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Business Context and Reporting Period

This Form 10-Q covers SBC Communications Inc. for the quarterly and six-month periods ended June 30, 1998. SBC is a major telecommunications provider operating primarily through its subsidiaries Southwestern Bell Telephone Company (SWBell) and Pacific Telesis Group (PAC). The company is currently in the process of integrating its merger with PAC (completed April 1997) and has announced definitive merger agreements with Ameritech Corporation and Southern New England Telecommunications Corporation (SNET).

Key Financial Metrics

Note: Free Cash Flow is calculated as Operating Cash Flow minus Capital Expenditures.

Material Changes vs. Prior Period

• Profitability Surge: The company reported a net income of $966 million for Q2 1998, a dramatic turnaround from a net loss of $787 million in Q2 1997. This improvement is largely attributable to the absence of $1.6 billion in after-tax charges recorded in Q2 1997 related to merger integration, asset impairments, and regulatory rulings.
• Revenue Growth: Operating revenues increased 11.3% in Q2 1998 and 9.4% year-to-date. Key drivers included an 8.2% increase in landline local service, an 11.6% increase in wireless local service, and a 28.8% increase in interstate network access (partially due to one-time regulatory settlements in 1997).
• Expense Reduction: Total operating expenses decreased 28.8% in Q2 1998 compared to Q2 1997. Excluding the one-time 1997 charges, operating expenses actually increased by 5.0% in 1998 due to higher costs for Personal Communications Services (PCS) operations and the implementation of the Federal universal service fund.
• Debt Management: The debt ratio improved from 59.65% to 53.69%. SBC retired $630 million in long-term debt in February 1998 and issued approximately $400 million in new debentures.

Outlook, Risks, and Management Commentary

• Mergers: SBC has definitive agreements to merge with Ameritech (exchange ratio 1.316 shares) and SNET (exchange ratio 1.7568 shares). Both transactions are subject to regulatory approvals and shareholder votes, with the SNET merger expected to close by the end of 1998 if approved.
• Regulatory Risks:
  • Reciprocal Compensation: Ongoing disputes regarding payments to Competitive Local Exchange Carriers (CLECs) for terminating Internet traffic. State commissions in Texas, Missouri, and Oklahoma have ordered payments, while SBC argues the FCC has jurisdiction over interstate traffic.
  • Universal Service: The California Public Utilities Commission (CPUC) issued a rate rebalancing decision in July 1998, reducing PacBell rates to offset high-cost fund receipts.
• Year 2000 Project: SBC estimates total expenses for Y2K compliance to be less than $250 million, with approximately $60 million incurred through June 30, 1998. Nearly half of the systems deployment was complete as of the reporting date.
• Accounting Changes: SBC is evaluating the impact of FAS 133 (Derivatives) and a new SOP on software costs, which may require capitalization of certain expenditures starting in 1999.

Investor Verification Checklist

• Merger Approvals: Verify the status of regulatory approvals for the Ameritech and SNET mergers, as these are critical to future growth and integration costs.
• Regulatory Settlements: Monitor the outcome of the reciprocal compensation disputes regarding Internet traffic, as state rulings could significantly impact future operating expenses.
• PCS Expansion Costs: Review the trajectory of expenses related to Personal Communications Services (PCS) operations, which are currently driving cost increases.
• Y2K Budget Adherence: Track actual Year 2000 compliance spending against the $250 million estimate to ensure no material overruns.
• Asset Impairments: Confirm that the significant asset write-offs and impairments recorded in 1997 were one-time events and do not signal ongoing asset valuation issues.