AT&T Inc. is a North American telecommunications company. In addition to telephone, data and video telecommunications, AT&T also provides mobile communications and internet services for companies, private customers and government organizations. AT&T has long had a monopoly in the United States and Canada.
United StatesSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549
For the quarterly period ended September 30, 2002
or
For the transition period from toCommission File Number 1-8610
Incorporated under the laws of the State of DelawareI.R.S. Employer Identification Number 43-1301883175 E. Houston, San Antonio, Texas 78205Telephone Number: (210) 821-4105
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No
At September 30, 2002, 3,320,203,438 common shares were outstanding.
See Notes to Consolidated Financial Statements.
SBC COMMUNICATIONS INC.SEPTEMBER 30, 2002
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)Dollars in millions except per share amounts
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
2. DISPOSITIONS
3.COMPREHENSIVE INCOME
4. EARNINGS PER SHARE
5. SEGMENT INFORMATION
Segment results, including a reconciliation to SBC consolidated results, for the three and nine months ended September 30, 2002 and 2001 are as follows:
6. SUBSIDIARY FINANCIAL INFORMATION
7. RELATED PARTY TRANSACTIONS
8. PENSION AND POSTRETIREMENT BENEFITS
9. SPECTRASITE AGREEMENT
Item 2. Management's Discussion and Analysis of Financial Condition and Results of OperationsDollars in Millions except per share amounts
RESULTS OF OPERATIONS
Throughout this document, SBC Communications Inc. is referred to as “we” or “SBC”. A reference to a “Note” in this section refers to the accompanying Notes to Consolidated Financial Statements.
Consolidated ResultsOur financial results in the third quarter and for the first nine months of 2002 and 2001 are summarized as follows:
Our reported operating revenues declined in the third quarter of 2002 primarily due to a significant increase in retail access lines lost to Unbundled Network Element-Platform (UNE-P) wholesale lines, the weak United States (U.S.) economy and increased competition including technology substitution. These items also contributed to the decline in operating income. UNE-P requires us to sell our lines and the end-to-end services provided over those lines to competitors at below cost while still absorbing the costs of deploying, provisioning, maintaining and repairing those lines. See our Competitive and Regulatory Environment section for further discussion of UNE-P. Reported revenues also fell due to a net change in the timing of directory publications from the third quarter to the fourth quarter of 2002.
Our reported operating expenses decreased in the third quarter due to the decline in our wireline work force (down over 15,000 employees from the third quarter of 2001), a lower volume of equipment sales and the effects of adopting FAS 142. As noted below, these decreases were mostly offset by a decline in our combined net pension and postretirement benefit, the provision of enhanced pension benefits, expenses from work force-reductions recorded in 2002 and by pension settlement gains recorded in 2001. Under generally accepted accounting principles in the U.S. (GAAP), if lump sum benefit payments made to employees upon termination or retirement exceed required thresholds we recognize a portion of previously unrecognized pension gains or losses. In past years, we had an unrecognized net gain, primarily because our actual investment returns exceeded our expected investment returns. During 2001, we made lump sum benefit payments in excess of the required thresholds under GAAP, resulting in the recognition of net gains, referred to as “pension settlement gains”. Due to U.S. securities market conditions, our plans experienced investment losses during 2001 and the first nine months of 2002 resulting in a decline in pension assets.
Reported operating expenses include our combined net pension and postretirement benefit, which decreased approximately $95 in the third quarter and $286 for the first nine months of 2002, primarily due to a decreased asset base of our employee pension and postretirement benefit plans from lower investment returns the past two years, and previous recognition of pension settlement gains reducing the amount of unrealized gains recognized in the current year. Increased medical and prescription drug claim costs and the reduction in the discount rate used for determining our pension and postretirement projected benefit obligations also contributed to the decrease in combined net benefit. See Note 8.
Reported operating expenses also include expenses for enhanced pension benefits of approximately $71 in the third quarter and $322 for the first nine months of 2002 in connection with an enhanced retirement program offered to certain nonmanagement employees. We also recognized pension settlement gains of approximately $35 and $180 in the third quarter and for the first nine months of 2002 and $173 and $1,227 in the third quarter and for the first nine months of 2001. Settlement gains for 2001 were primarily related to a voluntary enhanced pension and retirement program implemented in October 2000. We anticipate that additional lump sum pension payments will be made in the fourth quarter of 2002 and in early 2003 in connection with our planned work force reductions. These payments may result in the recognition of settlement losses or small settlement gains in the fourth quarter of 2002 and in settlement losses in 2003, depending primarily on the number of terminated employees who receive lump sum pension payments and, for 2003, on the market performance of pension fund assets in 2002.
As a result of the decrease in our combined net pension and postretirement benefit, we have taken steps to implement additional cost controls. To reduce the increased medical costs mentioned above, we have implemented cost-saving design changes in our management medical and dental plans including increased participant contributions for medical and dental coverage and increased prescription drug co-payments effective beginning in January 2003. We expect additional cost savings from these design changes in future years.
However, the other factors mentioned above depend largely on trends in the U.S. securities market and the general U.S. economy. Our ability to improve the performance of those factors is limited. In particular, the continued weakness in the securities market and U.S. economy are likely to result in investment losses and a decline in plan assets, which under GAAP we will recognize over the several years. Additionally, these weaknesses may potentially cause us to lower our expected return on assets and discount rate assumptions at year-end. Also, rising medical and prescription drug costs, despite our cost-saving efforts discussed above, could potentially cause us to increase our assumed medical trend rate. As a result of these economic impacts, we expect a combined net pension and postretirement cost of between $1,000 and $2,000 ($0.20 to $0.40 per share) in 2003. Should the securities market continue to decline and medical and prescription drug costs continue to increase, we would expect increasing annual combined net pension and postretirement cost for the next several years.
Our actuarial estimates of pension and postretirement benefit expense are determined annually at year-end based on certain weighted-average assumptions, the most significant of which is the expected return on assets assumption, which reflects our view of long-term returns. Our expected return on assets, which has not yet been determined for 2003, was 9.5% for 2002 and 2001 and 8.5% for 2000. The increase from 8.5% in 2000 to 9.5% in 2001 reflected our actual long-term results exceeding previous assumptions; for each of the three years ended 2001, our actual 10-year return on investments exceeded 10%, including the effect of negative returns in 2001. For both 2002 and 2001, a 0.25% increase in the expected long-term rate of return would have caused an increase of approximately $90 in the annual net pension benefit and a decrease of approximately $18 in the annual postretirement benefit cost (analogous changes would result from a 0.25% decrease.)
The third quarter and first nine months of 2001 include amortization expense related to goodwill and Federal Communications Commission (FCC) wireless licenses, which are no longer amortized under FAS 142. If applied retroactively, this accounting change would have decreased the third quarter and first nine months of 2001 operating expenses by approximately $53 and $163, increased equity in net income of affiliates by approximately $91 and $265, and increased income before extraordinary item and cumulative effect of accounting change by approximately $117 and $349, or $0.04 and $0.10 per share.
Interest expensedecreased $21, or 5.6%, in the third quarter and $215, or 17.0%, for the first nine months of 2002. The third quarter decrease was primarily due to lower composite rates on commercial paper. Approximately one-half of the decrease for the first nine months was due to interest accrued in 2001 on payables of approximately $2,500 to Cingular Wireless (Cingular). By agreement, these payables were netted with our notes receivable from Cingular late in the second quarter of 2001. The remaining decrease for the first nine months was primarily related to lower composite rates on commercial paper.
Interest incomedecreased $7, or 4.9%, in the third quarter and $88, or 17.1%, for the first nine months of 2002. The decrease was primarily related to lower income accrued on notes receivable from Cingular that were netted with notes payable to Cingular, as discussed in Interest expense. The income accrued from Cingular does not have a material impact on our net income because the interest income is mostly offset when we record our share of equity income in Cingular.
Equity in net income of affiliates increased $220, or 43.2%, in the third quarter and $165, or 11.4%, for the first nine months of 2002. This increase was partially due to an increase in segment income from our international segment of approximately $37 in the third quarter and $156 for the first nine months and is discussed in detail in the Segments Results section. Additionally, income increased approximately $371 in the third quarter and for the first nine months was from our proportionate share of the gains that TDC A/S (TDC) and Belgacom S.A. (Belgacom) recognized on the disposition of their interest in a Netherlands wireless operation. This increase was partially offset by a charge of approximately $58 in the third quarter and for the first nine months related to impairments on TDC’s investments in Poland, Norway and the Czech Republic and a charge of approximately $101 for the first nine months representing our proportionate share of restructuring costs at Belgacom.
Our wireless results, which are discussed in detail in the Segment Results section, partially offset the increased equity in net income of affiliates that were realized in our international segment. We account for our 60% economic interest in Cingular under the equity method of accounting and therefore include Cingular’s results in our equity in net income of affiliates line item, on a reported basis. Cingular’s results decreased our equity in net income in affiliates $140 in the third quarter and $191 for the first nine months.
Other income (expense) - net decreased $98 in the third quarter and increased $185 for the first nine months of 2002. Results in the third quarter and the first nine months of 2002 include gains on the sale of investments of approximately $19 and $168 respectively, consisting of the sale of shares of Teléfonos de Mexico, S.A. de C.V. (Telmex), América Móvil S.A. de C.V. (América Móvil) and Amdocs Limited (Amdocs). We also recorded income of approximately $28 in the third quarter and for the first nine months related to market adjustments on Canadian dollar foreign-currency contracts. An additional increase for the first nine months was due to a gain of $148 on the redemption of a portion of our interest in Bell Canada Holdings Inc. (Bell Canada). These increases were partially offset by a charge of approximately $32 in the third quarter and for the first nine months for the reduction in the value of wireless properties that may be received as a settlement of a receivable. Decreases for the first nine months also included approximately $12 related to the permanent declines in the value of cost investments and $75 related to the decrease in value of our investment in Williams Communication Group Inc. (Williams) combined with a loss on the sale of our webhosting operations.
The third quarter and first nine months of 2001 included gains on the sale of investments of approximately $78 and $301, consisting of the sale of Amdocs shares, our investment in Transasia Telecommunications and other investments. Increases in the first nine months included a reduction of a valuation allowance of $120 on a note receivable related to the sale of SBC Ameritech’s SecurityLink business, as well as gains of approximately $46 recognized for market adjustments on shares of Amdocs, which were used for deferred compensation. An offsetting deferred compensation expense was recorded in operations and support expense. These gains were partially offset by dividends paid on preferred securities issued by Ameritech subsidiaries of approximately $7 in the third quarter and $29 for the first nine months of 2001, as well as minority interest of $16 for the first nine months of 2001. The amount of our minority interest expense during 2001 was significantly lower than 2000 due to the contribution of our wireless properties to Cingular in the fourth quarter of 2000. Additionally, in the first nine months of 2001, we recognized combined expenses of approximately $401 related to valuation adjustments of Williams and certain other cost investments accounted for under Financial Accounting Standards Board Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (FAS 115). These valuation adjustments resulted from an evaluation that the decline was other than temporary. Also, in the first nine months, we recognized an expense of approximately $581 related to an endowment of Amdocs shares to the SBC Foundation and income of approximately $575 from the related mark to market adjustment on the Amdocs shares, for a net expense of $6.
Income taxesdecreased $263, or 23.4%, in the third quarter and $707, or 21.5%, for the first nine months of 2002 and include the tax effect of normalizing items described in the Segment Results section. Income taxes were lower due primarily to lower income and a decrease in our effective tax rate. Our effective tax rate was 32.8% in the third quarter and 32.7% for the first nine months in 2002, as compared to 35.2% in the third quarter and 35.4% for the first nine months of 2001. This lower effective tax rate is primarily related to lower state taxes, including changes in the legal forms of various entities, increased realization of foreign tax credits and adoption of FAS 142, which eliminates the amortization of goodwill.
Extraordinary ItemThe first nine months of 2001 includes an extraordinary loss of $18, ($28 pre-tax, with taxes of $10) related to the early redemption of approximately $1,000 of our TOPrS.
Cumulative Effect of Accounting Change On January 1, 2002, we adopted FAS 142. Adoption of FAS 142 means that we stop amortizing goodwill and at least annually, we must test the remaining book value of goodwill for impairment. Any future impairments will be recorded in operating expenses. During the first quarter of 2002 we performed the initial impairment test of goodwill under FAS 142 and determined that goodwill related to our investment in Sterling Commerce Inc. was impaired by $1,791. During the second quarter of 2002, Cingular completed their analyses of their goodwill and other unamortizable intangibles under FAS 142. They determined that an impairment existed. Our portion of the impairment was $19. As a result, our first-quarter 2002 net loss was changed from a net loss of $81, or $0.02 per share, to a net loss of $100, or $0.03 per share. We expect that our international holdings will complete their analysis by the end of the year. Any FAS 142 impairment resulting from that analyses will be reflected as a cumulative effect of accounting change at January 1, 2002 and will require us to change the first quarter of 2002 results. See Note 1.
Selected Financial And Operating Data
*Amounts represent 100% of the customers of Cingular. The 2001 amount also includes the customers of Cellular Communications of Puerto Rico (CCPR), which was contributed by us to Cingular in September 2001.#The 2001 employee count includes approximately 16,000 employees that became Cingular employees on or before December 31, 2001.
Segment Results
For internal management reporting purposes, we exclude (i.e., normalize) special items from our results and analyze them separately. The net effect of excluding the normalizing items was to decrease net income by $87 in the third quarter but increase net income by $99 for the first nine months of 2002, and to decrease net income by $73 in the third quarter and $204 for the first nine months of 2001. In addition to the normalizing items, for internal management purposes, we include the 60% proportional consolidation of Cingular in our normalized results. The proportional consolidation of Cingular changes our normalized revenues, expenses, operating income and nonoperating items, but does not change our net income. The following table summarizes our normalized results for the third quarter and first nine months of 2002 and 2001.
Normalized results for 2002 excluded the following special items, with the affected segment(s) shown in brackets. Please see the Segment Normalization table following this discussion for the total effect of normalizing adjustment on each segment:
Normalized results for 2001 excluded the following special items, with the affected segment(s) shown in brackets:
The following table summarizes by segment the net increase (decrease) of the normalizing items on income before income taxes, extraordinary items and cumulative effect of accounting change in the third quarter and for the nine month period ended September 30, 2002 and 2001.
In addition, our normalized results in the third quarter and for the first nine months of 2001 include amortization expense related to goodwill and FCC licenses which are no longer amortized under FAS 142. If applied retroactively, this accounting change would have decreased the third quarter and first nine months of 2001 normalized operating expenses by approximately $89 and $267, increased equity in net income of affiliates by approximately $55 and $161, and increased income before extraordinary item and cumulative effect of accounting change by approximately $117 and $349, or $0.03 and $0.10 per share.
Normalized operating revenues decreased in the third quarter of 2002 due to the same factors that impacted reported operating revenues, partially offset by an increase in Cingular’s revenues. Normalized operating expenses decreased in the third quarter of 2002 primarily due to cost savings from work force reductions, lower equipment sales and the FAS 142 effect noted above, partially offset by increased employee benefit costs as discussed above.
Excluding the FAS 142 impact, our normalized diluted earnings per share, before extraordinary item and cumulative effect of accounting change in the third quarter and for the first nine months of 2002 would have declined 17.7% and 10.5%. A lower effective tax rate and a decline in our weighted average common shares outstanding favorably affected our normalized diluted earnings per share.
The following tables show components of normalized results of operations by segment. A discussion of significant segment results is also presented. Intercompany interest affects the segment results of operations but is not discussed as it is eliminated in consolidation. The consolidated results section discusses interest expense, interest income, equity in net income of affiliates, other income (expense) – net, income taxes, extraordinary item and cumulative effect of accounting change. Capital expenditures for each segment are discussed in Liquidity and Capital Resources.
In the second quarter of 2002, we began reporting product-based revenue categories for this segment. The new categories, voice, data and long-distance voice, provide a presentation of our revenues that is more closely aligned with how we currently manage the business. Our wireline segment operating income margin was 18.3% in the third quarter of 2002, compared to 21.1% in the third quarter of 2001, and 19.6% for the first nine months of 2002, compared to 21.2% for the first nine months of 2001. The decline in our wireline segment operating income margins was due primarily to the loss of revenues from retail access lines caused by below-cost UNE-P, which was greater than the expense reductions in response to UNE-P, the weak U.S. economy, and increased competition, including technology substitution. See further discussion of the details of our wireline segment revenue and expense fluctuations below.
We account for our 60% economic interest in Cingular under the equity method of accounting in our Consolidated Financial Statements since we share control equally (i.e., 50/50) with our 40% economic partner in the joint venture. We have equal voting rights and representation on the board of directors that controls Cingular. However, in the table above we use proportional consolidation in order to evaluate the results of Cingular for internal management purposes. This means that we include 60% of the Cingular revenues and expenses in our wireless segment results. The proportional consolidation of Cingular changes our normalized revenues, expenses, segment operating income and nonoperating items, but does not change our net income. We also include our proportionate share of depreciation and amortization expense from the Cingular-T-Mobile USA, Inc. (formerly known as VoiceStream Wireless Corporation) network sharing agreement, which Cingular accounts for on the equity method of accounting. The results in the table above also include our residual wireless properties that we hold which have not been contributed to Cingular. In the third quarter of 2002, we excluded $19 in one-time expenses from operations and support expenses for our proportionate share of severance and restructuring costs at Cingular.
Our wireless segment operating income margin was 15.6% in the third quarter of 2002, compared to 18.9% in the third quarter of 2001, and 17.0% for the first nine months of 2002, compared to 17.8% for the first nine months of 2001. The decline in our wireless segment operating income margins was due primarily to increased system costs from increased minutes of use, which was greater than the increased subscriber revenue. See further discussion of the details of our wireless segment revenue and expense fluctuations below.
Our equity in net income of affiliates by major investment is listed below:
Our other segment results in the third quarter and for the first nine months of 2002 primarily consist of corporate and other operations. The third quarter and the first nine months of 2001 primarily include the results of our Ameritech cable television operations prior to its November 2001 sale.
COMPETITIVE AND REGULATORY ENVIRONMENT
Overview Passage of the Telecommunications Act of 1996 was intended to deregulate U.S. telecommunications markets. Despite passage of this Act, the telecommunications industry, particularly incumbent local exchange carriers such as our wireline subsidiaries, and advanced services including DSL, continue to be subject to significant regulation. The expected transition from an industry extensively regulated by multiple regulatory bodies to a market-driven industry monitored by state and federal agencies has not occurred as anticipated. Our wireline subsidiaries remain subject to extensive regulation by state regulatory commissions for intrastate services and by the FCC for interstate services. For example, certain state commissions, including those in California, Illinois, Michigan, Ohio and Indiana, have significantly lowered the wholesale rates we are allowed to charge competitors, including AT&T and WorldCom for leasing parts of our network (unbundled network elements, or UNEs). When UNEs are combined by incumbent local exchange carriers into a complete set capable of providing total local service to a customer, then they are referred to as UNE-P. These mandated rates, which are below our cost, are resulting in increased competition in some states and significantly contributing to continuing declines in our access-line revenues and profitability. In the third quarter and first nine months of 2002, we lost approximately 751,000 and 1.8 million customer lines, respectively, to competitors who obtained UNE-P lines from us. These UNE-P regulations are also causing, in part, decreases in our switched access revenue and universal service and other fees designed to support operation of the network for all customers. During September 2002, in response to the sluggish economy, increased competition, substitution and the impact of UNE-P, we announced plans to cut approximately 9,000 jobs by the end of 2002 and 2000 additional jobs in early 2003 and we expect to reduce our 2003 capital expenditure budget to approximately $5,000, from less than $8,000 expected for 2002 (a reduction from the original 2002 budget of between $9,200 and $9,700). If current UNE-P regulations remain in place, we could experience additional and more significant declines in access-line revenues, which, in turn, could reduce returns on our invested capital and compel us to continue to further reduce capital expenditures and employee levels.
This continuing adverse and uncertain regulatory environment combined with the continued weakness in the U.S. economy and increasing local competition from multiple wireline and wireless providers in various markets presents significant challenges for our business. A summary of significant third quarter 2002 regulatory developments follows.
Unbundled Network Elements/Line Sharing In May 2002, the United States Court of Appeals for the District of Columbia (Court of Appeals) granted petitions filed by several incumbents, including our wireline subsidiaries, and the United States Telecom Association to remand and vacate the FCC’s UNE Remand and Line Sharing Orders. The UNE Remand Order expanded the definition of UNEs and required incumbents, such as our wireline subsidiaries, to lease a variety of UNEs to competitors. The Line Sharing Order required incumbents to share the high frequency portion of local telephone lines with competitors so that competitors could offer DSL services on a national basis. The Court of Appeals overturned the FCC’s unbundling and line sharing rules. Specifically, the Court found that the FCC failed to properly apply the statutory “necessary and impair” requirement in deciding which UNEs needed to be unbundled and did not consider the costs of overly expansive unbundling requirements and the relevance of competition for broadband services from cable and, to a lesser extent, satellite offerings. The FCC and other parties petitioned the Court of Appeals for rehearing and a stay request. In September 2002, the Court of Appeals denied petitions for rehearing, but delayed the effectiveness of its decision until January 3, 2003. The ruling stated that the Court of Appeals anticipates the FCC will complete its triennial review of incumbent unbundling and line sharing obligations by year-end 2002.
We have voluntarily committed to maintain our affected line sharing offerings at least until February 15, 2003. During this period, we have indicated a willingness to work with our wholesale customers to develop mutually acceptable market-based offerings and prices related to line sharing. These actions are intended to provide certainty to our wholesale line sharing customers while preserving our rights. Our long-term success requires a balanced regulatory environment that encourages investment and results in sustainable, facilities-based competition, including the elimination of rules that require us to sell our lines and related services to competitors below our cost.
California Long Distance On September 20, 2002, we filed an application with the FCC to provide interstate and interexchange long-distance service in California and the FCC has 90 days from the filing date, or until December 19, 2002, to rule on the application. At least until we receive long-distance relief, we expect our competitive local service losses will continue at an increasing rate because of the very low UNE-P rates in California. We continue to seek interstate and interexchange long-distance approval in our other in-region states that do not have such authority and have filed applications with state commissions in Nevada, Illinois, Ohio, Michigan, Indiana and Wisconsin.
In conjunction with its September 2002 order that approved sending our long-distance application to the FCC, the CPUC did not decide whether state law intrastate long-distance requirements were satisfied. The CPUC recently issued a ruling calling for the parties to address the state law issues further in order to conclude its review. The CPUC is expected to issue a decision prior to the end of 2002.
California Marketing Ruling In August 2002, we paid approximately $15 from operating funds to the CPUC associated with its September 2001 marketing practices ruling.
Texas Rate Reclassification In October 2002, the Texas Public Utility Commission (TPUC) approved our Texas wireline subsidiary’s tariffs reclassifying 32 telephone exchanges (including Dallas, Fort Worth and Austin) to a higher rate group effective November 15, 2002. The higher tariffs are expected to increase annual revenues approximately $20. We also are entitled to recover the fees retroactively from the date of the TPUC’s original 1999 order allowing us to reclassify these exchanges (estimated at a minimum of $125, including interest, at September 30, 2002). Based on the present value of this gross amount, discounted for collectibility, we recorded revenue of $47 in the second quarter of 2002. Our method of recovery is subject to approval by the TPUC.
Michigan LegislationIn July 2000, the Michigan legislature eliminated the monthly intrastate end-user common line (EUCL) charge and implemented price caps for certain telecommunications services. In July 2001, the United States Court of Appeals for the 6th Circuit (6th Circuit) ruled that we had demonstrated a substantial likelihood of ultimately showing that the price cap and the EUCL charge elimination were unconstitutional and stayed both provisions pending completion of the litigation. In September 2002, our Michigan wireline subsidiary and the State of Michigan tentatively settled this case by agreeing to reduce the intrastate EUCL charge. The settlement is subject to approval by the 6th Circuit, which has not issued a timeframe for resolution. If approved, the settlement is expected to result in an annual revenue decrease of approximately $29.
Out-of-Region Competition In conjunction with the FCC’s approval of our acquisition of Ameritech Corporation, the FCC required us to satisfy four performance conditions and imposed payments for failing to meet two conditions, namely, “Out-of-Region Competition” and “Opening Local Markets to Competition”. As of December 31, 2001, $1,900 in remaining potential payments through June 2004 could have been triggered if these two conditions were not met. The “Out-of-Region Competition” condition required us to complete initial entry requirements in 30 new markets across the country as a provider of local services and established penalties of up to $40 per market for failure to meet this condition. In August 2002, we notified the FCC that we have timely fulfilled all the requirements of this merger condition. As a result, at September 30, 2002 we could be subject to approximately $415 in remaining potential payments for the “Opening Local Markets to Competition” condition. We do not expect to make any material payments for failure to satisfy this condition.
Wireless Auction In October 2002, the United States Supreme Court (Supreme Court) heard oral arguments on the validity of the FCC’s spectrum auction process in which wireless licenses of bankrupt carriers were reclaimed by the FCC and reauctioned. Thirty of these licenses were won at auction by Salmon PCS (Salmon), a company Cingular has invested in, and have not been issued pending completion of the Supreme Court proceedings. If the Supreme Court rules in favor of the FCC, Cingular could be required to provide approximately $2,000 in debt or equity capital to Salmon to pay for the licenses upon conclusion of further proceedings. A Supreme Court decision is expected during 2003. Additionally, the FCC has requested comment on a proposal to release the winning bidders from their bids and payment obligations. Cingular has filed comments supporting this initiative. The FCC is expected to issue a decision during the fourth quarter of 2002.
OTHER BUSINESS MATTERS
Pension and Postretirement Benefits Substantially all of our employees are covered by one of various noncontributory pension and death benefit plans. Our objective in funding these plans, in combination with the standards of the Employee Retirement Income Security Act of 1974, as amended (ERISA), is to accumulate funds sufficient to meet the plans’ benefit obligations to employees upon their retirement. Any plan contributions, as determined by ERISA regulations, are made to a pension trust for the benefit of plan participants. Trust assets consist primarily of private and public equity, government and corporate bonds, index funds and real estate. We do not anticipate any cash contributions to the trust will be required under ERISA regulations during 2002 or 2003. At December 31, 2001, pension plan assets exceeded our projected benefit obligation (PBO) by approximately $7,700 (funded status). Due to U.S. securities market conditions, our plans experienced investment losses during the first nine months of 2002 and a decline in pension assets; therefore, we expect the funded status at December 31, 2002 to be significantly lower than the prior year. Depending on final asset returns for 2002 and the discount rate used in valuing the liability, certain plans could have a PBO in excess of plan assets at December 31, 2002.
The PBO discussed above represents the actuarial present value of all benefits attributed by the pension benefit formula to previously rendered employee service. It is measured based on certain assumptions, including discount rates, expected return on plan assets and expected future employee compensation levels. GAAP also require a comparison of plan assets to the accumulated benefit obligation (ABO). In contrast to the PBO, the ABO represents the actuarial present value of benefits based on employee service and compensation as of a certain date and does not include an assumption about future compensation levels. Under GAAP, on a plan-by-plan basis, if the ABO exceeds plan assets and at least this amount has not been accrued, an additional minimum liability must be recognized, partially offset by an intangible asset for unrecognized prior service cost, with the remainder a direct charge to equity net of deferred tax benefits. Absent a significant appreciation in the value of pension assets, we expect, for certain plans, that the ABO will exceed plan assets at December 31, 2002. If this is the case, we will be required to record a direct charge to equity during the fourth quarter of 2002. The amount of the charge is dependent on economic factors, including asset returns for the remainder of 2002, and therefore cannot be estimated with any certainty at this time; however, we expect it will be substantial. This potential charge, while reducing equity and comprehensive income, will not affect our results of operations or cash flows.
We also provide certain medical, dental and life insurance benefits to substantially all retired employees under various plans and accrue costs for active employees as they earn these benefits in accordance with GAAP. While many companies do not, we maintain Voluntary Employee Beneficiary Association trusts (totaling approximately $6,300 at December 31, 2001) to partially fund these postretirement benefits; however, there are no ERISA or other regulations requiring these postretirement benefit plans to be funded annually. Trust assets consist principally of stocks, U.S. government and corporate bonds, and index funds. At December 31, 2001, our accumulated postretirement benefit obligation exceeded plan assets by approximately $13,900. Based on the market conditions noted above, we expect this amount to be higher at December 31, 2002.
In Note 8 and in the Consolidated Results section, we also discuss the effect that several factors, including the decline in the securities markets and adverse medical trends, have had on results of operations this year and are expected to have next year. As more fully discussed in those two places, in 2003 we expect combined net pension and postretirement cost of between $1,000 and $2,000.
New Accounting StandardStatement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations”, is effective January 1, 2003. The standard requires companies with legal obligations associated with the retirement of long-lived assets to recognize the fair value of the liability for these asset retirement obligations in the period in which the obligations are incurred and capitalize that amount as a part of the book value of the long-lived asset. We are currently evaluating the standard but do not expect it to have a material effect on our results of operations or financial position.
Pending TransactionIn October 2002, we entered into an agreement to sell our 15% interest in Cegetel to Vodafone Group PLC (Vodafone) for approximately $2,270. For additional details see Note 2.
Disposition SeeNote 2 for a discussion of our disposition transactions related to Bell Canada.
Executive Appointment In November 2002, we appointed an officer to assume the responsibilities of our chief operating officer, who was named president and chief executive officer of Cingular.
WorldCom BankruptcyOn July 21, 2002, WorldCom and more than 170 related entities, hereafter referred to as “WorldCom”, filed petitions for reorganization under Chapter 11 of the U.S. Bankruptcy Code. Our receivables from WorldCom as of the bankruptcy filing were approximately $325. At September 30, 2002, we had reserves of approximately $200 related to that filing. In addition to the reserves, we are withholding payments on amounts we owed WorldCom as of the filing date that equal or exceed the remaining $125. These withholdings relate primarily to amounts collected from WorldCom’s long-distance customers in our role as billing agent and other general payables. The bankruptcy court has recognized that some providers, including our subsidiaries, have certain rights to offset such pre-bankruptcy amounts they owe WorldCom against unpaid pre-bankruptcy charges WorldCom owes these providers. The court has also directed WorldCom to negotiate post-petition offset arrangements with these providers. We estimate our post-petition billing to WorldCom to be approximately $160 per month. To date, WorldCom has paid its post-petition obligations to us on a timely basis. WorldCom’s bankruptcy proceeding is still in its initial stages and the effect on our financial position or results of operations cannot be determined at this time
LIQUIDITY AND CAPITAL RESOURCES
We had $873 in cash and cash equivalents available at September 30, 2002. During the first nine months of 2002 and 2001 our primary source of funds continued to be cash provided by operating activities.
In October 2002, we entered into a 364-day credit agreement totaling $4,250 with a syndicate of banks replacing pre-existing credit agreements of approximately $3,700. Advances under this agreement may be used for general corporate purposes, including support of commercial paper borrowings and other short-term borrowings. Under the terms of the agreement, repayment of advances up to $1,000 may be extended two years from the termination date of the agreement. Repayment of advances up to $3,250 may be extended to one year from the termination date of the agreement. There is no material adverse change provision governing the drawdown of advances under this credit agreement. We had no borrowings outstanding under committed lines of credit as of September 30, 2002.
Our commercial paper borrowings decreased $3,206 during the first nine months of 2002, and at September 30, 2002, totaled $2,832, of which $2,451 had an original maturity of 90 days or less, and $381 had an original maturity of more than 90 but less than 365 days. In the first quarter of 2002 SBC International initiated a commercial paper borrowing program in order to simplify intercompany borrowing arrangements. Our total commercial paper borrowings include borrowings under this program of $2,283 at September 30, 2002.
Our investing activities during the first nine months of 2002 consisted of $4,998 in construction and capital expenditures, primarily in the wireline segment. Investing activities during the first nine months of 2002 also include proceeds of $116 relating to the sale of Amdocs shares, $197 related to the sale of Telmex and América Móvil L shares and $863 related to the second quarter 2002 sale of approximately 20% of our interest in Bell Canada. Cash paid for asset acquisitions in 2002 include approximately $300 for our first-quarter 2002 Yahoo! investment, $106 in payments to América Móvil for our purchase of a 50% non-controlling interest in CCPR and $164 cash paid for an investment in BCE, Inc. (BCE), an affiliate of Bell Canada.
Substantially all of our capital expenditures are made in the wireline segment. We expect to fund these expenditures using cash from operations, depending on interest rate levels and overall market conditions, and incremental borrowings. The wireless and international segments should be self-funding as they are predominantly equity investments and not direct Company operations. We expect to fund any directory segment capital expenditures using cash from operations.
We currently expect our capital spending for 2002 to be less than $8,000, excluding Cingular, reflecting previously announced reductions from the original 2002 capital expenditure budget of between $9,200 and $9,700. As discussed in our segment results section, we are reducing expenses in response to continued pressure from the U.S. economic and regulatory environments and our resulting lower revenue expectations. In line with these expectations, we target our capital spending for 2003 to be approximately $5,000, excluding Cingular, predominantly all of which we expect to relate to our wireline segment.
On November 11, 2002, BCE exercised its right to purchase our remaining 16% interest in Bell Canada at a price of 4,990 Canadian Dollars (CAD), to be paid by BCE with 250 CAD in BCE stock and the remainder in cash. See more detail in Note 2. The transaction is expected to close in the fourth quarter of 2002. We expect to use the proceeds from this transaction to pay down debt.
Upon the sale of our remaining interest in Bell Canada, BCE has the right to redeem notes held by us, at face value, for 314 CAD ($198 at September 30, 2002 exchange rates), plus accrued interest. Otherwise, the notes will mature on December 31, 2004. Our carrying value of the notes at September 30, 2002 was approximately $182.
As discussed in Other Business Matters, in October 2002, we agreed to sell our 15% interest in Cegetel to Vodafone for approximately $2,270 in cash, with a one-time pre-tax gain of approximately $1,500. We anticipate using the net proceeds from this transaction to pay down debt.
Short-term borrowings with original maturities of three months or less decreased $415 in the first nine months of 2002 as a result of our current focus on replacing short-term debt with long term debt. We also spent $1,398 in the first nine months of 2002 on the repurchase of shares of our common stock under the repurchase plans announced in January 2000 and in November 2001. As of September 30, 2002, we had repurchased a total of approximately 138 million shares of our common stock of the 200 million shares authorized to be repurchased. We do not expect to repurchase significant additional shares under these authorizations given our current intent to pay down our debt levels. Cash paid for dividends in the first nine months of 2002 was $2,660, or 2.7% higher than in the first nine months of 2001, due to an increase in dividends declared per share in 2002.
During the first quarter of 2002, we reclassified $1,000 of 20-year annual Puttable Reset Securities (PURS) from debt maturing within one year to long-term debt. The PURS, a registered trademark, contain a twenty-year series of simultaneous annual put and call options at par. These options are exercisable on June 2 of each year until June 2, 2021. At the time of issuance, we sold to an investment banker the twenty-year option to call the PURS on each annual reset date of June 2. If the call option is exercised, each PURS holder will be deemed to have sold its PURS to the investment banker. The investment banker will then have the right to remarket the PURS at a new interest rate for an additional 12-month period. The new annual interest rate will be determined according to a pre-set mechanism based on the then prevailing London Interbank Offer Rate (LIBOR). If the call option is not exercised on any given June 2, the put option will be deemed to have been exercised, resulting in the redemption of the PURS on that June 2. The proceeds of the PURS were used to retire short-term debt and for general corporate purposes. There are no special covenants or other provisions applicable to the global notes or the PURS. The company supports this long-term classification based on its intent and ability to refinance the PURS on a long-term basis.
In February 2002, we issued a $1,000 global bond. The bond pays interest semi-annually at a rate of 5.875%, beginning on August 1, 2002. The bond will mature on February 1, 2012. Proceeds from this debt issuance were used for general corporate purposes.
In March 2002, we issued two $500 one-year notes. The notes pay interest beginning on June 14, 2002, then quarterly on the 14th day of the month, thereafter. The interest rate is based on LIBOR, which is determined two London business days preceding the settlement date. Proceeds from this debt issuance were used to refinance debt.
In August 2002, we issued $1,000 global notes. The notes pay interest semi-annually at a rate of 5.875%, beginning on February 15, 2003. The notes will mature on August 15, 2012. Proceeds from this debt issuance were used primarily to repay a portion of our commercial paper borrowings and for general corporate purposes.
In October 2002, we called, prior to maturity, approximately $350 of multiple debt obligations that were originally scheduled to mature between October 2005 and April 2007. These notes carried interest rates ranging between 4.75% and 5.5%, with an average yield of 5.3%. We also redeemed, prior to maturity, approximately $55 of debt obligations during June 2002.
Funding for these capital expenditures will be provided by cash from operations or through incremental borrowings.
Item 3. Quantitative and Qualitative Disclosures About Market RiskDollars in Millions except per share amounts
In June 2002, we entered into an agreement to sell our 20% ownership interest in Bell Canada Holdings Inc. (Bell Canada) to BCE, Inc. (BCE), the 80% owner. We redeemed a portion of our interest in June 2002, with proceeds received in July 2002.
On November 11, 2002, BCE exercised its right to purchase our remaining 16% interest in Bell Canada at a price of 4,990 CAD, to be paid by BCE with 250 CAD in BCE stock and the remainder in cash. The transaction is expected to close in the fourth quarter of 2002. We expect to recognize a pre-tax gain of approximately $520. In anticipation of receipt of CAD, we have entered into a series of foreign currency exchange contracts to provide us with a fixed rate of conversion of these CAD proceeds into U.S. dollars.
In July 2002, we entered into a series of forward contracts to sell 1,500 CAD on January 3, 2003, at an average exchange rate of 1.53. There was no initial up-front cost to enter into these contracts. As the amount of the remaining proceeds that we would receive in CAD was uncertain, we entered into two put option contracts, which give us the right to sell up to 3,192 CAD on January 3, 2003, at an average exchange rate of 1.57. We paid fees of approximately $28 to enter into these contracts. At September 30, 2002, the fair value of these contracts discussed above increased by $28 to approximately $56. This increase of $28 was recorded in other income (expense) – net in the third quarter of 2002.
Item 4. Controls and Procedures
The company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed by the Company is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. The Chief Executive Officer and Chief Financial Officer have performed an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of November 7, 2002. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of November 7, 2002. There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls subsequent to November 7, 2002.
CAUTIONARY LANGUAGE CONCERNING FORWARD-LOOKING STATEMENTS
Information set forth in this report contains forward-looking statements that are subject to risks and uncertainties. We claim the protection of the safe harbor for forward-looking statements provided by the Private Securities Litigation Reform Act of 1995.
The following factors could cause our future results to differ materially from those expressed in the forward-looking statements:
Readers are cautioned that other factors discussed in this report, although not enumerated here, also could materially impact our future earnings.
PART II - OTHER INFORMATION
Item 2. Changes in Securities and Use of Proceeds
During the third quarter of 2002, non-employee directors acquired from the Company shares of common stock pursuant to the Company’s Non-Employee Director Stock and Deferral Plan. Under the plan, a director may make an annual election to receive all or part of his or her annual retainer or fees in the form of SBC shares or deferred stock units (DSUs) that are convertible into SBC shares. Each Director also receives an annual grant of DSUs. During this period, an aggregate of 8,462 SBC shares and DSUs were acquired by non-employee directors at prices ranging from $20.15 to $30.01, in each case the fair market value of the shares on the date of acquisition. The issuances of shares and DSUs were exempt from registration pursuant to Section 4(2) of the Securities Act.
Item 6. Exhibits
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
CERTIFICATIONS
I, Edward E. Whitacre Jr., certify that:
Date: November 13, 2002
/s/ Edward E. Whitacre Jr.
Edward E. Whitacre Jr.Chairman and Chief Executive Officer
I, Randall Stephenson, certify that:
/s/ Randall Stephenson
Randall StephensonSenior Executive Vice President and Chief Financial Officer