretirement benefit costs as
active employees earn these benefits. Employees retiring after certain
dates will pay a share of the costs of medical coverage that exceed a
defined dollar medical cap. Such future cost sharing provisions have been
reflected in determining SBC's postretirement benefit costs.
Postretirement benefit cost is composed of the following:
---------------------------------------------------------------------
1997 1996 1995
---------------------------------------------------------------------
Service cost--benefits earned
during the period $ 102 $ 101 $ 99
Interest cost on accumulated
postretirement benefit
obligation (APBO) 480 475 496
Actual return on assets (619) (375) (452)
Other--net 398 208 318
=====================================================================
Postretirement benefit cost $ 361 $ 409 $ 461
=====================================================================
SBC maintains Voluntary Employee Beneficiary Association (VEBA) trusts to
fund postretirement benefits. During 1997 and 1996, SBC contributed $415
and $320 into the VEBA trusts to be ultimately used for the payment of
postretirement benefits. Assets consist principally of stocks and U.S.
government and corporate bonds.
The following table sets forth the plans' funded status and the amount
included in SBC's Consolidated Balance Sheets at December 31:
-----------------------------------------------------------------------
1997 1996
-----------------------------------------------------------------------
Retirees $ 4,470 $ 4,047
Fully eligible active plan participants 773 706
Other active plan participants 1,932 1,819
-----------------------------------------------------------------------
Total APBO 7,175 6,572
Less: Fair value of plan assets 3,533 2,697
-----------------------------------------------------------------------
APBO in excess of plan assets 3,642 3,875
Unrecognized prior service cost 24 (31)
Unrecognized net gain 1,105 1,119
-----------------------------------------------------------------------
Accrued postretirement benefit obligation $ 4,771 $ 4,963
=======================================================================
In December 1995, one of the life insurance benefit plans was merged with
one of the medical plans. The fair value of plan assets restricted to the
payment of life insurance benefits only was $887 and $746 at December 31,
1997 and 1996. At December 31, 1997 and 1996, the accrued life insurance
benefits included in the accrued postretirement benefit obligation were
$74 and $57.
The assumed medical cost trend rate in 1998 is 7.5%, decreasing gradually
to 5.5% in 2002, prior to adjustment for cost-sharing provisions of the
plan for active and certain recently retired employees. The assumed dental
cost trend rate in 1998 is 6%, reducing to 5% in 2002. Raising the annual
medical and dental cost trend rates by one percentage point increases the
APBO as of December 31, 1997 by $458 and increases the aggregate service
and interest cost components of the net periodic postretirement benefit
cost for 1997 by approximately $45. Significant assumptions for the
discount rate, long-term rate of return on plan assets and composite rate
of compensation increase used in developing the APBO and related
postretirement benefit costs were the same as those used in developing the
pension information.
Note 13. Other Employee Benefits
Employee Stock Ownership Plans - SBC maintains contributory savings plans
which cover substantially all employees. Under the savings plans, SBC
matches a stated percentage of eligible employee contributions, subject to
a specified ceiling.
SBC has three leveraged Employee Stock Ownership Plans (ESOPs) as part of
the existing savings plans. Two of the ESOPs were funded with notes issued
by the savings plans to various lenders, the proceeds of which were used
to purchase shares of SBC's common stock in the open market. These notes
are unconditionally guaranteed by SBC and therefore presented as a
reduction to shareowners' equity and an increase in long-term debt. They
will be repaid with SBC contributions to the savings plans, dividends paid
on SBC shares and interest earned on funds held by the ESOPs.
The third ESOP purchased PAC treasury shares in exchange for a promissory
note from the plan to PAC. Since PAC is the lender, this note is not
reflected as a liability and the remaining cost of unallocated trust
shares is carried as a reduction of shareowners' equity. Principal and
interest on the note are paid from employer contributions and dividends
received by the trust. All PAC shares were exchanged for SBC shares
effective with the merger April 1, 1997. The provisions of this ESOP were
unaffected by this exchange.
SBC's match of employee contributions to the savings plans is fulfilled
with shares of stock allocated from the ESOPs and with purchases of SBC's
stock in the open market. Shares held by the ESOPs are released for
allocation to the accounts of employees as employer matching contributions
are earned. Benefit cost is based on a combination of the contributions to
the savings plans and the cost of shares allocated to participating
employees' accounts. Both benefit cost and interest expense on the notes
are reduced by dividends on SBC's shares held by the ESOPs and interest
earned on the ESOPs' funds.
Information related to the ESOPs and the savings plans is summarized
below:
------------------------------------------------------------------------
1997 1996 1995
------------------------------------------------------------------------
Benefit expense--net of dividends and
interest income $ 46 $ 65 $ 66
Interest expense--net of dividends and
interest income 18 26 37
------------------------------------------------------------------------
Total expense $ 64 $ 91 $ 103
========================================================================
Company contributions for ESOPs $ 98 $ 108 $ 89
========================================================================
Dividends and interest income for debt
service $ 58 $ 62 $ 72
========================================================================
SBC shares held by the ESOPs are summarized as follows at December 31:
-----------------------------------------------------------------------
1997 1996
-----------------------------------------------------------------------
Unallocated 15,621,250 31,005,792
Committed to be allocated 282,388 355,188
Allocated to participants 43,151,816 31,119,148
=======================================================================
Total 59,055,454 62,480,128
=======================================================================
Note 14. Stock-Based Compensation
Under various SBC plans, senior and other management employees and
non-employee directors have received stock options, SARs, performance
shares and nonvested stock units to purchase shares of SBC common stock.
Options issued through December 31, 1997 carry exercise prices equal to
the market price of the stock at the date of grant and have maximum terms
ranging from five to ten years. Depending upon the grant, vesting of
options may occur up to four years from the date of grant. Performance
shares are granted to key employees in the form of common stock and/or in
cash based upon the price of common stock at date of grant and are awarded
at the end of a two or three year period, subject to the achievement of
certain performance goals. Nonvested stock units are also valued at market
price of the stock at date of grant and vest over a three year period. Up
to 156 million shares may be issued under these plans.
In 1996 SBC elected to continue measuring compensation cost for these
plans using the intrinsic value based method of accounting prescribed in
Statement of Financial Accounting Standards No. 123, "Accounting for
Stock-Based Compensation" (FAS 123). Accordingly, no compensation cost for
SBC's stock option plans has been recognized. The compensation cost that
has been charged against income for SBC's other stock-based compensation
plans, primarily SARs and nonvested stock units, totaled $43, $22 and $24
for 1997, 1996 and 1995. Had compensation cost for stock option plans been
recognized using the fair value based method of accounting at the date of
grant for awards in 1997, 1996 and 1995 as defined by FAS 123, SBC's net
income (loss) would have been $1,400, $3,250 and $(3,074) and basic net
income (loss) per share would have been $0.77, $1.77 and $(1.67).
Options and SARs held by the continuing employees of PAC at the time of
the AirTouch Communications Inc. spin-off were supplemented with an equal
number of options and SARs for common shares of spun-off operations. The
exercise prices for outstanding options and SARs held by continuing
employees of PAC were adjusted downward to reflect the value of the
supplemental spun-off operations' options and SARs. The balance sheet
reflects a related liability equal to the difference between the current
market price of spun-off operations stock and the exercise prices of the
supplemental options outstanding (see Note 10). As of December 31, 1997,
831,139 supplemental spun-off operations options and SARs were outstanding
with expiration dates ranging from 1998 to 2003. Outstanding options and
SARs that were held by employees of the wireless operations at the
spin-off date were replaced by options and SARs for common shares of
spun-off operations. The spun-off operations assumed liability for these
replacement options and SARs.
For purposes of these pro forma disclosures, the estimated fair value of
the options granted after 1994 is amortized to expense over the options'
vesting period. Because most employee options vest over a two to three
year period, these disclosures will not be indicative of future pro forma
amounts until the FAS 123 rules are applied to all outstanding non-vested
awards. The fair value for these options was estimated at the date of
grant, using a Black-Scholes option pricing model with the following
weighted-average assumptions used for grants in 1997, 1996 and 1995:
risk-free interest rate of 6.57%, 6.26% and 6.34%; dividend yield of
2.99%, 4.92% and 3.61%; expected volatility factor of 15%, 18% and 18%;
and expected option life of 5.8, 4.7 and 4.6 years.
Information related to options and SARs is summarized below and has been
restated to reflect the two-for-one stock split declared January 30,
1998:
Information related to options and SARs outstanding at December 31, 1997:
The weighted-average grant-date fair value of each option granted during
1997, 1996 and 1995 was $5.65, $3.45 and $4.16.
Note 15. Shareowners' Equity
Common Stock Split - On January 30, 1998, the Board of Directors of SBC
(Board) declared a two-for-one stock split, effected in the form of a
stock dividend, on the shares of SBC's common stock. Each shareholder of
record on February 20, 1998 will receive an additional share of common
stock for each share of common stock then held. The stock will be issued
March 19, 1998. SBC will retain the current par value of $1.00 per share
for all shares of common stock.
Shareowners' Rights Plan - The Shareowners' Rights Plan (Plan) becomes
operative in certain events involving the acquisition of 20% or more of
SBC's common stock by any person or group in a transaction not approved by
the Board, or the designation by the Board of a person or group owning
more than 10% of the outstanding stock as an adverse person, as provided
in the Plan. Upon the occurrence of these events, each right, unless
redeemed by the Board, generally entitles the holder (other than the
holder triggering the right) to purchase an amount of common stock of SBC
(or, in certain circumstances, of the potential acquiror) having a value
equal to two times the exercise price of $160. The rights expire in
January 1999. After giving effect to stock splits in January 1998 and May
1993, effected in the form of a stock dividend, each share of common stock
represents one-quarter of a right.
The rights have certain antitakeover effects. The rights will cause
substantial dilution to a person or group that attempts to acquire SBC on
terms not approved by the Board.
The rights should not interfere with any merger or other business
combination approved by the Board since the rights may be redeemed.
Note 16. Acquisitions and Dispositions
In May 1997, a consortium made up of SBC and Telekom Malaysia Berhad, 60%
owned by SBC, completed the purchase of 30% of Telkom SA Limited (Telkom),
the state-owned telecommunications company of South Africa. SBC invested
$760, approximately $600 of which will remain in Telkom.
In October 1995, SBC combined its United Kingdom cable television
operations with those of TeleWest Communications, P.L.C., a publicly held
joint venture between Telecommunications, Inc. and U S WEST, Inc. The
resulting entity, TeleWest P.L.C. (TeleWest), is the largest cable
television operator in the United Kingdom. SBC owns approximately 15% of
the new entity and accounts for its investment using the cost method of
accounting. Restrictions expiring over the next three years exist on the
sale of SBC's interest in TeleWest. SBC recorded an after-tax gain of $111
associated with the combination.
During 1995, SBC purchased at auction PCS licenses in Los Angeles-San
Diego, California; San Francisco-Oakland-San Jose, California; Memphis,
Tennessee; Little Rock, Arkansas; and Tulsa, Oklahoma for approximately
$769. During 1996, SBC received several AT&T cellular networks in Arkansas
in exchange for SBC's PCS licenses in Memphis and Little Rock and other
consideration.
These acquisitions were primarily accounted for under the purchase method
of accounting. The purchase prices in excess of the underlying fair value
of identifiable net assets acquired are being amortized over periods not
to exceed 40 years. Results of operations of the properties acquired have
been included in the consolidated financial statements from their
respective dates of acquisition.
The above developments did not have a significant impact on consolidated
results of operations for 1997 or 1995, nor would they had they occurred
on January 1 of the respective periods.
Note 17. Additional Financial Information
-------------------------------------------------------------------------------
December 31,
----------------------
Balance Sheets 1997 1996
-------------------------------------------------------------------------------
Accounts payable and accrued liabilities
Accounts payable $ 2,848 $ 2,741
Accrued taxes 1,108 893
Advance billing and customer deposits 699 611
Compensated future absences 524 479
Accrued interest 306 279
Accrued payroll 315 194
Other 2,088 1,387
-------------------------------------------------------------------------------
Total $ 7,888 $ 6,584
===============================================================================
-------------------------------------------------------------------------------
Statements of Income 1997 1996 1995
-------------------------------------------------------------------------------
Interest expense incurred $ 1,067 $ 948 $ 1,000
Capitalized interest (120) (136) (43)
-------------------------------------------------------------------------------
Total interest expense $ 947 $ 812 $ 957
===============================================================================
Allowance for funds used during
construction - - $ 48
===============================================================================
-------------------------------------------------------------------------------
Statements of Cash Flows 1997 1996 1995
-------------------------------------------------------------------------------
Cash paid during the year for:
Interest $ 920 $ 799 $ 974
Income taxes $ 410 $ 1,283 $ 1,220
-------------------------------------------------------------------------------
No customer accounted for more than 10% of consolidated revenues in 1997,
1996 or 1995.
Several subsidiaries of SBC have negotiated contracts with the
Communications Workers of America (CWA). Approximately 67% of SBC's
employees are represented by the CWA. Contracts covering an estimated
77,000 employees between the CWA and several SBC subsidiaries end in 1998.
New contracts are scheduled to be negotiated in 1998.
Note 18. Quarterly Financial Information (Unaudited)
--------------------------------------------------------------------------------
Basic
Earnings Stock Price (3)
(Loss) per --------------------------
Calendar Total Operating Net Income Common
Quarter Operating Income (Loss) Share (3) High Low Close
Revenues(4) (Loss)
--------------------------------------------------------------------------------
1997
First (1)$ 5,973 $ 1,586 $ 857 $ 0.47 $ 29.125 $ 24.813 $ 26.250
Second (1) 5,921 (933) (787) (0.43) 30.938 24.625 30.938
Third (1) 6,329 1,472 816 0.45 31.125 26.781 30.719
Fourth (1) 6,633 1,045 588 0.32 38.063 30.000 36.625
------------------------------------------
Annual(1)$ 24,856 $ 3,170 $ 1,474 $ 0.81
================================================================================
1996
First (2)$ 5,564 $ 1,458 $ 888 $ 0.48 $ 30.125 $ 24.875 $ 26.313
Second 5,731 1,489 803 0.44 25.375 23.125 24.625
Third 5,948 1,532 867 0.47 25.500 23.000 24.063
Fourth 6,202 1,357 721 0.39 27.625 23.500 25.938
------------------------------------------
Annual(2)$ 23,445 $ 5,836 $ 3,279 $ 1.78
================================================================================
(1)Net income (loss) includes $90 first quarter pension settlement gain for
1996 retirements (see Note 12), $1.6 billion second quarter charges related
to post-merger initiatives (see Note 3), $43 and $360 of third and fourth
quarter merger integration costs and customer number portability expenses and
$33 fourth quarter gain on sale of SBC's interests in Bell Communications
Research, Inc.
(2)Net Income and Earnings per Common Share reflect a cumulative effect of
accounting change of $90 or $0.05 per share from change in accounting for
directory operations.
(3)Restated to reflect two-for-one stock split declared January 30, 1998. Stock
prices have not been adjusted to reflect the merger with PAC.
(4) Quarterly information has been restated to conform to the current
presentation of promotional discounts.
Report of Independent Auditors
The Board of Directors and Shareowners
SBC Communications Inc.
We have audited the accompanying consolidated balance sheets of SBC
Communications Inc. (the Company) as of December 31, 1997 and 1996, and the
related consolidated statements of income, shareowners' equity, and cash flows
for each of the three years in the period ended December 31, 1997. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits. We did not audit the 1996 and 1995
financial statements of Pacific Telesis Group, a wholly-owned subsidiary, which
statements reflect total assets constituting 42% of the Company's related 1996
consolidated financial statement total and which reflect total operating
revenues constituting approximately 41% and 42% of the Company's related
consolidated financial statement totals for the years ended December 31, 1996
and 1995, respectively. Those statements were audited by other auditors whose
report, which has been furnished to us, included an explanatory paragraph that
describes the change in its method of recognizing directory publishing revenues
and related expenses, and the discontinuance of Statement of Financial
Accounting Standards No. 71, "Accounting for the Effects of Certain Types of
Regulation." Our opinion, insofar as it relates to the 1996 and 1995 data
included for Pacific Telesis Group, is based solely on the report of the other
auditors.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the 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 and the report of other auditors provide a reasonable
basis for our opinion.
In our opinion, based on our audits and, for 1996 and 1995, the report of other
auditors, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of SBC
Communications Inc. at December 31, 1997 and 1996, and the consolidated results
of its operations and its cash flows for each of the three years in the period
ended December 31, 1997, in conformity with generally accepted accounting
principles.
As discussed in Note 1 to the consolidated financial statements, Pacific Bell, a
subsidiary of Pacific Telesis Group, changed its method of recognizing directory
publishing revenues and related expenses effective January 1, 1996. As discussed
in Note 2 to the consolidated financial statements, SBC Communications Inc.
discontinued its application of Statement of Financial Accounting Standards No.
71, "Accounting for the Effects of Certain Types of Regulation" in 1995.
ERNST & YOUNG LLP
San Antonio, Texas
February 20, 1998
Report of Management
The consolidated financial statements have been prepared in conformity with
generally accepted accounting principles. The integrity and objectivity of the
data in these financial statements, including estimates and judgments relating
to matters not concluded by year end, are the responsibility of management, as
is all other information included in the Annual Report, unless otherwise
indicated.
The financial statements of SBC Communications Inc. (SBC) have been audited by
Ernst & Young LLP, independent auditors. Management has made available to Ernst
& Young LLP all of SBC's financial records and related data, as well as the
minutes of shareowners' and directors' meetings. Furthermore, management
believes that all representations made to Ernst & Young LLP during its audit
were valid and appropriate.
Management has established and maintains a system of internal accounting
controls 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 concept of reasonable assurance recognizes that the costs of an internal
accounting controls system should not exceed, in management's judgment, the
benefits to be derived.
Management also seeks to ensure the objectivity and integrity of its financial
data by the careful selection of its managers, by organizational arrangements
that provide an appropriate division of responsibility and by communication
programs aimed at ensuring that its policies, standards and managerial
authorities are understood throughout the organization. Management continually
monitors the system of internal accounting controls for compliance. SBC
maintains an internal auditing program that independently assesses the
effectiveness of the internal accounting controls and recommends improvements
thereto.
The Audit Committee of the Board of Directors, which consists of eight directors
who are not employees, meets periodically with management, the internal auditors
and the independent auditors to review the manner in which they are performing
their responsibilities and to discuss auditing, internal accounting controls and
financial reporting matters. Both the internal auditors and the independent
auditors periodically meet alone with the Audit Committee and have access to the
Audit Committee at any time.
/s/ Edward E. Whitacre Jr.
Edward E. Whitacre Jr.
Chairman of the Board and
Chief Executive Officer
/s/ Donald E. Kiernan
Donald E. Kiernan
Senior Vice President, Treasurer
and Chief Financial Officer
Stock Trading Information
Trading: SBC is listed on the New York, Chicago and Pacific stock exchanges and
The Swiss Exchange. SBC is traded on the London Stock Exchange through the SEAQ
International Markets facility.
Ticker symbol (NYSE): SBC
Newspaper stock listing: SBC or SBC Comm
APPENDIX
All page numbers referenced in this Exhibit and the Form 10-K relate to the
printed Annual Report. The order of the sections is as they appear in the
printed Annual Report. The colored graphs and related footnotes that appear in
the printed document are approximately 1-1/4 inches by 2-1/4 inches. The Stock
Data section appears on the back cover.
The section titled "Management's Discussion and Analysis of Financial Condition
and Results of Operations" appears on pages 19-30. The text of this section
appears in two columns.
A stacked bar graph titled "Income From Continuing Operations Before
Extraordinary Loss and Accounting Changes (dollars in billions)" appears in the
right column towards the bottom of page 19. The graph shows Income From
Continuing Operations Before Extraordinary Loss and Accounting Changes for the
past five years. The graph also shows special charges for 1993 and 1997 above
Income From Continuing Operations Before Extraordinary Loss and Accounting
Changes. The actual figures for both items are listed on the graph. Listed below
are the plot points, with the first column representing Income From Continuing
Operations Before Extraordinary Loss and Accounting Changes and the second
column representing Special Charges:
1993 1.6 .9
1994 2.8
1995 3.0
1996 3.2
1997 1.5 1.9
The following footnote appears at the side of the graph: Results for 1997 and
1993 were affected by special charges.
A stacked bar graph titled "Distribution of Revenues (dollars in billions)"
appears in the left column on page 20 and below the section titled "Local
Service". The graph shows various categories of revenue distribution for the
past five years. The actual figures are listed on the graph. Listed below are
the plot points by category:
Local Network Directory
Year Total service access Long-distance advertising Other
---- ----- ------- ------ ------------- ----------- -----
1993 20.1 8.7 5.0 3.0 1.9 1.5
1994 21.0 9.2 5.2 2.9 2.0 1.7
1995 21.7 10.3 5.5 2.1 2.0 1.8
1996 23.4 11.4 5.8 2.2 2.0 2.3
1997 24.9 12.6 5.8 2.1 2.1 3.0
The following footnote appears at the side of the graph: Operating revenue
growth has been driven by local service growth.
In the section titled "Operating Environment and Trends of the Business", a
stacked bar graph titled "Access Lines " appears in the right column on page 23
above the subsection titled "State Regulation". The graph shows access lines in
total and by state for the past five years. Total access line figures are listed
on the graph. Listed below are the plot points:
----------------------------------------------------------------------------
Year Total Arkansas California Kansas Missouri Nevada Oklahoma Texas
----------------------------------------------------------------------------
----------------------------------------------------------------------------
1993 28.2 .8 14.8 1.1 2.2 .3 1.4 7.6
----------------------------------------------------------------------------
----------------------------------------------------------------------------
1994 29.1 .8 15.3 1.2 2.2 .3 1.4 7.9
----------------------------------------------------------------------------
----------------------------------------------------------------------------
1995 30.3 .9 15.8 1.2 2.3 .3 1.5 8.3
----------------------------------------------------------------------------
----------------------------------------------------------------------------
1996 31.8 .9 16.6 1.3 2.4 .3 1.5 8.8
----------------------------------------------------------------------------
----------------------------------------------------------------------------
1997 33.4 .9 17.4 1.3 2.5 .3 1.7 9.3
----------------------------------------------------------------------------
The following footnote appears at the side of the graph: Access lines in
California and Texas account for 80% of total access lines.
A stacked bar graph titled "Local Service (dollars in billions)" appears in the
left column at the top of page 26. The graph shows landline and wireless local
service revenues for the past five years. The actual figures are listed on the
graph. Listed below are the plot points:
-------------------------------------------------
Year Total Landline Wireless
-------------------------------------------------
-------------------------------------------------
1993 8.7 7.4 1.3
-------------------------------------------------
-------------------------------------------------
1994 9.2 7.5 1.7
-------------------------------------------------
-------------------------------------------------
1995 10.3 8.1 2.2
-------------------------------------------------
-------------------------------------------------
1996 11.4 8.8 2.6
-------------------------------------------------
-------------------------------------------------
1997 12.6 9.6 3.0
-------------------------------------------------
The following footnote appears at the side of the graph: Wireless local service
revenues have more than doubled in the last four years.
A bar graph titled "Wireless Penetration (network-based non-PCS)" appears in the
left column on page 27 above the subsection titled "Wireless Local Service". The
graph shows the percentage of Wireless Penetration for network-based non-PCS
services for the past five years. Actual figures are listed on the graph. Listed
below are the plot points:
1993 5.7%
1994 7.4%
1995 9.0%
1996 10.8%
1997 12.2%
The following footnote appears at the side of the graph: SBC's wireless
penetration for its network-based non-PCS services is among the highest in the
industry.
A bar graph titled "Capital Expenditures (dollars in billions)" appears in the
left column on page 29 and below the section titled "Liquidity and Capital
Resources" and the subsection titled "Capital Expenditures and Other
Commitments". The graph shows Capital Expenditures for the past five years. The
actual figures are listed on the graph. Listed below are the plot points:
1993 4.0
1994 4.0
1995 4.3
1996 5.5
1997 5.8
The following footnote appears at the side of the graph: Continued growth and
the build-out of PCS networks led to increases in capital expenditures.
A bar graph titled "Dividends (whole dollars adjusted for stock split)" appears
in the left column at the top of page 30 above the subsection titled "Cash,
Lines of Credit and Cash Flows". The graph shows dividends for the past 5 years.
The actual figures are listed on the graph. Listed below are the plot points:
1993 0.755
1994 0.790
1995 0.825
1996 0.860
1997 0.895
The following footnote appears at the side of the graph: SBC has increased its
dividend every year since divestiture.