10-Q 1 d10q.txt VERIZON CALIFORNIA 2ND QUARTER FORM 10-Q 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 June 30, 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 1-6417 VERIZON CALIFORNIA INC. A California Corporation I.R.S. Employer Identification No. 95-0510200 1095 Avenue of the Americas, Room 3868, New York, New York 10036 Telephone Number (212) 395-2121 ------------------------- THE REGISTRANT MEETS THE CONDITIONS SET FORTH IN GENERAL INSTRUCTION H(1)(a) AND (b) OF FORM 10-Q AND IS THEREFORE FILING THIS FORM WITH REDUCED DISCLOSURE FORMAT PURSUANT TO GENERAL INSTRUCTION H(2). Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- Verizon California Inc. PART I - FINANCIAL INFORMATION Item 1. Financial Statements CONDENSED CONSOLIDATED STATEMENTS OF INCOME

See Notes to Condensed Consolidated Financial Statements. 1 Verizon California Inc. CONDENSED CONSOLIDATED BALANCE SHEETS ASSETS ------

See Notes to Condensed Consolidated Financial Statements. 2 Verizon California Inc. CONDENSED CONSOLIDATED BALANCE SHEETS LIABILITIES AND SHAREOWNER'S INVESTMENT ---------------------------------------

See Notes to Condensed Consolidated Financial Statements. 3 Verizon California Inc. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

See Notes to Condensed Consolidated Financial Statements. 4 Verizon California Inc. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. Basis of Presentation Verizon California Inc. is a wholly owned subsidiary of GTE Corporation (GTE), which is a wholly owned subsidiary of Verizon Communications Inc. (Verizon Communications). The accompanying unaudited condensed consolidated financial statements have been prepared based upon Securities and Exchange Commission rules that permit reduced disclosure for interim periods. These financial statements reflect all adjustments that are necessary for a fair presentation of results of operations and financial position for the interim periods shown including normal recurring accruals. The results for the interim periods are not necessarily indicative of results for the full year. The balance sheet at December 31, 2000 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. For a more complete discussion of significant accounting policies and certain other information, you should refer to the financial statements included in our 2000 Annual Report on Form 10-K. We have reclassified certain amounts from prior year's data to conform to the 2001 presentation. 2. Revenue Recognition We recognize revenue when services are rendered based on usage of our local exchange network and facilities. For other products and services, revenues are generally recognized when services are rendered or products are delivered to customers. We defer nonrecurring service activation revenues and costs and amortize them over the expected term of the customer relationship. The deferred costs are equal to the activation fee revenue and any excess cost is expensed immediately. The deferred costs represent incremental direct costs associated with certain nonrecurring fees, such as service activation and installation fees. 3. Long-Lived Assets We assess the impairment of long-lived assets under Statement of Financial Accounting Standards (SFAS) No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" whenever events or changes in circumstances indicate that the carrying value may not be recoverable. A determination of impairment (if any) is made based on estimates of future cash flows. 4. Dividend On August 1, 2001, we declared and paid a dividend in the amount of $180.0 million to GTE. 5. Derivatives and Hedging Activities 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 fair value 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. We presently do not have any derivative instruments or hedging activities and, consequently, SFAS No. 133 did not have an impact on our financial statements. 6. Recent Accounting Pronouncements In June 2001, the Financial Accounting Standards Board issued SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. Use of the pooling-of-interests method is no longer permitted. SFAS No. 141 also includes guidance on the initial 5 Verizon California Inc. recognition and measurement of goodwill and other intangible assets acquired in a business combination that is completed after June 30, 2001. SFAS No. 142 no longer permits the amortization of goodwill and indefinite-lived intangible assets. Instead, these assets must be reviewed annually (or more frequently under certain conditions) for impairment in accordance with this statement. This impairment test uses a fair value approach rather than the undiscounted cash flows approach previously required by SFAS No. 121. Intangible assets that do not have indefinite lives will continue to be amortized over their useful lives and reviewed for impairment in accordance with SFAS No. 121. We are required to adopt SFAS No. 142 effective January 1, 2002. We are currently evaluating our intangible assets in relation to the provisions of SFAS No. 142 to determine the impact, if any, the adoption of SFAS No. 142 will have on our results of operations or financial position. 7. Merger Charges In connection with the merger of Bell Atlantic and GTE on June 30, 2000, we incurred charges associated with employee severance of $51.5 million pre-tax. Employee severance costs, as recorded under SFAS No. 112, "Employers' Accounting for Postemployment Benefits," represent the benefit costs for the separation of management employees who were entitled to benefits under pre-existing separation plans, as well as an accrual for ongoing SFAS No. 112 obligations for former GTE employees. During the second quarter of 2000, in connection with the merger, we also recorded a pre-tax charge of $32.3 million for direct, incremental merger-related costs, including compensation, professional services and other direct costs. In addition, we recorded pre-tax merger-related transition costs of $15.8 million in the first six months of 2001. Transition costs consisted of costs to integrate systems, consolidate real estate, relocate employees and meet certain regulatory conditions of the merger. They also included costs for advertising and other costs to establish the Verizon brand. Transition costs since the date of the merger totaled $26.6 million. Transition costs are expensed as incurred. During the second quarter of 2000, we also recorded a $2.5 million pre-tax charge for other actions in relation to the Bell Atlantic-GTE merger. Results of operations for the first six months of 2000 also included adjustments that were required to conform our accounting methods and presentation to that of Verizon Communications. These conforming adjustments are differences in capitalization policies. As a result of these adjustments, operating income increased $9.1 million for the six month period ended June 30, 2000. 8. Shareowner's Investment

Net income and comprehensive income were the same for the six months ended June 30, 2001 and 2000. 9. Net Assets Held For Sale During May 1999, we entered into an agreement to sell approximately 46,000 switched access lines located in California and Arizona to Citizens Utilities Company. This agreement consummates our previously announced 1998 plan to sell selected access lines located in California and Arizona. The sale is contingent upon final agreements and regulatory approval, the latter of which has been obtained, and is expected to close during 2001. The associated net assets, which approximate $50.8 million and $46.9 million at June 30, 2001 and December 31, 2000, respectively, consist of property, plant and equipment, and have been classified as "Net assets held for sale" in the balance sheets. We intend to continue to operate all of these assets until sold. Given the decision to sell, no depreciation expense was recorded for these assets during 2000 or 2001 in accordance with SFAS No. 121. Accordingly, depreciation expense was lowered by $2.1 million and $4.2 million for the three and six months ended June 30, 2001 and $2.1 million and $4.2 million for the three and six months ended June 30, 2000, respectively. No charges were recorded for the access lines to be sold because their estimated fair values were in excess of their carrying values. The access line agreement represents approximately 1.0% of the switched access lines that we had in service at the end of 2000, and contributed approximately 1.0% to 2000 revenues and approximately 1.0% to 2000 operating income. 6 Verizon California Inc. 10. Commitments and Contingencies Various legal actions and regulatory proceedings are 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 which 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. Several regulatory matters may require us to refund a portion of the revenues collected in the current and prior periods. The outcome of each pending matter, as well as the time frame within which each matter will be resolved, is not presently determinable. Regulatory conditions to the Bell Atlantic - GTE merger include 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. 7 Verizon California Inc. Item 2. Management's Discussion and Analysis of Results of Operations (Abbreviated pursuant to General Instruction H(2).) This discussion should be read in conjunction with the Financial Statements and Notes to Financial Statements. RESULTS OF OPERATIONS --------------------- We reported net income of $362.3 million for the six month period ended June 30, 2001, compared to net income of $402.0 million for the same period in 2000. Our results for 2001 and 2000 were affected by special items. The special items in both periods include our allocated share of charges from affiliates that provide various centralized services on behalf of Verizon Communications Inc. subsidiaries. The following table shows how special items are reflected in our consolidated statements of income for each period:

What follows is a further explanation of the nature of these special items. Merger Charges In connection with the merger of Bell Atlantic and GTE on June 30, 2000, we incurred charges associated with employee severance of $51.5 million pre-tax. Employee severance costs, as recorded under SFAS No. 112, "Employers' Accounting for Postemployment Benefits," represent the benefit costs for the separation of management employees who were entitled to benefits under pre-existing separation plans, as well as an accrual for ongoing SFAS No. 112 obligations for former GTE employees. During the second quarter of 2000, in connection with the merger, we also recorded a pre-tax charge of $32.3 million for direct, incremental merger-related costs, including compensation, professional services and other direct costs. In addition, we recorded pre-tax merger-related transition costs of $15.8 million in the first six months of 2001. Transition costs consisted of costs to integrate systems, consolidate real estate, relocate employees and meet certain regulatory conditions of the merger. They also included costs for advertising and other costs to establish the Verizon brand. Transition costs are expensed as incurred. During the second quarter of 2000, we also recorded a $2.5 million pre-tax charge for other actions in relation to the Bell Atlantic - GTE merger Results of operations for the first six months of 2000 also included adjustments that were required to conform our accounting methods and presentation to that of Verizon Communications. These conforming adjustments are differences in capitalization policies. As a result of these adjustments, operating income increased $9.1 million for the six month period ended June 30, 2000. 8 Verizon California Inc. Other Charges and Special Items In the second quarter of 2000, we recognized a pre-tax charge for a regulatory matter totaling $1.9 million. We recorded a reduction to operating revenue in the amount of $1.5 million and a charge to interest expense of $.4 million. This matter relates to a specific issue currently under investigation by the Federal Communications Commission (FCC). We believe that it is probable that the ultimate resolution of this matter will result in refunds to customers, including interest. In the second quarter of 2000, we also recorded other charges and special items totaling approximately $5.8 million pre-tax. These and other items affecting the comparison of our results of operations for the six month periods ended June 30, 2001 and 2000 are discussed in the following sections. OPERATING REVENUES ------------------ (Dollars in Millions)

LOCAL SERVICES 2001 - 2000 Increase -------------------------------------------------------------------------------- Six Months $1.2 0.1% -------------------------------------------------------------------------------- Local service revenues are earned 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 revenues, 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. The increase in local service revenues was driven primarily by increased demand for value-added services as a result of new packaging of services. This increase was substantially offset by the effects of certain regulatory matters in 2000 and price reductions on certain local services in 2001. Local service revenues also reflect the impact of an economic slowdown during the first half of 2001. NETWORK ACCESS SERVICES 2001 - 2000 Increase -------------------------------------------------------------------------------- Six Months $43.8 7.3% -------------------------------------------------------------------------------- Network access revenues are earned from end-user subscribers and from 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. The growth in network access revenues was mainly attributable to increased demand for special access services. This growth reflects a continuing expansion of the business market, particularly for high-capacity, high-speed digital services. Volume-related growth was partially offset by mandated price reductions on certain interstate and intrastate access services and other regulatory decisions. The FCC regulates 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 9 Verizon California Inc. the Coalition for Affordable Local and Long Distance Service (CALLS) plan. Rates included in the July 2000 CALLS plan were in effect through June 2001. The impact of the slowing economy also affected network access revenues in 2001. LONG DISTANCE SERVICES 2001 - 2000 (Decrease) -------------------------------------------------------------------------------- Six Months $(19.9) (20.9)% -------------------------------------------------------------------------------- Long distance revenues are earned primarily from calls made to points outside a customer's local calling area, but within our service area (intraLATA toll). IntraLATA toll calls originate and terminate within the same LATA, but generally cover a greater distance than a local call. These services are regulated by state regulatory commissions except where they cross state lines. Other long distance services that we provide include 800 services and Wide Area Telephone Service (WATS). The decline in long distance revenues was principally caused by the competitive effects of other providers of long distance services, as well as the effect of price reductions of certain long distance services. OTHER SERVICES 2001 - 2000 Increase -------------------------------------------------------------------------------- Six Months $25.7 18.5% -------------------------------------------------------------------------------- Our other services include such services as billing and collections for long distance carriers and affiliates, facilities rentals to affiliates and nonaffiliates, public (pay) telephone and customer premises equipment (CPE). Other service revenues also include fees paid by customers for non-publication of telephone numbers and multiple white page listings and fees paid by an affiliate for usage of our directory listings. The growth in other service revenues was primarily attributable to increased sales and services to affiliates and higher revenues from billing and collection services and CPE sales. OPERATING EXPENSES ------------------ (Dollars in Millions) OPERATIONS AND SUPPORT 2001 - 2000 Increase -------------------------------------------------------------------------------- Six Months $129.8 23.2% -------------------------------------------------------------------------------- Operations and support expenses consist of employee costs and other operating expenses. Employee costs consist of salaries, wages and other employee compensation, employee benefits and payroll taxes. Other operating expenses consist of contract services including centralized services expenses allocated from affiliates, rent, network software costs, operating taxes other than income, the provision for uncollectible accounts receivable, reciprocal compensation, and other costs. Operations and support expenses increased primarily due to the effect of pre-tax gains recorded in the first half of 2000 associated with lump-sum settlements of pension obligations for certain active and former employees. These cost increases were partially offset by the effect of merger-related costs and other special items recorded in 2000 and 2001, as described in the Results of Operations section. Operating costs have also decreased due to business integration activities, declining work force levels and a reduction in materials and supplies. We continue to incur expenditures related to reciprocal compensation arrangements with competitive local exchange carriers and other carriers to terminate calls on their network. 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 10 Verizon California Inc. 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. DEPRECIATION AND AMORTIZATION 2001 - 2000 Increase -------------------------------------------------------------------------------- Six Months $3.5 1.1% -------------------------------------------------------------------------------- Depreciation and amortization expense increased principally due to growth in depreciable telephone plant as a result of increased capital expenditures for higher growth services. This factor was partially offset by the effect of lower rates of depreciation. Partially affecting the change in depreciation and amortization expense were adjustments made to conform the accounting policies of Bell Atlantic and GTE as a result of the merger, as described in Results of Operations. INTEREST EXPENSE 2001 - 2000 Increase -------------------------------------------------------------------------------- Six Months $6.2 8.5% -------------------------------------------------------------------------------- Interest expense includes costs associated with borrowings and capital leases, net of interest capitalized as a cost of acquiring or constructing plant assets. Interest expense increased in the first six months of 2001, compared to the same period in 2000, primarily due to overall higher levels of average borrowings, partially offset by higher capitalized interest costs associated with telephone plant under construction. EFFECTIVE INCOME TAX RATES Six Months Ended June 30, -------------------------------------------------------------------------------- 2001 40.9% -------------------------------------------------------------------------------- 2000 42.7% -------------------------------------------------------------------------------- The effective income tax rate is the provision for income taxes as a percentage of income before provision for income taxes. Our effective income tax rate was lower for the six months ended June 30, 2001, compared to the same period in 2000, primarily due to a decrease in preferred dividends and a decrease in non-recurring income tax expense. OTHER MATTERS ------------- Recent Accounting Pronouncements In June 2001, the Financial Accounting Standards Board issued SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. Use of the pooling-of-interests method is no longer permitted. SFAS No. 141 also includes guidance on the initial 11 Verizon California Inc. recognition and measurement of goodwill and other intangible assets acquired in a business combination that is completed after June 30, 2001. SFAS No. 142 no longer permits the amortization of goodwill and indefinite-lived intangible assets. Instead, these assets must be reviewed annually (or more frequently under certain conditions) for impairment in accordance with this statement. This impairment test uses a fair value approach rather than the undiscounted cash flows approach previously required by SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." Intangible assets that do not have indefinite lives will continue to be amortized over their useful lives and reviewed for impairment in accordance with SFAS No. 121. We are required to adopt SFAS No. 142 effective January 1, 2002. We are currently evaluating our intangible assets in relation to the provisions of SFAS No. 142 to determine the impact, if any, the adoption of SFAS No. 142 will have on our results of operations or financial position. 12 Verizon California Inc. PART II - OTHER INFORMATION Item 1. Legal Proceedings There were no proceedings reportable under this Item. Item 6. Exhibits and Reports on Form 8-K (b) There were no Current Reports on Form 8-K filed during the quarter ended June 30, 2001. 13 Verizon California Inc. 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 California Inc. Date: August 13, 2001 By /s/ Edwin F. Hall --------------------------- Edwin F. Hall Controller UNLESS OTHERWISE INDICATED, ALL INFORMATION IS AS OF AUGUST 8, 2001. 14

VERIZON CALIFORNIA INC 10-Q