Verizon Communications Inc., or Verizon for short, is an American telecommunications company headquartered in New York City.
Verizon was founded on June 30, 2000 and is registered in Delaware, resulting from the merger of Bell Atlantic Corporation and GTE Corporation (formerly General Telephone & Electronics Corporation).
1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark one) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2001 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number 1-8606 VERIZON COMMUNICATIONS INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 23-2259884 (STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NO.) 1095 AVENUE OF THE AMERICAS 10036 NEW YORK, NEW YORK (ZIP CODE) (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) REGISTRANT'S TELEPHONE NUMBER (212) 395-2121 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 March 31, 2001, 2,704,675,542 shares of the registrant's Common Stock were outstanding, after deducting 46,974,942 shares held in treasury. ================================================================================
2 TABLE OF CONTENTS ITEM NO. <TABLE> <CAPTION> PART I. FINANCIAL INFORMATION PAGE - ----------------------------- ---- <S> <C> 1. FINANCIAL STATEMENTS (UNAUDITED) CONDENSED CONSOLIDATED STATEMENTS OF INCOME For the three months ended March 31, 2001 and 2000 1 CONDENSED CONSOLIDATED BALANCE SHEETS March 31, 2001 and December 31, 2000 2 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS For the three months ended March 31, 2001 and 2000 3 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 4 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 13 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 29 PART II. OTHER INFORMATION - -------------------------- 1. LEGAL PROCEEDINGS 30 6. EXHIBITS AND REPORTS ON FORM 8-K 30 </TABLE>
3 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CONDENSED CONSOLIDATED STATEMENTS OF INCOME Verizon Communications Inc. and Subsidiaries <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, (Dollars in Millions, Except Per Share Amounts) (Unaudited) 2001 2000 - ----------------------------------------------------------- ------------ ------------ <S> <C> <C> OPERATING REVENUES $ 16,266 $ 14,532 Operations and support expense 9,299 8,210 Depreciation and amortization 3,360 2,591 Gains on sales of assets, net -- (97) ------------ ------------ OPERATING INCOME 3,607 3,828 Equity in income from unconsolidated businesses 216 230 Other income and (expense), net 70 78 Interest expense (921) (774) Minority interest (98) (26) Mark-to-market adjustment - financial instruments (116) (825) ------------ ------------ Income before provision for income taxes, extraordinary item and cumulative effect of change in accounting principle 2,758 2,511 Provision for income taxes 1,004 947 ------------ ------------ INCOME BEFORE EXTRAORDINARY ITEM AND CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE 1,754 1,564 Extraordinary item, net of tax -- (9) Cumulative effect of change in accounting principle, net of tax (182) (40) ------------ ------------ NET INCOME 1,572 1,515 Redemption of subsidiary preferred stock -- (8) ------------ ------------ NET INCOME AVAILABLE TO COMMON SHAREOWNERS $ 1,572 $ 1,507 ============ ============ BASIC EARNINGS (LOSS) PER COMMON SHARE: Income before extraordinary item and cumulative effect of change in accounting principle $ .65 $ .56 Extraordinary item, net of tax -- -- Cumulative effect of change in accounting principle, net of tax (.07) (.01) ------------ ------------ NET INCOME $ .58 $ .55 ============ ============ Weighted-average shares outstanding (in millions) 2,704 2,725 ------------ ------------ DILUTED EARNINGS (LOSS) PER COMMON SHARE: Income before extraordinary item and cumulative effect of change in accounting principle $ .65 $ .56 Extraordinary item, net of tax -- -- Cumulative effect of change in accounting principle, net of tax (.07) (.01) ------------ ------------ NET INCOME $ .58 $ .55 ============ ============ Weighted-average shares outstanding - diluted (in millions) 2,725 2,756 ------------ ------------ Dividends declared per common share $ .385 $ .385 ============ ============ </TABLE> See Notes to Condensed Consolidated Financial Statements 1
4 CONDENSED CONSOLIDATED BALANCE SHEETS Verizon Communications Inc. and Subsidiaries <TABLE> <CAPTION> MARCH 31, DECEMBER 31, (Dollars in Millions, Except Per Share Amounts) (Unaudited) 2001 2000 - ----------------------------------------------------------- ------------ ------------ <S> <C> <C> ASSETS Current assets Cash and cash equivalents $ 689 $ 757 Short-term investments 1,010 1,613 Accounts receivable, net of allowances of $1,580 and $1,562 13,988 14,010 Inventories 2,049 1,910 Net assets held for sale 567 518 Prepaid expenses and other 3,674 3,313 ------------ ------------ Total current assets 21,977 22,121 ------------ ------------ Plant, property and equipment 162,892 158,957 Less accumulated depreciation 91,523 89,453 ------------ ------------ 71,369 69,504 ------------ ------------ Investments in unconsolidated businesses 12,369 13,115 Intangible assets 44,083 41,990 Other assets 18,000 18,005 ------------ ------------ Total assets $ 167,798 $ 164,735 ============ ============ LIABILITIES AND SHAREOWNERS' INVESTMENT Current liabilities Debt maturing within one year $ 17,429 $ 14,838 Accounts payable and accrued liabilities 12,610 13,965 Other 5,376 5,433 ------------ ------------ Total current liabilities 35,415 34,236 ------------ ------------ Long-term debt 44,394 42,491 Employee benefit obligations 12,470 12,543 Deferred income taxes 15,559 15,260 Other liabilities 3,561 3,797 Minority interest 21,701 21,830 Shareowners' investment Series preferred stock ($.10 par value; none issued) -- -- Common stock ($.10 par value; 2,751,650,484 shares issued in both periods) 275 275 Contributed capital 24,545 24,555 Reinvested earnings 15,200 14,667 Accumulated other comprehensive loss (2,737) (2,176) ------------ ------------ 37,283 37,321 Less common stock in treasury, at cost 1,753 1,861 Less deferred compensation - employee stock ownership plans and other 832 882 ------------ ------------ Total shareowners' investment 34,698 34,578 ------------ ------------ Total liabilities and shareowners' investment $ 167,798 $ 164,735 ============ ============ </TABLE> See Notes to Condensed Consolidated Financial Statements 2
5 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS Verizon Communications Inc. and Subsidiaries <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, (Dollars in Millions) (Unaudited) 2001 2000 - --------------------------------- ------------ ------------ <S> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES Income before extraordinary item and cumulative effect of change in accounting principle $ 1,754 $ 1,564 Adjustments to reconcile income before extraordinary item and cumulative effect of change in accounting principle to net cash provided by operating activities: Depreciation and amortization 3,360 2,591 Gains on sales of assets, net -- (97) Mark-to-market adjustment - financial instruments 116 825 Employee retirement benefits (476) (1,033) Deferred income taxes 416 211 Provision for uncollectible accounts 364 262 Equity in income from unconsolidated businesses (216) (230) Changes in current assets and liabilities, net of effects from acquisition/disposition of businesses (2,170) 182 Other, net (46) 199 ------------ ------------ Net cash provided by operating activities 3,102 4,474 ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES Capital expenditures (4,478) (3,149) Acquisitions, net of cash acquired, and investments (2,099) (2,022) Proceeds from disposition of businesses and assets -- 47 Net change in short-term investments 577 208 Other, net (454) (151) ------------ ------------ Net cash used in investing activities (6,454) (5,067) ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from long-term borrowings 2,941 1,362 Repayments of long-term borrowings and capital lease obligations (798) (1,064) Increase in short-term obligations, excluding current maturities 2,205 1,098 Dividends paid (1,040) (1,053) Proceeds from sale of common stock 77 159 Purchase of common stock for treasury (6) (1,083) Other, net (95) (155) ------------ ------------ Net cash provided by (used in) financing activities 3,284 (736) ------------ ------------ Decrease in cash and cash equivalents (68) (1,329) Cash and cash equivalents, beginning of period 757 2,033 ------------ ------------ Cash and cash equivalents, end of period $ 689 $ 704 ============ ============ </TABLE> See Notes to Condensed Consolidated Financial Statements 3
6 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Verizon Communications Inc. and Subsidiaries (Unaudited) 1. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements have been prepared based upon Securities and Exchange Commission (SEC) rules that permit reduced disclosure for interim periods. The condensed consolidated financial statements for the three months ended March 31, 2000 give retroactive effect to the merger of Bell Atlantic Corporation (Bell Atlantic) and GTE Corporation (GTE) on June 30, 2000, as required for business combinations using pooling-of-interests accounting. These financial statements reflect all adjustments that are necessary for a fair presentation of results of operations and financial condition for the interim periods shown including normal recurring accruals and other items. The results for the interim periods are not necessarily indicative of results for the full year. For a more complete discussion of significant accounting policies and certain other information, you should refer to the financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2000. We have reclassified certain amounts from prior year's data to conform to the 2001 presentation. 2. GAINS ON SALES OF ASSETS, NET During the first quarter of 2000, we recorded a pretax gain of $97 million ($55 million after-tax, or $.02 per diluted share), primarily comprised of the gain on the sale of our CyberTrust line of business. 3. EXTRAORDINARY ITEM During the first quarter of 2000, we retired $128 million of debt prior to the stated maturity date, resulting in a one-time pretax extraordinary charge of $15 million ($9 million after-tax, or less than $.01 per diluted share). 4. WIRELESS JOINT VENTURE On April 3, 2000, Verizon and Vodafone Group plc consummated the previously announced agreement to combine U.S. wireless assets, including cellular, Personal Communications Services (PCS) and paging operations. We accounted for this transaction as a purchase business combination, and accordingly, began reporting the combined wireless operations prospectively in the second quarter of 2000. 5. INVESTMENTS Marketable Securities We have investments in marketable securities, primarily common stocks, which are considered "available-for-sale" under Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." These investments have been included in our condensed consolidated balance sheets in Investments in Unconsolidated Businesses and Other Assets. Under SFAS No. 115, available-for-sale securities are required to be carried at their fair value, with unrealized gains and losses (net of income taxes) recorded in Accumulated Other Comprehensive Loss. The fair values of our investments in marketable securities are determined based on market quotations. 4
7 The following table shows certain summarized information related to our investments in marketable securities: <TABLE> <CAPTION> GROSS GROSS UNREALIZED UNREALIZED (Dollars in Millions) COST GAINS LOSSES FAIR VALUE - --------------------- ------------ ------------ ------------ ------------ <S> <C> <C> <C> <C> AT MARCH 31, 2001 Investments in unconsolidated businesses $ 4,911 $ 651 $ (2,683) $ 2,879 Other assets 962 33 (61) 934 ------------ ------------ ------------ ------------ $ 5,873 $ 684 $ (2,744) $ 3,813 ============ ============ ============ ============ AT DECEMBER 31, 2000 Investments in unconsolidated businesses $ 4,529 $ 559 $ (1,542) $ 3,546 Other assets 1,326 29 (241) 1,114 ------------ ------------ ------------ ------------ $ 5,855 $ 588 $ (1,783) $ 4,660 ============ ============ ============ ============ </TABLE> At March 31, 2001, the unrealized gains on marketable securities relate primarily to our investment in Telecom Corporation of New Zealand Limited (TCNZ) and the unrealized losses primarily relate to our investments in NTL Incorporated (NTL), Cable & Wireless plc (C&W) and Metromedia Fiber Network, Inc. (MFN). Our investment in NTL has been adjusted from a cost of $1,557 million to its fair value of $616 million at March 31, 2001. The unrealized holding loss of $583 million (net of income tax benefit of $358 million) has been recorded in Accumulated Other Comprehensive Loss. Our investment in C&W shares has been adjusted from a cost of $2,141 million to its fair value of $881 million at March 31, 2001. The unrealized holding loss of $780 million (net of income tax benefit of $480 million) has been recorded in Accumulated Other Comprehensive Loss. At December 31, 2000, one half of our total MFN shares were deemed to be "available for sale" securities due to a one year sale restriction on the shares. In March 2001, the remaining half of our MFN shares became available-for-sale and we have included the cost and fair value of all the shares in the table above. Our investment in MFN shares has been adjusted from a cost of $715 million to its fair value of $280 million at March 31, 2001. This decrease in the value of our investment has been recorded in Investments in Unconsolidated Businesses. The unrealized holding loss of $435 million has been recognized in Accumulated Other Comprehensive Loss. We consider the declines in market value of our investments in marketable securities to be temporary. If a decline in the market value of any security is deemed to be other than temporary, due to persistent, declining stock prices in addition to general economic and company-specific factors, a charge to earnings would be recorded for all or a portion of the unrealized loss. Our investment in MFN's subordinated debt securities is convertible at our option into MFN common stock. Prior to January 1, 2001, the MFN debt securities were recorded as available-for-sale. Under newly adopted accounting rules (see Note 6), the conversion option, considered an embedded derivative, is valued separately from the debt securities. The MFN debt securities have been adjusted from a carrying value net of discount of $619 million to its fair value of $558 million at March 31, 2001. This decrease in the value of our investment has been recorded in Other Assets. The unrealized holding loss of $61 million has also been recognized in Accumulated Other Comprehensive Loss. Other Securities Prior to the merger of Bell Atlantic and GTE, we owned and consolidated Genuity Inc. (Genuity). In June 2000, as a condition of the merger, 90.5% of the voting equity of Genuity was issued in an initial public offering (IPO). We currently own 9.5% of the voting equity of Genuity, which contains a contingent conversion feature. The conversion rights are dependent on the percentage of certain of Verizon's access lines that are compliant with Section 271 of the Telecommunications Act of 1996. Verizon cannot currently exercise this conversion feature. Genuity's revenues and net loss for the first quarter of 2000 were $254 million and $128 million, respectively. Although no longer included in Verizon's consolidated results of operations, Genuity's revenues and net loss for the first quarter of 2001 were $299 million and $292 million, respectively. 5
8 6. ACCOUNTING CHANGE - DERIVATIVE FINANCIAL INSTRUMENTS Effective January 1, 2001, we adopted SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" and SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities." SFAS No. 133 requires that all derivatives, including derivatives embedded in other financial instruments, be measured at fair value and recognized as either assets or liabilities on our balance sheet. Changes in the fair values of derivative instruments not qualifying as hedges under SFAS No. 133 or any ineffective portion of hedges are recognized in earnings in the current period. Changes in the fair values of derivative instruments used effectively as hedges are recognized in earnings, along with changes in the fair value of the hedged item. Changes in the fair value of the effective portions of cash flow hedges are reported in other comprehensive income (loss), and recognized in earnings when the hedged item is recognized in earnings. The initial impact of adoption on our consolidated financial statements was recorded as a cumulative effect of an accounting change resulting in a charge of $182 million to current earnings and income of $110 million to other comprehensive income (loss). The recognition of assets and liabilities was immaterial to our financial position. The ongoing effect of SFAS No. 133 on our consolidated financial statements will be determined each quarter by several factors, including the specific hedging instruments in place and their relationships to hedged items, as well as market conditions at the end of each period. For the three months ended March 31, 2001, we recorded a charge to current earnings of $116 million (before minority interest of $2 million) and a loss of $12 million to other comprehensive income (loss). Interest Rate Risk Management We have entered into domestic interest rate swaps, to achieve a targeted mix of fixed and variable rate debt, where we principally receive fixed rates and pay floating rates based on LIBOR. These swaps hedge against changes in the fair value of our debt portfolio. We record the interest rate swaps at fair value in our balance sheet as assets and liabilities and adjust debt for the change in its fair value due to changes in interest rates. The ineffective portions of these hedges at January 1, 2001 and March 31, 2001 were immaterial to our operating results. Foreign Exchange Risk Management Our foreign exchange risk management includes the use of foreign currency forward contracts and a cross currency interest rate swap with a foreign currency forward. These contracts are typically used to hedge short-term foreign currency transactions and commitments, or to offset foreign exchange gains or losses on the foreign currency obligations and are designated as cash flow hedges. The contracts have maturities ranging from approximately one month to four years. We record these contracts at fair value as assets or liabilities and the related gains or losses are deferred in shareowners' investment (as a component of other comprehensive income (loss)). Other Derivatives Conversion Option On March 6, 2000, we invested approximately $1.7 billion in MFN, a domestic and international provider of dedicated fiber optic networks in major metropolitan markets. This investment included approximately $975 million in subordinated debt securities convertible at our option, upon receipt of necessary government approvals, into common stock at a conversion price of $17 per share (after two-for-one stock split) or 9.6% of the equity of MFN. The conversion option on the MFN debt securities has, as its underlying risk, changes in the MFN stock price. This risk is not clearly and closely related to the change in interest rate risk underlying the debt securities. Under SFAS No. 133 we are required to separate the conversion option, considered an embedded derivative, from the debt securities in order to account for changes in the fair value of the conversion option separately from changes in the fair value of the debt securities. The debt securities will retain their classification as available-for-sale with any changes to fair value being recorded to other comprehensive income (loss). The fair value of the conversion option is recognized as an asset in our balance sheet and we record the mark-to-market adjustment in current earnings. 6
9 A net charge of $186 million related to the conversion option was included as part of the cumulative effect of the accounting change recorded on January 1, 2001. It consisted of $202 million for the fair value of the conversion option partially offset by a $16 million incremental interest credit associated with the amortization of the discount on the debt securities. A net charge of $108 million was recorded to mark-to-market adjustment for the three months ended March 31, 2001. It consisted of a charge of $113 million for the fair value of the conversion option partially offset by a $5 million incremental interest credit associated with the amortization of the discount on the debt securities. As of March 31, 2001, the remaining value of the conversion option on our balance sheet is approximately $62 million. Warrants On October 10, 2000, we received warrants giving us the right to obtain 3.1 million shares of Interland, Inc. common stock for an exercise price of $18 per share in association with an agreement to purchase an ownership interest in a business. SFAS No. 133 requires that these warrants be recorded at fair value in the balance sheet with mark-to-market adjustments recorded in current earnings. A gain of $3 million was recorded as the cumulative effect of an accounting change on January 1, 2001 and a $2 million charge was recorded for the three months ended March 31, 2001 in mark-to-market adjustment. Call options We previously entered into several long-term call options on our common stock to hedge our exposure to compensation expense related to stock-based compensation. Prior to the adoption of SFAS No. 133, we recognized gains and losses in current earnings based on changes in the intrinsic values of the options caused by changes in the underlying stock price. SFAS No. 133 requires that we record the fair value of the options as assets and recognize the mark-to-market adjustments as gains or losses in current earnings. As such, we included income of $3 million as part of the cumulative effect of an accounting change on January 1, 2001 and recorded a charge of $4 million in mark-to-market adjustment for the three months ended March 31, 2001. Japanese Leveraged Leases In 1996 and 1997, we entered into several long-term foreign currency forward contracts to offset foreign exchange gains or losses associated with Japanese Yen denominated capitalized lease payments. In accordance with SFAS No. 133, these contracts were designated as effective cash flow hedges; however, late in 2000, we sold a location which held some of the capital leased assets. The assets and corresponding capital lease obligations were transferred to the purchaser as part of the sale. The forward contracts associated with the sold assets no longer qualify for hedge accounting under SFAS No. 133, and are recorded at fair value with mark-to-market adjustments recognized in current earnings. We recorded a charge of $4 million as part of the cumulative effect of an accounting change on January 1, 2001 and recorded a charge of $2 million in mark-to-market adjustment for the three months ended March 31, 2001. 7. DEBT Exchangeable Notes Previously, Verizon Global Funding Corp. issued two series of notes that are exchangeable for shares of TCNZ and for C&W and NTL shares. The exchangeable notes are indexed to the fair market value of the common stock into which they are exchangeable. If the price of the shares exceeds the exchange price established at the offering date, a mark-to-market adjustment is recorded, recognizing an increase in the carrying value of the debt obligation and a charge to income. If the price of the shares subsequently declines, the debt obligation is reduced (but not to less than the amortized carrying value of the notes). At March 31, 2001, the exchange price of the notes exchangeable into C&W and NTL shares exceeded the combined value of the share prices. Consequently, the notes were recorded at their amortized carrying value with no mark-to-market adjustments recorded in the first quarter of 2001. At March 31, 2000, the share price exceeded the exchange price, and we recorded an increase in the carrying value of the notes of $825 million and a corresponding charge to income ($536 million after-tax) in the first quarter of 2000. As of March 31, 2001, we have recorded no mark-to-market adjustments for the TCNZ exchangeable notes. 7
10 Support Agreements All of Verizon Global Funding's debt (including the TCNZ and the C&W and NTL exchangeable notes) have the benefit of Support Agreements between us and Verizon Global Funding, which guarantee payment of interest, premium (if any) and principal outstanding should Verizon Global Funding fail to pay. The holders of Verizon Global Funding debt do not have recourse to the stock or assets of some of our telephone operations or TCNZ; however, they do have recourse to dividends paid to us by any of our consolidated subsidiaries as well as assets not covered by the exclusion. Verizon Global Funding's long-term debt, including current portion, aggregated $14,712 million at March 31, 2001. The carrying value of the available assets reflected in our condensed consolidated financial statements was approximately $66.7 billion at March 31, 2001. 8. COMPREHENSIVE INCOME Comprehensive income consists of net income and other gains and losses affecting shareowners' investment that, under generally accepted accounting principles, are excluded from net income. Changes in the components of other comprehensive income (loss), net of income tax expense (benefit), are as follows: <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, (Dollars in Millions) 2001 2000 - --------------------- ------------ ------------ <S> <C> <C> NET INCOME $ 1,572 $ 1,515 ------------ ------------ FOREIGN CURRENCY TRANSLATION ADJUSTMENTS, net of taxes 248 (64) ------------ ------------ UNREALIZED GAINS (LOSSES) ON MARKETABLE SECURITIES Unrealized gains (losses), net of taxes (907) 1,007 Less: Reclassification adjustments for gains (losses) realized in net income, net of taxes -- 44 Add: Reclassification to earnings due to accounting change for derivatives 112 -- ------------ ------------ Net unrealized gains and losses on marketable securities (795) 963 ------------ ------------ UNREALIZED DERIVATIVE LOSSES ON CASH FLOW HEDGES Cumulative effect of accounting change (2) -- Net unrealized derivative losses on cash flow hedges (12) -- ------------ ------------ (14) -- ------------ ------------ MINIMUM PENSION LIABILITY ADJUSTMENT, net of taxes -- (22) ------------ ------------ OTHER COMPREHENSIVE INCOME (LOSS) (561) 877 ------------ ------------ TOTAL COMPREHENSIVE INCOME $ 1,011 $ 2,392 ============ ============ </TABLE> The net unrealized losses on marketable securities in 2001 primarily relate to our investments in C&W and MFN (see Note 5). The net unrealized gains on marketable securities in 2000 primarily relate to our investments in MFN. The reclassification to earnings was required to reflect the fair value of the MFN convertible debt securities separately from the embedded derivative of the conversion option, resulting from the adoption of SFAS No. 133 as of January 1, 2001 (see Note 6). The components of accumulated other comprehensive loss are as follows: <TABLE> <CAPTION> AT MARCH 31, AT DECEMBER 31, (Dollars in Millions) 2001 2000 - --------------------- ------------ --------------- <S> <C> <C> Foreign currency translation adjustments $ (1,160) $ (1,408) Unrealized gains (losses) on marketable securities (1,529) (734) Unrealized derivative losses on cash flow hedges (14) -- Minimum pension liability adjustment (34) (34) ------------ ------------ Accumulated other comprehensive loss $ (2,737) $ (2,176) ============ ============ </TABLE> 8
11 9. EARNINGS PER SHARE The following table is a reconciliation of the share amounts used in computing earnings per share. <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, (Dollars and Shares in Millions, Except Per Share Amounts) 2001 2000 - ---------------------------------------------------------- ------------ ------------ <S> <C> <C> NET INCOME AVAILABLE TO COMMON SHAREOWNERS Income before extraordinary item and cumulative effect of change in accounting principle $ 1,754 $ 1,564 Redemption of subsidiary preferred stock -- (8) ------------ ------------ Income available to common shareowners* 1,754 1,556 Extraordinary item, net of tax -- (9) Cumulative effect of change in accounting principle, net of tax (182) (40) ------------ ------------ Net income available to common shareowners* $ 1,572 $ 1,507 ============ ============ BASIC EARNINGS (LOSS) PER COMMON SHARE Weighted-average shares outstanding 2,704 2,725 ------------ ------------ Income available to common shareowners before extraordinary item and cumulative effect of change in accounting principle $ .65 $ .56 Extraordinary item, net of tax -- -- Cumulative effect of change in accounting principle, net of tax (.07) (.01) ------------ ------------ Net income available to common shareowners $ .58 $ .55 ============ ============ DILUTED EARNINGS (LOSS) PER COMMON SHARE Weighted-average shares outstanding 2,704 2,725 Effect of dilutive securities 21 31 ------------ ------------ Weighted-average shares outstanding - diluted 2,725 2,756 ------------ ------------ Income available to common shareowners before extraordinary item and cumulative effect of change in accounting principle $ .65 $ .56 Extraordinary item, net of tax -- -- Cumulative effect of change in accounting principle, net of tax (.07) (.01) ------------ ------------ Net income available to common shareowners $ .58 $ .55 ============ ============ </TABLE> *Income and Net income available to common shareowners are the same for purposes of calculating basic and diluted earnings per share. Stock options for 117.6 million shares for the three months ended March 31, 2001 and 34.8 million shares for the three months ended March 31, 2000 were not included in the computation of diluted earnings per share because the exercise price of stock options was greater than the average market price of the common stock. 10. SEGMENT INFORMATION We have four reportable segments, which we operate and manage as strategic business units and organize by products and services. Our segments include a Domestic Telecom group which provides domestic wireline communications services; a Domestic Wireless group which provides domestic wireless communications services; an International group which includes our foreign wireline and wireless communications investments; and an Information Services group which is responsible for our domestic and international publishing businesses and electronic commerce services. We measure and evaluate our reportable segments based on adjusted net income, which excludes unallocated corporate expenses and other adjustments arising during each period. The other adjustments include transactions that management excludes in assessing business unit performance due primarily to their nonrecurring and/or non-operational nature. Although such transactions are excluded from the business segment results, they are included in reported consolidated earnings. 9
12 REPORTABLE SEGMENTS The following table provides adjusted operating financial information for our four reportable segments and a reconciliation of adjusted segment results to consolidated results: <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, (Dollars in Millions) 2001 2000 - --------------------- ------------ ------------ <S> <C> <C> EXTERNAL OPERATING REVENUES Domestic Telecom $ 10,784 $ 10,416 Domestic Wireless 4,038 2,155 International 525 457 Information Services 784 750 ------------ ------------ Total segments - adjusted 16,131 13,778 Reconciling items 135 754 ------------ ------------ Total consolidated - reported $ 16,266 $ 14,532 ============ ============ INTERSEGMENT REVENUES Domestic Telecom $ 136 $ 200 Domestic Wireless 8 9 International 2 -- Information Services 5 29 ------------ ------------ Total segments - reported 151 238 Reconciling items (151) (238) ------------ ------------ Total consolidated - reported $ -- $ -- ============ ============ TOTAL OPERATING REVENUES Domestic Telecom $ 10,920 $ 10,616 Domestic Wireless 4,046 2,164 International 527 457 Information Services 789 779 ------------ ------------ Total segments - adjusted 16,282 14,016 Reconciling items (16) 516 ------------ ------------ Total consolidated - reported $ 16,266 $ 14,532 ============ ============ NET INCOME Domestic Telecom $ 1,350 $ 1,262 Domestic Wireless 98 129 International 210 171 Information Services 212 198 ------------ ------------ Total segments - adjusted 1,870 1,760 Reconciling items (298) (245) ------------ ------------ Total consolidated - reported $ 1,572 $ 1,515 ============ ============ </TABLE> <TABLE> <CAPTION> (Dollars in Millions) MARCH 31, 2001 DECEMBER 31, 2000 - --------------------- -------------- ----------------- <S> <C> <C> ASSETS Domestic Telecom $ 79,386 $ 78,112 Domestic Wireless 58,284 56,029 International 14,207 14,466 Information Services 3,328 3,148 ------------ ------------ Total segments 155,205 151,755 Reconciling items 12,593 12,980 ------------ ------------ Total consolidated $ 167,798 $ 164,735 ============ ============ </TABLE> 10
13 Major reconciling items between the segments and the consolidated results are as follows: <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, (Dollars in Millions) 2001 2000 - --------------------- ------------ ------------ <S> <C> <C> TOTAL REVENUES Genuity (see Note 5) $ -- $ 254 Significant operations sold in 2000 -- 360 Corporate, eliminations and other (16) (98) ------------ ------------ $ (16) $ 516 ============ ============ NET INCOME Genuity (see Note 5) $ -- $ (128) Significant operations sold in 2000 -- 122 Mark-to-market adjustment - exchangeable notes (see Note 7) -- (536) Mark-to-market adjustment - other financial instruments (see Note 6) (114) -- Special items -- (35) Merger transition and integration costs (88) -- Gains on sales of assets, net (see Note 2) -- 55 Cumulative effect of accounting change (182) (40) Pension settlements -- 304 Extraordinary item (see Note 3) -- (9) Corporate, eliminations and other 86 22 ------------ ------------ $ (298) $ (245) ============ ============ </TABLE> Pension settlement gains before tax of $486 million ($304 million after-tax) for the three months ended March 31, 2000 were recorded in accordance with SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits." They relate to certain settlements of pension obligations for former GTE employees through direct payment, the purchase of annuities or otherwise. There were no pension settlement gains recorded during the first quarter of 2001. Corporate, eliminations and other includes unallocated corporate expenses, intersegment eliminations recorded in consolidation, the results of other businesses such as lease financing, and asset impairments and expenses that are not allocated in assessing segment performance due to their nonrecurring nature. We generally account for intersegment sales of products and services and asset transfers at current market prices. We are not dependent on any single customer. 11. COMMITMENTS AND CONTINGENCIES In connection with certain state regulatory incentive plan commitments, we have deferred revenues which will be recognized as the commitments are met or obligations are satisfied under the plans. In addition, several state and federal regulatory proceedings may require our telephone operations to refund a portion of the revenues collected in the current and prior periods. There are also various legal actions pending to which we are a party and claims which, if asserted, may lead to other legal actions. We have established reserves for specific liabilities in connection with regulatory and legal matters that we currently deem to be probable and estimable. We do not expect that the ultimate resolution of pending regulatory and legal matters in future periods will have a material effect on our financial condition, but it could have a material effect on our results of operations. Verizon Wireless was the winning bidder for 113 licenses in the Federal Communications Commission's (FCC) auction of 1.9 GHz spectrum, which concluded in January 2001. These licenses would add capacity for growth and advanced services in markets including New York, Boston, Los Angeles, Chicago, Philadelphia, Washington, D.C., Seattle and San Francisco, for a total price of approximately $8.8 billion, $1.8 billion of which has already been paid and the balance of which will be paid when the FCC requires payment, which is expected to occur in 2001. There were no legal challenges to Verizon Wireless's qualifications to acquire these licenses. However, most of the licenses that were auctioned are the subject of pending litigation by the original licensees, NextWave Personal Communications Inc. and NextWave Power Partners Inc., which have appealed to the federal courts the FCC's 11
14 action canceling NextWave's licenses and reclaiming the spectrum. If the licenses must be returned, the FCC's only obligation is to refund to winning bidders any amounts that they may have paid, without interest. Nearly all of Verizon Wireless's $8.8 billion license cost relates to licenses subject to NextWave's appeal. During the fourth quarter of 2000, Verizon Wireless agreed to acquire Price Communications Wireless, a wholly owned subsidiary of Price Communications, for $1.5 billion in Verizon Wireless stock and the repayment by Verizon Wireless of $550 million in net debt. The transaction is conditioned upon completion of a Verizon Wireless initial public offering. The deal will significantly expand our footprint in the Southeastern U.S. and add approximately 500,000 customers. In the first quarter of 2001, we agreed to provide up to $500 million in interim financing to Genuity, subsequently increased to $900 million. As of March 31, 2001, $200 million of that commitment had been loaned to Genuity. 12
15 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Verizon Communications Inc. was formed in June 2000 by the merger of Bell Atlantic Corporation and GTE Corporation. Financial information for the three months ended March 31, 2000 gives retroactive effect to the merger, as required for business combinations using pooling-of-interests accounting. The formation of the wireless joint venture occurred in April 2000. Financial information for the three months ended March 31, 2000 does not give retroactive effect to the formation of the wireless joint venture, as required for purchase business combinations. CONSOLIDATED RESULTS OF OPERATIONS In this section, we discuss our overall reported results and highlight special and nonrecurring items. In the following section, we review the performance of our segments on an adjusted basis. We adjust the segments' reported results for the effects of these items, which management does not consider in assessing segment performance due primarily to their nonrecurring and/or non-operational nature. We believe that this presentation will assist readers in better understanding trends from period to period. We reported net income available to common shareowners of $1,572 million, or $.58 diluted earnings per share for the quarter ended March 31, 2001, compared to net income available to common shareowners of $1,507 million, or $.55 diluted earnings per share for the quarter ended March 31, 2000. Our reported results for both quarters were affected by special items. After adjusting for such items, net income would have been $1,956 million, or $.72 diluted earnings per share in the first quarter of 2001 and $1,904 million, or $.69 diluted earnings per share in the first quarter of 2000. The table below summarizes reported and adjusted results of operations for each period. <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, (Dollars in Millions, Except Per Share Amounts) 2001 2000 - ----------------------------------------------- ------------ ------------ <S> <C> <C> Reported operating revenues $ 16,266 $ 14,532 Reported operating expenses 12,659 10,704 ------------ ------------ Reported operating income 3,607 3,828 REPORTED NET INCOME AVAILABLE TO COMMON SHAREHOLDERS 1,572 1,507 ------------ ------------ Merger transition and integration costs 88 -- Gains on sales of assets, net -- (55) Pension settlements -- (304) Mark-to-market adjustment - financial instruments 114 536 Genuity loss -- 128 Special items -- 35 Extraordinary item -- 9 Cumulative effect of accounting change 182 40 Redemption of subsidiary preferred stock -- 8 ------------ ------------ ADJUSTED NET INCOME $ 1,956 $ 1,904 ============ ============ DILUTED EARNINGS PER SHARE - REPORTED $ .58 $ .55 DILUTED EARNINGS PER SHARE - ADJUSTED $ .72 $ .69 </TABLE> 13
16 MERGER TRANSITION AND INTEGRATION COSTS From the date of the merger, we expect to incur a total of approximately $2.0 billion of transition costs related to the merger and the formation of the wireless joint venture. These costs will be incurred to integrate systems, consolidate real estate and relocate employees. They also include approximately $500 million for advertising and other costs to establish the Verizon brand. Transition costs related to the merger have totaled $857 million since the date of the merger. During the first quarter of 2001, we incurred transition costs of $163 million ($88 million after taxes and minority interests, or $.03 per diluted share). GAINS ON SALES OF ASSETS, NET During the first quarter of 2000, we recorded a pretax gain of $97 million ($55 million after-tax, or $.02 per diluted share), primarily comprised of the gain on the sale of our CyberTrust line of business. PENSION SETTLEMENTS In the first quarter of 2000, we recorded pension settlement gains of $486 million pretax ($304 million after-tax, or $.11 per diluted share) in accordance with Statement of Financial Accounting Standards (SFAS) No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits." They relate to certain settlements of pension obligations for former GTE employees through direct payment, the purchase of annuities or otherwise. MARK-TO-MARKET ADJUSTMENT - FINANCIAL INSTRUMENTS In the first quarter of 2001, we recorded a loss on a mark-to-market adjustment of $116 million ($114 million after minority interest, or $.04 per diluted share) due primarily to the change in the fair value of the Metromedia Fiber Network, Inc. (MFN) notes conversion option. We began recording changes in the fair values of this conversion option and other derivatives in connection with a change in accounting principle effective January 1, 2001 (see impact of SFAS No. 133 below). In the first quarter of 2000, we recorded a loss on a mark-to-market adjustment of $825 million ($536 million after-tax, or $.19 per diluted share) related to our $3,180 million of notes which are exchangeable into shares of Cable & Wireless plc (C&W) and NTL Incorporated (NTL). The mark-to-market adjustments are non-cash, non-operational transactions that result in either an increase or decrease in the carrying value of the asset or obligation and a charge or credit to income. The mark-to-market adjustment recorded in the first quarter of 2001 was required primarily because the MFN stock price, which is used to determine the fair value of the conversion option, declined. The mark-to-market adjustment recorded in the first quarter of 2000 was required because the carrying value of the exchangeable notes is indexed to the fair market value of the underlying common stock. If the combined fair value of the C&W and NTL common stocks declines, our debt obligation is reduced (but not to less than its amortized carrying value) and income is increased. If the combined fair value of the C&W and NTL common stock increases, our debt obligation increases and income is decreased. GENUITY LOSS In accordance with the provisions of a Federal Communications Commission (FCC) order in June 2000, Genuity Inc. (Genuity), formerly a wholly-owned subsidiary of GTE, sold in a public offering 174 million of its Class A common shares, representing 100% of the issued and outstanding Class A common stock and 90.5% of the overall voting equity in Genuity. GTE retained 100% of Genuity's Class B common stock, which represents 9.5% of the voting equity in Genuity and contains a contingent conversion feature. The sale transferred ownership and control of Genuity to the Class A common stockholders and, accordingly, we deconsolidated our investment in Genuity on June 30, 2000 and are accounting for our investment in Genuity using the cost method. The impact of this change is that Genuity's revenues and expenses, as well as changes in balance sheet accounts and cash flows subsequent to June 30, 2000 are no longer included in our consolidated financial results. As a result, for comparability, we have 14
17 adjusted the reported results for the first quarter of 2000 to exclude the results of Genuity. The after-tax loss was $128 million (or $.05 per diluted share) for the first quarter of 2000. SPECIAL ITEMS During the first quarter of 2000, we recorded charges of $57 million ($35 million after-tax, or $.01 per diluted share) for the write-down of certain impaired assets. These impaired assets primarily relate to an exit of a foreign operation and video-related exit charges. EXTRAORDINARY ITEM During the first quarter of 2000, we retired $128 million of debt prior to the stated maturity date, resulting in a one-time, pretax extraordinary charge of $15 million ($9 million after-tax, or less than $.01 per diluted share). CUMULATIVE EFFECT OF ACCOUNTING CHANGE Impact of SAB No. 101 We adopted the provisions of the Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) No. 101, "Revenue Recognition in Financial Statements" in the fourth quarter of 2000, retroactive to January 1, 2000, as required by the SEC. The impact to Verizon pertains to the deferral of certain non-recurring fees, such as service activation and installation fees, and associated incremental direct costs, and the recognition of those revenues and costs over the expected term of the customer relationship. The initial impact of adoption was recorded as a cumulative effect of an accounting change of $40 million after-tax (or $.01 per diluted share) for the first quarter of 2000. Impact of SFAS No. 133 We adopted the provisions of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," and the related SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities" on January 1, 2001. The impact to Verizon pertains to the recognition of changes in the fair value of derivative instruments. The initial impact of adoption was recorded as a cumulative effect of an accounting change of $182 million (or $.07 per diluted share) for the first quarter of 2001. SEGMENT RESULTS OF OPERATIONS We have four reportable segments, which we operate and manage as strategic business units and organize by products and services. Our segments are Domestic Telecom, Domestic Wireless, International and Information Services. You can find additional information about our segments in Note 10 to the condensed consolidated financial statements. We measure and evaluate our reportable segments based on adjusted net income, which excludes unallocated corporate expenses and other adjustments arising during each period. Other adjustments include transactions that management has excluded in assessing business unit performance, due primarily to their nonrecurring and/or non-operational nature, but has included in reported consolidated earnings. We previously described these items in the "Consolidated Results of Operations" section. 15
18 Special items affected our segments as follows: <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, (Dollars in Millions) 2001 2000 - --------------------- ------------ ------------ <S> <C> <C> DOMESTIC TELECOM Reported net income $ 1,281 $ 1,549 Special items 69 (287) ------------ ------------ Adjusted net income $ 1,350 $ 1,262 ============ ============ DOMESTIC WIRELESS Reported net income $ 79 $ 130 Special items 19 (1) ------------ ------------ Adjusted net income $ 98 $ 129 ============ ============ INTERNATIONAL Reported net income $ 210 $ 131 Special items -- 40 ------------ ------------ Adjusted net income $ 210 $ 171 ============ ============ INFORMATION SERVICES Reported net income $ 209 $ 200 Special items 3 (2) ------------ ------------ Adjusted net income $ 212 $ 198 ============ ============ CORPORATE AND OTHER Reported net income $ (207) $ (495) Special items 293 639 ------------ ------------ Adjusted net income $ 86 $ 144 ============ ============ </TABLE> Corporate and Other includes intersegment eliminations. DOMESTIC TELECOM Our Domestic Telecom segment consists primarily of our telephone operations that provide local telephone services in over 30 states. These services include voice and data transport, enhanced and custom calling features, network access, directory assistance, private lines and public telephones. This segment also provides customer premises equipment distribution, data solutions and systems integration, billing and collections, Internet access services, research and development and inventory management services. In addition, this segment includes our long distance service. <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, (Dollars in Millions) 2001 2000 % CHANGE - --------------------- ------------ ------------ ------------ <S> <C> <C> <C> RESULTS OF OPERATIONS - ADJUSTED BASIS OPERATING REVENUES Local services $ 5,620 $ 5,430 3.5% Network access services 3,292 3,230 1.9 Long distance services 762 804 (5.2) Other services 1,246 1,152 8.2 ------------ ------------ 10,920 10,616 2.9 ------------ ------------ OPERATING EXPENSES Operations and support 5,957 6,015 (1.0) Depreciation and amortization 2,283 2,097 8.9 ------------ ------------ 8,240 8,112 1.6 ------------ ------------ OPERATING INCOME $ 2,680 $ 2,504 7.0 ============ ============ ADJUSTED NET INCOME $ 1,350 $ 1,262 7.0 </TABLE> 16
19 DOMESTIC TELECOM - CONTINUED HIGHLIGHTS Domestic Telecom's operating revenues grew 2.9% for the first quarter of 2001 over the same period last year. Much of this growth was generated by increased sales of core and advanced communications services, primarily our data services revenues that grew 27.6% in 2001. These revenues include our high-bandwidth, packet-switched and special access services, as well as our network integration business. We ended the first quarter of 2001 with 112 million access line equivalents in service, an increase of 19.8% from March 31, 2000. These include data circuits equivalent to 49.1 million voice-grade lines, 58.7% more than 2000, as more customers chose high-capacity, high-speed transport services, and 62.9 million access lines. Minutes of use from interexchange carriers and competitive local exchange carriers (CLECs) increased 1.1% in the first quarter of 2001. Our interLATA long distance business showed strong growth in the first quarter of 2001. We ended the first quarter of 2001 with 5.2 million customers nationwide, an increase of 44.9% from the same period last year (excluding our CLEC services). Operating revenue growth in 2001 was negatively affected by federal and state regulatory rate reductions totaling approximately $250 million, primarily affecting our network access revenues. Solid expense management and merger-related expense savings, partially offset by increased costs associated with our growth businesses such as long distance and data services, contributed to 1.0% lower operations and support expenses in the first quarter of 2001. These and other items affecting Domestic Telecom's adjusted results of operations for the three months ended March 31, 2001 and 2000 are discussed in the following section. OPERATING REVENUES Local Services Local service revenues are earned by our telephone operations from the provision of local exchange, local private line, wire maintenance, voice messaging and value-added services. Value-added services are a family of services that expand the utilization of the network, including products such as Caller ID, Call Waiting and Return Call. The provision of local exchange services not only includes retail revenue but also includes local wholesale revenues from unbundled network elements (UNEs), interconnection revenues from competitive local exchange carriers, certain data transport revenues, and wireless interconnection revenues. Growth in local service revenues of $190 million, or 3.5%, in the first quarter of 2001 was driven by higher payments received from competitive local exchange carriers for interconnection of their networks with our network. The first quarter of 2001 also reflects solid demand for our value-added services as a result of new packaging of services. Local service revenue growth was affected by lower retail access line growth, partially offset by higher resold lines and interconnection charges. Network Access Services Network access services revenues are earned from end-user subscribers and long distance and other competing carriers who use our local exchange facilities to provide usage services to their customers. Switched access revenues are derived from fixed and usage-based charges paid by carriers for access to our local network. Special access revenues originate from carriers and end-users that buy dedicated local exchange capacity to support their private networks. End-user access revenues are earned from our customers and from resellers who purchase dial-tone services. Our network access revenues grew $62 million, or 1.9%, in the first quarter of 2001. This growth was mainly attributable to higher customer demand, primarily for special access services that grew approximately 31.4% over the first quarter of 2000. This growth reflects a continuing expansion of the business market, particularly for high-capacity, high-speed digital services. 17
20 DOMESTIC TELECOM - CONTINUED Volume-related growth was substantially offset by price reductions of approximately $186 million associated with federal and state price cap filings and other regulatory decisions. State public utility commissions regulate our telephone operations with respect to certain intrastate rates and services and certain other matters. The FCC regulates the rates that we charge long distance carriers and end-user subscribers for interstate access services. We are required to file new access rates with the FCC each year. In July 2000, we implemented the Coalition for Affordable Local and Long Distance Service (CALLS) plan. Rates included in the July 2000 CALLS plan will be in effect through June 2001. Long Distance Services Long distance service revenues include both intraLATA toll services and interLATA long distance voice and data services. Long distance service revenues declined $42 million, or 5.2%, in the first quarter of 2001 primarily due to competition and the effects of toll calling discount packages and product bundling offers of our intraLATA toll services. These reductions were partially offset by revenue growth from our interLATA long distance services offered throughout the region, including substantial customer win-backs in the state of New York where interLATA long distance was introduced during the first quarter of 2000. Other Services Our other services include such services as billing and collections for long distance carriers, public (coin) telephone and customer premises equipment services. Other services revenues also include services provided by our non-regulated subsidiaries such as inventory management and purchasing, Internet access, and data solutions and systems integration businesses. Revenues from other services grew $94 million, or 8.2%, in the first quarter of 2001. This revenue growth was primarily attributable to higher demand for such services as systems integration and data solutions and inventory management and purchasing services as a result of new contracts with business customers. These factors were partially offset by lower revenue growth from our public telephone and directory services, primarily due to increased competition for these services. OPERATING EXPENSES Operations and Support Operations and support, which consists of employee costs and other operating expenses, decreased by $58 million, or 1.0%, in the first quarter of 2001, principally due to lower costs at our telephone operations. These reductions were largely attributable to reduced employee overtime for repair and maintenance activity as a result of improved productivity and the effects of cost containment measures and merger-related expense savings. Other items contributing to the decrease, but to a lesser extent, were lower work force levels at our telephone operations and lower pension and benefit costs. These cost reductions were partially offset by higher costs associated with our growth businesses such as long distance and data services, salary and wage increases for management and non-management employees, and increased uncollectible costs associated with outstanding receivables with other carriers. Depreciation and Amortization Depreciation and amortization expense increased by $186 million, or 8.9%, in the first quarter of 2001. This expense increase was principally due to growth in depreciable telephone plant as a result of increased capital expenditures for higher growth services and increased software amortization costs. These factors were partially offset by the effect of lower rates of depreciation. 18
21 DOMESTIC WIRELESS Our Domestic Wireless segment provides cellular, personal communications services (PCS) and paging services and equipment sales. This segment primarily represents the operations of Verizon Wireless, a joint venture combining our merged wireless properties with the U.S. properties and paging assets of Vodafone Group plc (Vodafone), including the consolidation of PrimeCo Communications (PrimeCo). The formation of Verizon Wireless occurred in April 2000. Verizon owns a 55% interest in the joint venture and Vodafone owns the remaining 45%. The first quarter 2001 information in the table below reflects the combined results of Verizon Wireless. All periods prior to the formation of Verizon Wireless are reported on an historical basis and, therefore, do not reflect the contribution of the Vodafone properties and the consolidation of PrimeCo. <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, (Dollars in Millions) 2001 2000 % CHANGE - --------------------- ------------ ------------ ------------ <S> <C> <C> <C> RESULTS OF OPERATIONS - ADJUSTED BASIS OPERATING REVENUES Wireless services $ 4,046 $ 2,164 87.0% ------------ ------------ OPERATING EXPENSES Operations and support 2,637 1,484 77.7 Depreciation and amortization 919 322 185.4 ------------ ------------ 3,556 1,806 96.9 ------------ ------------ OPERATING INCOME $ 490 $ 358 36.9 ============ ============ EQUITY IN INCOME (LOSS) FROM UNCONSOLIDATED BUSINESSES $ (11) $ 1 -- MINORITY INTEREST $ (155) $ (31) -- ADJUSTED NET INCOME $ 98 $ 129 (24.0) </TABLE> OPERATING REVENUES Revenues earned from our consolidated wireless businesses grew by $1,882 million, or 87.0%, in the first quarter of 2001 compared to the same period in 2000. By including the revenues of the properties of the wireless joint venture in the first quarter of 2000, revenues were $596 million, or 17.3%, higher in the first quarter of 2001. On this comparable basis, revenue growth was largely attributable to customer additions and higher revenue per customer per month. Our domestic wireless customer base grew to 27.1 million customers in the first quarter of 2001, compared to 24.6 million customers in the first quarter of 2000, an increase of 10%. In the first quarter of 2001, we removed approximately 900,000 non-revenue producing customers as a result of a customer base assessment performed as part of the merger integration process. During the quarter, 304,000 customers selected one of Verizon Wireless's new national SingleRate plans. Over 70% of national SingleRate subscribers are taking plans at $55 a month or higher. In addition, on March 31, 2001, approximately 16.3 million customers were using digital service. OPERATING EXPENSES Operations and Support Operations and support expenses, which represent employee costs and other operating expenses, increased by $1,153 million, or 77.7%, in the first quarter of 2001 principally as a result of the formation of the wireless joint venture in the second quarter of 2000. By including the expenses of the properties of the wireless joint venture in the first quarter of 2000, operations and support expenses were $358 million, or 15.7%, higher in the first quarter of 2001. On this comparable basis, higher costs were also attributable to the significant growth in the subscriber base described above, as well as the continuing migration of analog customers to digital, partially offset by lower cash expenses from merger synergies. 19
22 DOMESTIC WIRELESS - CONTINUED Depreciation and Amortization Depreciation and amortization expense increased by $597 million, or 185.4%, in the first quarter of 2001, compared to the same period in 2000. This increase was mainly attributable to the formation of the wireless joint venture in the second quarter of 2000. Adjusting for the wireless joint venture in a manner similar to operations and support expenses above, depreciation and amortization was $97 million, or 11.8%, higher in the first quarter of 2001. On this comparable basis, capital expenditures for our cellular network have increased in 2001 to support increased demand in all markets. MINORITY INTEREST The significant increase in minority interest in the first quarter of 2001 was principally due to the formation of the wireless joint venture and the significant minority interest attributable to Vodafone. INTERNATIONAL Our International segment includes international wireline and wireless telecommunication operations, investments and management contracts in the Americas, Europe, Asia and the Pacific. Our consolidated international investments include Grupo Iusacell (Iusacell) (Mexico), CODETEL (Dominican Republic), CTI Holdings, S.A. (CTI) (Argentina) and Micronesian Telecommunications Corporation (Northern Mariana Islands). Our international investments in which we have a less than controlling interest are accounted for on either the cost or equity method. <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, (Dollars in Millions) 2001 2000 % CHANGE - --------------------- ------------ ------------ ------------ <S> <C> <C> <C> RESULTS OF OPERATIONS - ADJUSTED BASIS OPERATING REVENUES Wireline and other $ 209 $ 180 16.1% Wireless 318 277 14.8 ------------ ------------ 527 457 15.3 ------------ ------------ OPERATING EXPENSES Operations and support 384 328 17.1 Depreciation and amortization 105 81 29.6 ------------ ------------ 489 409 19.6 ------------ ------------ OPERATING INCOME $ 38 $ 48 (20.8) ============ ============ EQUITY IN INCOME FROM UNCONSOLIDATED BUSINESSES $ 217 $ 172 26.2 ADJUSTED NET INCOME $ 210 $ 171 22.8 </TABLE> The revenues and operating expenses for the International segment exclude QuebecTel, which was deconsolidated in the second quarter of 2000. QuebecTel's net results for all periods are included in Equity in Income from Unconsolidated Businesses. OPERATING REVENUES Revenues earned from our international businesses grew by $70 million, or 15.3%, in the first quarter of 2001 as compared to the same period in 2000. The increase in revenues is primarily due to an increase in wireless subscribers and wireline access lines of the consolidated subsidiaries and by the start-up of CTI's Buenos Aires PCS operations in the second quarter of 2000, partially offset by lower revenue per customer per month at CTI. OPERATING EXPENSES Operations and Support Operations and support expenses, which represent employee costs and other operating expenses, increased $56 million, or 17.1%, in the first quarter of 2001 as compared to the same period in 2000. The higher costs were driven 20
23 INTERNATIONAL - CONTINUED primarily by customer acquisition costs associated with wireless customer growth and the start-up of CTI's Buenos Aires PCS operations. Depreciation and Amortization Depreciation and amortization expense increased $24 million, or 29.6%, for the first quarter of 2001 as compared to the same period in 2000. This increase is attributable to the ongoing network capital expenditures necessary to meet the increase in subscriber base. EQUITY IN INCOME FROM UNCONSOLIDATED BUSINESSES Equity in income from unconsolidated businesses increased $45 million, or 26.2%, in the first quarter of 2001 as compared to the same period in 2000. The increase is primarily due to improved operational growth at Omnitel Pronto Italia S.p.A, Telecomunicaciones de Puerto Rico, Taiwan Cellular Corporation, EuroTel Praha and EuroTel Bratislava. These increases were partially offset by lower income from our Canadian business due to Telus Corporation's investment in Clearnet Communications Inc. in the third quarter of 2000 and a reduction in dividends received from Telecom Corporation of New Zealand Limited. In addition, results for the first quarter of 2000 include equity losses for Cable & Wireless Communications plc (CWC). Our investment in CWC was exchanged for interests in C&W and NTL in the second quarter of 2000. Both C&W and NTL are accounted for under the cost method. INFORMATION SERVICES Our Information Services segment consists of our domestic and international publishing businesses, including print and electronic directories and Internet-based shopping guides, as well as website creation and other electronic commerce services. This segment has operations principally in North America, Europe, Asia and Latin America. <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, (Dollars in Millions) 2001 2000 % CHANGE - --------------------- ------------ ------------ ------------ <S> <C> <C> <C> RESULTS OF OPERATIONS - ADJUSTED BASIS OPERATING REVENUES Information services $ 789 $ 779 1.3% ------------ ------------ OPERATING EXPENSES Operations and support 416 434 (4.1) Depreciation and amortization 21 19 10.5 ------------ ------------ 437 453 (3.5) ------------ ------------ OPERATING INCOME $ 352 $ 326 8.0 ============ ============ ADJUSTED NET INCOME $ 212 $ 198 7.1 </TABLE> OPERATING REVENUES Operating revenues from our Information Services segment improved by $10 million, or 1.3%, in the first quarter of 2001 as compared to the same period in 2000. This revenue increase was primarily generated by growth in print directory advertising revenue and expansion of our Internet directory service, SuperPages.com(R), offset by reductions in certain affiliate transactions. OPERATING EXPENSES Total operating expenses for the first quarter of 2001 decreased $16 million, or 3.5%, over the corresponding period in 2000. This change was primarily attributable to a reduction in operations and support expenses from our ongoing cost containment efforts to reduce directory publishing expenses. 21
24 NONOPERATING ITEMS <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, (Dollars in Millions) 2001 2000 % CHANGE - --------------------- ------------ ------------ ------------ <S> <C> <C> <C> OTHER INCOME AND (EXPENSE), NET Interest income $ 53 $ 68 (22.1)% Foreign exchange gains (losses), net (1) 11 (109.1) Other, net 18 (1) -- ------------ ------------ Total $ 70 $ 78 (10.3) ============ ============ </TABLE> The changes in other income and expense in the three months ended March 31, 2001, as compared to the same period in 2000, were due to changes in several components as shown in the table above. We recorded additional interest income in the first quarter of 2000 in connection with the settlement of a tax-related matter. Foreign exchange gains were affected primarily by our Iusacell subsidiary, which uses the Mexican peso as its functional currency. We expect that our earnings will continue to be affected by foreign currency gains or losses associated with the U.S. dollar denominated debt issued by Iusacell. <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, (Dollars in Millions) 2001 2000 % CHANGE - --------------------- ------------ ------------ ------------ <S> <C> <C> <C> INTEREST EXPENSE Interest expense $ 921 $ 774 19.0% Capitalized interest costs 84 45 86.7 ------------ ------------ Total interest costs on debt balances $ 1,005 $ 819 22.7 ============ ============ Average debt outstanding $ 59,416 $ 48,901 21.5 Effective interest rate 6.8% 6.7% </TABLE> The increase in interest costs for the three months ended March 31, 2001, as compared to the same period in 2000, was principally attributable to higher average debt levels. The increase in debt levels was mainly the result of the debt assumed by Verizon Wireless in connection with the formation of Verizon Wireless and higher capital expenditures primarily in our Domestic Telecom and Domestic Wireless segments. <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, (Dollars in Millions) 2001 2000 % CHANGE - --------------------- ------------ ------------ ------------ <S> <C> <C> <C> MINORITY INTEREST $ 98 $ 26 276.9% </TABLE> The increase in minority interest was primarily due to the impact of the wireless joint venture with Vodafone, partially offset by higher operating losses at our operations in Argentina. <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, 2001 2000 ------------ ------------ <S> <C> <C> EFFECTIVE INCOME TAX RATES 36.4% 37.7% </TABLE> The effective income tax rate is the provision for income taxes as a percentage of income before the provision for income taxes. Our effective income tax rate for the three month period ended March 31, 2001 was lower than the corresponding period in 2000, principally as a result of tax benefits related to our foreign operations and lower state taxes. 22
25 CONSOLIDATED FINANCIAL CONDITION <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, (Dollars in Millions) 2001 2000 $ CHANGE - --------------------- ------------ ------------ ------------ <S> <C> <C> <C> CASH FLOWS PROVIDED BY (USED IN) Operating activities $ 3,102 $ 4,474 $ (1,372) Investing activities (6,454) (5,067) (1,387) Financing activities 3,284 (736) 4,020 ------------ ------------ ------------ DECREASE IN CASH AND CASH EQUIVALENTS $ (68) $ (1,329) $ 1,261 ============ ============ ============ </TABLE> We use the net cash generated from our operations and from external financing to fund capital expenditures for network expansion and modernization, pay dividends and invest in new businesses. While current liabilities exceeded current assets at March 31, 2001, our sources of funds, primarily from operations and, to the extent necessary, from readily available external financing arrangements, are sufficient to meet ongoing operating and investing requirements. We expect that capital spending requirements will continue to be financed primarily through internally generated funds. Additional debt or equity financing may be needed to fund additional development activities (including the purchase of wireless licenses obtained in the recent FCC auction, see "Other Factors That May Affect Future Results") or to maintain our capital structure to ensure our financial flexibility. CASH FLOWS PROVIDED BY OPERATING ACTIVITIES Cash generated from operations continued to be one of our primary sources of funds. The decrease in cash from operations compared to the first quarter of 2000 primarily reflects an increase in working capital requirements, partially offset by improved results of operations. CASH FLOWS USED IN INVESTING ACTIVITIES Capital expenditures continued to be our primary use of capital resources. We invested $3,339 million in our Domestic Telecom business in the first quarter of 2001, compared to $2,464 million in the first quarter of 2000 to facilitate the introduction of new products and services, enhance responsiveness to competitive challenges and increase the operating efficiency and productivity of the network. We also invested approximately $988 million in our Domestic Wireless businesses in the first quarter of 2001, compared to $473 million during the same period last year. The increase in 2001 is primarily due to the inclusion of both Vodafone and PrimeCo properties in Verizon Wireless in April 2000, as well as increased capital spending in existing Bell Atlantic and GTE wireless properties. We expect capital expenditures in 2001 to be approximately $17.5 billion, excluding the cost of wireless licenses obtained in the recent FCC auction (see "Other Factors That May Affect Future Results"). We invested $2,099 million in acquisitions and investments in businesses in the first quarter of 2001, including $1,625 million for wireless licenses obtained in the recent FCC auction and $410 million for additional wireless spectrum purchased from another telecommunications carrier. In the first quarter of 2000, we invested $2,022 million in acquisitions and investments, including $975 million in subordinated convertible notes of MFN, $715 million in the equity of MFN, $205 million in wireless properties and $96 million in PrimeCo. CASH FLOWS PROVIDED BY (USED IN) FINANCING ACTIVITIES The net cash proceeds from increases in our total debt during the first quarter of 2001 of $4,348 million was primarily due to the issuance of $2.1 billion of long-term debt and $1.4 billion of commercial paper and other short-term borrowings by Verizon Global Funding, partially offset by $400 million maturity of other corporate long-term debt. In addition, Verizon Wireless issued $580 million of long-term debt and Domestic Telecom incurred $773 million of net short-term debt and retired $310 million of long-term debt. The $1,396 million increase in our total debt (including capital lease obligations) during the first quarter of 2000 was primarily due to the issuances of debt by Verizon Global Funding. Our debt ratio was 64.1% as of March 31, 2001, compared to 65.1% as of March 31, 2000. 23
26 As of March 31, 2001, we had in excess of $9.8 billion of unused bank lines of credit and $5.2 billion in bank borrowings outstanding. As of March 31, 2001, our telephone and financing subsidiaries had shelf registrations for the issuance of up to $3.5 billion of unsecured debt securities. The debt securities of our telephone and financing subsidiaries continue to be accorded high ratings by primary rating agencies. However, in April 2001, Moody's Investors Service (Moody's) revised our credit rating outlook from stable to negative. Moody's cited concern about our ability to complete an initial public offering (IPO) of Verizon Wireless in a timely fashion in order to pay for the recent FCC spectrum auction purchases of $8.8 billion. A delay in the IPO would require us to issue debt to cover these purchases. A change in an outlook does not necessarily signal a rating downgrade but rather highlights an issue whose final resolution may result in placing a company on review for possible downgrade. We also have a $2.0 billion Euro Medium Term Note Program, under which we may issue notes that are not registered with the SEC. The notes may be issued from time to time by Verizon Global Funding, and will have the benefit of a support agreement between Verizon Global Funding and us. There have been no notes issued under this program. As in prior quarters, dividend payments were a significant use of capital resources. We determine the appropriateness of the level of our dividend payments on a periodic basis by considering such factors as long-term growth opportunities, internal cash requirements, and the expectations of our shareowners. In the first quarter of 2001 and 2000, we announced a quarterly cash dividend of $.385 per share. DECREASE IN CASH AND CASH EQUIVALENTS Our cash and cash equivalents at March 31, 2001 totaled $689 million, a decrease of $68 million compared to December 31, 2000. MARKET RISK We are exposed to various types of market risk in the normal course of our business, including the impact of interest rate changes, foreign currency exchange rate fluctuations, changes in equity investment prices and changes in corporate tax rates. We employ risk management strategies using a variety of derivatives, including interest rate swap agreements, interest rate caps and floors, foreign currency forwards and options, equity options and basis swap agreements. We do not hold derivatives for trading purposes. It is our policy to enter into interest rate, foreign currency and other derivative transactions only to the extent necessary to achieve our desired objectives in limiting our exposures to the various market risks. Our objectives include maintaining a mix of fixed and variable rate debt to lower borrowing costs within reasonable risk parameters and protecting against earnings and cash flow volatility resulting from changes in market conditions. We do not hedge our market risk exposure in a manner that would completely eliminate the effect of changes in interest rates, equity prices and foreign exchange rates on our earnings. While we do not expect that our liquidity and cash flows will be materially affected by these risk management strategies, our net income may be materially affected by certain market risks associated with the exchangeable notes discussed below. EXCHANGEABLE NOTES In 1998, we issued exchangeable notes as described in Note 7 to the condensed consolidated financial statements and discussed earlier under "Mark-to-Market Adjustment - Financial Instruments." These financial instruments expose us to market risk, including: o Equity price risk, because the notes are exchangeable into shares that are traded on the open market and routinely fluctuate in value. o Foreign exchange rate risk, because the notes are exchangeable into shares that are denominated in a foreign currency. 24
27 o Interest rate risk, because the notes carry fixed interest rates. Periodically, equity price or foreign exchange rate movements may require us to mark-to-market the exchangeable note liability to reflect the increase or decrease in the current share price compared to the established exchange price, resulting in a charge or credit to income. The following sensitivity analysis measures the effect on earnings and financial condition due to changes in the underlying share prices of the TCNZ, C&W and NTL stock. o At March 31, 2001, the exchange price for the TCNZ shares (expressed as American Depositary Receipts) was $44.93. The C&W and NTL notes of $3,180 million are exchangeable into 128.4 million shares of C&W stock and 24.5 million shares of NTL stock. o For each $1 increase in the value of the TCNZ shares above the exchange price, our pretax earnings would be reduced by approximately $55 million. Assuming the aggregate value of the C&W and NTL stocks exceeds the value of the debt liability, each $1 increase in the value of the C&W shares (expressed as American Depositary Receipts) or NTL shares would reduce our pretax earnings by approximately $43 million or $24 million, respectively. A subsequent decrease in the value of these shares would correspondingly increase earnings, but not to exceed the amount of any previous reduction in earnings. o Our cash flows would not be affected by mark-to-market activity relating to the exchangeable notes. o If we decide to deliver shares in exchange for the notes, the exchangeable note liability (including any mark-to-market adjustments) will be eliminated and the investment will be reduced by the fair market value of the related number of shares delivered. Upon settlement, the excess of the liability over the book value of the related shares delivered will be recorded as a gain. We also have the option to settle these liabilities with cash upon exchange. EQUITY RISK We also have equity price risk associated with our cost investments, primarily in common stocks, and equity price sensitive derivatives and derivatives embedded in other financial instruments that are carried at fair value. The value of these cost investments and derivatives is subject to changes in the market prices of the underlying securities. Our cost investments and equity price sensitive derivatives recorded at fair value totaled $3,927 million at March 31, 2001. A sensitivity analysis of our cost investments and equity price sensitive derivatives recorded at fair value indicated that a 10% increase or decrease in the fair value of the underlying common stock equity prices would result in a $306 million increase or decrease in the fair value of our cost investments and equity price sensitive derivatives. Of this amount, a change in the fair value of our cost investments of $285 million would be recognized in Accumulated Other Comprehensive Loss in our condensed consolidated statement of changes in shareowners' investment under SFAS No. 115. Our equity price sensitive derivatives and embedded derivatives (primarily a MFN conversion option and several long-term call options on our common stock) (see Note 6 - Accounting Change-Derivative Financial Instruments) do not qualify for hedge accounting under SFAS No. 133. As such, a change of $21 million in the fair value of our equity price sensitive derivatives and embedded derivatives would be recognized in our condensed consolidated balance sheets and in current earnings in mark-to-market adjustment. We consider the recent declines in market value of our cost investments in C&W, NTL and MFN to be temporary, driven by overall weakness in the securities markets as well as telecommunications sector share prices. We continually evaluate our cost investments for impairment due to declines in market value considered to be other than temporary. That evaluation includes, in addition to persistent, declining stock prices, general economic and company-specific evaluations. In the event of a determination that a decline in market value is other than temporary, a significant charge to earnings could be recorded for all or a portion of the unrealized loss. 25
28 OTHER FACTORS THAT MAY AFFECT FUTURE RESULTS BELL ATLANTIC - GTE MERGER Federal and state regulatory conditions to the merger included certain commitments to, among other things, promote competition and the widespread deployment of advanced services while helping to ensure that consumers continue to receive high-quality, low-cost telephone services. In some cases there are significant penalties associated with not meeting these commitments. The cost of satisfying these commitments could have a significant impact on net income in future periods. The pretax cost to begin compliance with these conditions was approximately $200 million in 2000. We expect a similar impact in 2001 and 2002. RECENT DEVELOPMENTS VERIZON WIRELESS FCC Auctions Verizon Wireless was the winning bidder for 113 licenses in the FCC's auction of 1.9 GHz spectrum, which concluded in January 2001. These licenses would add capacity for growth and advanced services in markets including New York, Boston, Los Angeles, Chicago, Philadelphia, Washington, D.C., Seattle and San Francisco, for a total price of approximately $8.8 billion, $1.8 billion of which has already been paid and the balance of which will be paid when the FCC requires payment, which is expected to occur in 2001. There were no legal challenges to Verizon Wireless's qualifications to acquire these licenses. However, most of the licenses that were auctioned are the subject of pending litigation by the original licensees, NextWave Personal Communications Inc. and NextWave Power Partners Inc., which have appealed to the federal courts the FCC's action canceling NextWave's licenses and reclaiming the spectrum. If the licenses must be returned, the FCC's only obligation is to refund to winning bidders any amounts that they may have paid, without interest. Nearly all of Verizon Wireless's $8.8 billion license cost relates to licenses subject to NextWave's appeal. Timing of Initial Public Offering On October 16, 2000, we announced that Verizon Wireless would defer its planned IPO of common stock. Verizon and Vodafone agreed that, despite Verizon Wireless's strong third quarter subscriber growth, the recent volatility of capital markets has created an environment in which it is prudent to defer the offering. We announced in February 2001, and have periodically reiterated, that our bias is to complete the IPO in 2001. Price Communications Wireless During the fourth quarter of 2000, Verizon Wireless agreed to acquire Price Communications Wireless, a wholly owned subsidiary of Price Communications, for $1.5 billion in Verizon Wireless stock and the repayment by Verizon Wireless of $550 million in net debt. The transaction is conditioned upon completion of a Verizon Wireless IPO. The deal will significantly expand our footprint in the Southeastern U.S. and add approximately 500,000 customers. TELECOMMUNICATIONS ACT OF 1996 In-Region Long Distance We now have authority to offer in-region long distance service in two states in the former Bell Atlantic territory. In December 1999, the FCC released an order approving our application for permission to enter the in-region long distance market in New York. The U.S. Court of Appeals rejected both requests to stay and appeals of the New York order. On April 16, 2001 we received approval for our application to offer long distance in Massachusetts and on April 26, 2001, we began offering the service. One party has since appealed that order to the U.S. Court of Appeals and requested a stay pending a decision on its appeal. We intend to oppose this action. On April 23, 2001 we filed an application with the FCC for approval to offer in-region long distance in Connecticut. Under the terms of the Telecommunications Act of 1996 (the Telecommunications Act), the FCC is required to act on our application no later than July 23, 2001. 26
29 The accounting and consulting firm KPMG is conducting a review comparing operations support systems (OSS) in Rhode Island to those in Massachusetts and PricewaterhouseCoopers LLP is doing the same for the remaining New England states of Vermont, New Hampshire and Maine. FCC REGULATION AND INTERSTATE RATES Access Charges Interstate access charges are the rates long distance carriers pay for use and availability of our operating telephone subsidiaries' facilities for the origination and termination of interstate service. The FCC has adopted rules for special access services that provide for pricing flexibility and ultimately the removal of services from price regulation when prescribed competitive thresholds are met. In order to use these rules, carriers must forego the ability to take advantage of provisions in the current rules that provide relief in the event earnings fall below prescribed thresholds. In November and December 2000, we made filings to obtain this added pricing flexibility. On March 14, 2001, those petitions were granted. The flexibility granted includes the ability to remove from price cap regulation those interstate special access services in Metropolitan Statistical Areas (MSAs) that meet the competitive thresholds. We are authorized to remove special access and dedicated transport services from price caps in 35 of the 57 MSAs in the former Bell Atlantic territory and in three additional MSAs in the former GTE territory. In addition, the FCC found that in 10 MSAs we have met the stricter standards to remove special access connections to end-user customers from price caps. Unbundling of Network Elements In November 1999, the FCC announced its decision setting forth new unbundling requirements, eliminating elements that it had previously required to be unbundled, limiting the obligation to provide others and adding new elements. Appeals from this decision are pending. In addition to the unbundling requirements released in November 1999, the FCC released an order in a separate proceeding in December 1999, requiring incumbent local exchange companies also to unbundle and provide to competitors the higher frequency portion of their local loop. This provides competitors with the ability to provision data services on top of incumbent carriers' voice services. Appeals from this order are also pending. In July 2000, the U.S. Court of Appeals for the Eighth Circuit found that aspects of the FCC's requirements for pricing unbundled network elements (UNEs) were inconsistent with the Telecommunications Act. In particular, it found that the FCC was wrong to require incumbent carriers to base these prices not on their real costs but on the imaginary costs of a hypothetical carrier using the most efficient technologies and the most efficient network configuration. This portion of the Court of Appeals' decision has been stayed pending review by the U.S. Supreme Court. In addition, the Court of Appeals upheld the FCC's decision that UNEs should be priced based on a forward-looking cost model that ignores actual historical costs. The U.S. Supreme Court has accepted this decision for review in a case to be heard in the fall term of 2001. There are also several pending proceedings evaluating what network elements must be unbundled under the Telecommunications Act. In particular, in January 2001, the FCC opened a proceeding asking whether competing carriers may substitute combinations of unbundled loops and transport for already competitive special access services. We have opposed making unbundled elements available under these circumstances as inconsistent with the standards in the Telecommunications Act. That proceeding is expected to be resolved in 2001. In conjunction with several other incumbent local exchange carriers, we have also petitioned the FCC to remove unbundling requirements for high capacity loops and transport service. The petition asks the FCC to find that other carriers are not impaired in their ability to provide competing services without access to unbundled elements, and that these elements do not have to be provided on an unbundled basis under the standards set forth in the Telecommunications Act. 27
30 Compensation for Internet Traffic In March 2000, the United States Court of Appeals for the District of Columbia Circuit reversed and remanded the FCC's February 1999 order that concluded that calls to the Internet through Internet service providers (ISP) do not terminate at the ISP but are single interstate calls. The FCC had concluded that calls to the Internet are not therefore subject to reciprocal compensation under section 251(b)(5) of the Telecommunications Act, but left it to state regulatory commissions to determine whether local interconnection agreements entered into with competing carriers required the payment of compensation on such calls. On April 27, 2001, the FCC released an order responding to the court's remand. The FCC found that Internet-bound traffic is interstate and subject to the FCC's jurisdiction. Moreover, the FCC again found that Internet-bound traffic is not subject to reciprocal compensation under section 251(b)(5) of the Telecommunications Act. Instead, the FCC established federal rates that decline from $0.0015 to $0.0007 over a three year period. The FCC order also sets caps on the total minutes that may be subject to any intercarrier compensation and requires that incumbent local exchange carriers must offer to pay reciprocal compensation for local traffic at the same rate as they are required to pay on Internet-bound traffic. STATE REGULATION Verizon Pennsylvania On March 22, 2001, the Pennsylvania Public Utility Commission (PPUC) rejected the recommended decision of an administrative law judge and declined to order a retail/wholesale structural separation of Verizon Pennsylvania. Rather, the PPUC gave Verizon Pennsylvania the option of instituting a functional separation between its retail and wholesale businesses with a code of conduct. The PPUC also proposed that Verizon Pennsylvania maintain in Pennsylvania, the separate data affiliate it established when the FCC approved the merger of Bell Atlantic and GTE, decrease UNE loop rates in rural areas, and increase penalties payment under the Performance Assurance Plan. On April 20, 2001, Verizon Pennsylvania accepted the proposed order with the conditions described in that order. In addition, Verizon Pennsylvania withdrew most of the pending appeals. 28
31 CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS In this Management's Discussion and Analysis, and elsewhere in this Quarterly Report, we have made forward-looking statements. These statements are based on our estimates and assumptions and are subject to risks and uncertainties. Forward-looking statements include the information concerning our possible or assumed future results of operations. Forward-looking statements also include those preceded or followed by the words "anticipates," "believes," "estimates," "hopes" or similar expressions. For those statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. The following important factors, along with those discussed elsewhere in this Quarterly Report, could affect future results and could cause those results to differ materially from those expressed in the forward-looking statements: o materially adverse changes in economic conditions in the markets served by us or by companies in which we have substantial investments; o material changes in available technology; o an adverse change in the ratings afforded our debt securities by nationally accredited ratings organizations; o the final outcome of federal, state and local regulatory initiatives and proceedings, including arbitration proceedings, and judicial review of those initiatives and proceedings, pertaining to, among other matters, the terms of interconnection, access charges, universal service, and unbundled network elements and resale rates; o the extent, timing, success and overall effects of competition from others in the local telephone and intraLATA toll service markets; o the timing and profitability of our entry into the in-region long distance market; o our ability to combine former Bell Atlantic and GTE operations, satisfy regulatory conditions and obtain revenue enhancements and cost savings; o the profitability of our entry into the broadband access market; o the ability of Verizon Wireless to combine operations and obtain revenue enhancements and cost savings; o our ability to convert our ownership interest in Genuity into a controlling interest consistent with regulatory conditions, and Genuity's ensuing profitability; and o changes in our accounting assumptions that may be required by regulatory agencies, including the SEC, or that result from changes in the accounting rules or their application, which could result in an impact on earnings. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Information relating to market risk is included in Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations, in the Consolidated Financial Condition section under the caption "Market Risk." 29
32 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS On April 10, 2001, Telesector Resources Group, Inc. (TRG), a wholly owned indirect subsidiary of Verizon, entered into an agreement with the New York State Attorney General's Office to resolve on a civil basis, without a finding of liability on the part of TRG, the Attorney General's investigation of possible environmental violations and false document charges relating to the former Orangeburg, New York, Material Reclamation Center. Pursuant to the agreement TRG has paid a $100,000 civil penalty and $2.65 million in support of certain environmental projects. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits: <TABLE> <CAPTION> Exhibit Number ------ <S> <C> 12 Computation of Ratio of Earnings to Fixed Charges. </TABLE> (b) Reports on Form 8-K filed during the quarter ended March 31, 2001: A Current Report on Form 8-K, dated February 1, 2001, was filed regarding our 2000 financial results. A Current Report on Form 8-K, dated February 7, 2001, was filed regarding our financial outlook for 2001 as reported in a meeting on February 7, 2001 with the investment community. A Current Report on Form 8-K, dated March 28, 2001, was filed regarding material presented at an investment conference reiterating our previous financial guidance. 30
33 SIGNATURES 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. VERIZON COMMUNICATIONS INC. Date: May 15, 2001 By /s/ Lawrence R. Whitman -------------------------------------- Lawrence R. Whitman Senior Vice President and Controller (Principal Accounting Officer) UNLESS OTHERWISE INDICATED, ALL INFORMATION IS AS OF MAY 7, 2001. 31
34 INDEX TO EXHIBITS <TABLE> <CAPTION> EXHIBIT NUMBER DESCRIPTION - ------- ----------- <S> <C> 12 Computation of Ratio of Earnings to Fixed Charges </TABLE>