10-Q 1 d10q.txt GTE SOUTHWEST 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, 2002 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 1-7077 GTE SOUTHWEST INCORPORATED A Delaware Corporation I.R.S. Employer Identification No. 75-0573444 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 --- --- GTE Southwest Incorporated PART I - FINANCIAL INFORMATION Item 1. Financial Statements CONDENSED STATEMENTS OF INCOME

See Notes to Condensed Financial Statements. 1 GTE Southwest Incorporated CONDENSED BALANCE SHEETS ASSETS ------

See Notes to Condensed Financial Statements. 2 GTE Southwest Incorporated CONDENSED BALANCE SHEETS LIABILITIES AND SHAREOWNER'S INVESTMENT ---------------------------------------

See Notes to Condensed Financial Statements. 3 GTE Southwest Incorporated CONDENSED STATEMENTS OF CASH FLOWS

See Notes to Condensed Financial Statements. 4 GTE Southwest Incorporated NOTES TO CONDENSED FINANCIAL STATEMENTS (Unaudited) 1. Basis of Presentation GTE Southwest Incorporated 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 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, 2001 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 2001 Annual Report on Form 10-K. We have reclassified certain amounts from prior year's data to conform to the 2002 presentation. 2. Adoption of New Accounting Standards Goodwill and Other Intangible Assets Effective January 1, 2002, we adopted Statement of Financial Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets." 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 prescribed 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." The goodwill impairment test under SFAS No. 142 requires a two-step approach, which is performed at the reporting unit level, as defined in SFAS No. 142. Step one identifies potential impairments by comparing the fair value of the reporting unit to its carrying amount. Step two, which is only performed if there is a potential impairment, compares the carrying amount of the reporting unit's goodwill to its implied value, as defined in SFAS No. 142. If the carrying amount of the reporting unit's goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized for an amount equal to that excess. Intangible assets that do not have indefinite lives are amortized over their useful lives and reviewed for impairment in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." The adoption of SFAS No. 142 did not impact our results of operations or financial position because we had no goodwill or other intangible assets at December 31, 2001 and 2000. Impairment or Disposal of Long-Lived Assets Effective January 1, 2002, we adopted SFAS No. 144. This standard supersedes SFAS No. 121 and the provisions of Accounting Principles Board (APB) Opinion No. 30, "Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions," with regard to reporting the effects of a disposal of a segment of a business. SFAS No. 144 establishes a single accounting model for assets to be disposed of by sale and addresses several SFAS No. 121 implementation issues. The adoption of SFAS No. 144 did not have a material effect on our results of operations or financial position. 3. Recent Accounting Pronouncements Asset Retirement Obligations In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 143, "Accounting for Asset Retirement Obligations." This standard provides the accounting for the cost of legal obligations associated with the retirement of long-lived assets. SFAS No. 143 requires that companies recognize the fair value of a liability for asset retirement obligations in the period in which the obligations are incurred and capitalize that amount as a part of the book value of the long-lived asset. That cost is then depreciated over the remaining life of the underlying long-lived asset. We are required to adopt SFAS No. 143 effective January 1, 2003. We are currently evaluating the impact this new standard will have on our future results of operations or financial position. 5 GTE Southwest Incorporated Debt Extinguishment In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections." SFAS No. 145, among other things, eliminates the requirement that all gains and losses on the extinguishment of debt must be classified as extraordinary items on the income statement, thereby permitting the classification of such gains and losses as extraordinary items only if the criteria of APB Opinion No. 30, "Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions," are met. We are required to adopt this provision of SFAS No. 145 no later than January 1, 2003 and upon adoption we will reclassify in our statements of income previously reported extraordinary charges for the early extinguishment of debt to income from continuing operations. Exit or Disposal Activities In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." This standard addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." EITF Issue No. 94-3 required accrual of liabilities related to exit and disposal activities at a plan (commitment) date. SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. The provisions of this standard are effective for exit or disposal activities that are initiated after December 31, 2002. 4. Dividend On August 1, 2002, we declared and paid a dividend in the amount of $60.0 million to GTE. 5. Shareowner's Investment

Net income and comprehensive income were the same for the six months ended June 30, 2002 and 2001. 6. 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 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. Several regulatory matters may require us to refund to customers 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 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. 6 GTE Southwest Incorporated 7. Investment in Verizon Ventures III Inc. In December, 2000, we transferred certain advanced data assets to an affiliated company, Verizon Ventures III Inc. (Ventures III) in exchange for common stock of Ventures III. This transfer was done to satisfy a condition of the Federal Communications Commission's (FCC) approval of the Bell Atlantic - GTE merger, which required the provision of advanced data services through a separate affiliate. Throughout 2000 and 2001, we continued to invest in Ventures III through the transfer of additional assets. As a result of the transfers, we acquired an ownership interest in Ventures III, which we accounted for under the equity method of accounting. In September 2001, the FCC issued an order eliminating this merger condition. Following the FCC order, we made necessary filings with our state regulatory commission for approval of the transfer of these assets back to us. During the fourth quarter of 2001, after required state regulatory approvals were obtained, Ventures III transferred these assets to us. In consideration of the transfer of these assets, we surrendered our common stock in Ventures III and remitted cash compensation. No gain or loss was recognized as a result of the reintegration of the advanced data assets to us. This reintegration did not have a material effect on our results of operations or financial condition. 8. Employee Severance and Other Items In connection with the Bell Atlantic-GTE merger on June 30, 2000, we incurred charges associated with employee severance of $30.0 million. These 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 of ongoing SFAS No. 112 obligations for GTE employees. As of June 30, 2002, the severances in connection with the Bell Atlantic-GTE merger are complete. During the fourth quarter of 2001, we recorded a charge of $4.5 million for the voluntary and involuntary separation of employees in accordance with SFAS No. 112. During the second quarter of 2002, we recorded a charge of $3.2 million in accordance with SFAS No. 112 associated with employee severance. As of June 30, 2002, a total of approximately 110 employees have been separated under the 2001 and 2002 severance programs. The remaining severance liability relating to these programs is $2.6 million, which includes future payments to employees separated as of June 30, 2002. We expect to complete the severance programs within a year of when the charge was recorded. In addition, during the second quarter of 2002, we recorded an impairment charge of $8.4 million driven by our financial statement exposure of WorldCom Inc. 7 GTE Southwest Incorporated 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 Condensed Financial Statements and Condensed Notes to Financial Statements. RESULTS OF OPERATIONS --------------------- We reported net income of $92.2 million for the six month period ended June 30, 2002, compared to net income of $131.2 million for the same period in 2001. Our reported results for the first half of 2002 included the following special items: Employee Severance and Other Items During the second quarter of 2002, we recorded a charge of $3.2 million in accordance with Statement of Financial Accounting Standards (SFAS) No.112, "Employers' Accounting for Postemployment Benefits," associated with employee severance. In addition, during the second quarter of 2002, we recorded an impairment charge of $8.4 million driven by our financial statement exposure of WorldCom Inc. Verizon Ventures III During 2000 and 2001, pursuant to one of the Federal Communications Commission's (FCC) requirements for the Bell Atlantic - GTE merger, we transferred our advanced data assets to Verizon Ventures III Inc. (Ventures III) in exchange for an ownership interest in Ventures III, which we accounted for under the equity method of accounting. In September 2001, the FCC issued an order eliminating this merger condition. In the fourth quarter of 2001, after required state regulatory approvals were obtained, these assets were transferred back to us and we surrendered our ownership in Ventures III. (See Note 7 to the Condensed Financial Statements.) This reintegration principally affected our comparison of Network access services revenues, Operations and support expenses, Other income and (expense), net, and the Provision for income taxes, as described below. OPERATING REVENUES ------------------ (Dollars in Millions) Six Months Ended June 30, ------------------------------------------ 2002 2001 ------------------------------------------------------------------------------ Local services $376.0 $395.1 Network access services 224.8 222.9 Long distance services 10.8 13.0 Other services 61.6 58.7 ------------------------------------------ Total $673.2 $689.7 ========================================== We recognize service revenues based upon usage of our local exchange network and facilities and contract fees. We recognize product and other service revenues when the products are delivered and accepted by the customers and when services are provided in accordance with contract terms. 8 GTE Southwest Incorporated LOCAL SERVICES 2002 - 2001 (Decrease) -------------------------------------------------------------------------------- Six Months $(19.1) (4.8)% -------------------------------------------------------------------------------- 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 (CLECs), certain data transport revenues and wireless interconnection revenues. Local service revenues decreased in the first six months of 2002 primarily due to the effect of lower demand and usage of some basic wireline services, as reflected by a decline in our switched access lines in service of 2.7% from June 30, 2001. This decrease primarily reflects the impact of the economic slowdown and competition. In addition, lower billings to CLECs for interconnection of their network with our network, also contributed to the decrease in local service revenues. Rate reductions resulting from expanded calling area service implementations effective January 1, 2002 and technology substitution have also affected local service revenue growth in the first half of 2002. NETWORK ACCESS SERVICES 2002 - 2001 Increase -------------------------------------------------------------------------------- Six Months $1.9 .9% -------------------------------------------------------------------------------- Network access service 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. Network access service revenue increased in the first six months of 2002 primarily due to higher customer demand for special access services, particularly for high-capacity, high-speed digital services, and to the reintegration of Ventures III. These increases were substantially offset by the effects of mandated price reductions on interstate access services and other regulatory decisions. In addition, growth in switched access service revenue declined in the first half of 2002 due to the impact of the slowing economy, as reflected by a decline in minutes of use from carriers and CLECs. LONG DISTANCE SERVICES 2002 - 2001 (Decrease) -------------------------------------------------------------------------------- Six Months $(2.2) (16.9)% -------------------------------------------------------------------------------- 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 the Texas Public Utility Commission (TPUC) except where they cross state lines. Other long distance services that we provide include 800 services and Wide Area Telephone Service (WATS). We also earn revenue from private line and operator services associated with long distance calls. Long distance service revenues declined in the first six months of 2002 primarily due to the effects of competition, technology substitution and the slowing economy. 9 GTE Southwest Incorporated OTHER SERVICES 2002 - 2001 Increase -------------------------------------------------------------------------------- Six Months $2.9 4.9% -------------------------------------------------------------------------------- Our other services include such services as billing and collections for long distance carriers and affiliates, facilities rentals to affiliates and non-affiliates, 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, fees paid by an affiliate for usage of our directory listings and fees paid by an affiliate for the provision of sales agent services. Other service revenues increased in the first six months of 2002 primarily due to higher rates charged to customers for late payment fees and an increase in sales and services to affiliates. These increases were partially offset by a decrease in CPE sales. OPERATING EXPENSES ------------------ (Dollars in Millions) OPERATIONS AND SUPPORT 2002 - 2001 Increase -------------------------------------------------------------------------------- Six Months $45.9 14.7% -------------------------------------------------------------------------------- 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. The increase in operations and support expenses was primarily attributable to the effect of a favorable adjustment recorded in 2001 associated with the previous sale of assets, as well as higher centralized services expenses allocated to us by Verizon Services. An increase in the provision for uncollectible accounts receivable, the reintegration of Ventures III and employee severance costs recorded in the second quarter of 2002 also contributed to the increase in operations and support expenses. These increases were partially offset by effective cost control measures and lower interconnection and related costs associated with reciprocal compensation arrangements. The effect of declining workforce levels further offset the increase in operations and support expenses for the six months ended June 30, 2002. DEPRECIATION AND AMORTIZATION 2002 - 2001 Increase -------------------------------------------------------------------------------- Six Months $1.1 .8% -------------------------------------------------------------------------------- Depreciation expense is principally based on the composite group remaining life method and straight-line composite rates. This method provides for the recognition of the cost of the remaining net investment in telephone plant, less anticipated net salvage value, over the remaining asset lives. This method requires the periodic revision of depreciation rates. Depreciation and amortization expense increased in the first six months of 2002 primarily due to growth in depreciable telephone plant and, to a lesser extent, increased software amortization costs. These increases were substantially offset by the effect of lower rates of depreciation. 10 GTE Southwest Incorporated OTHER RESULTS ------------- (Dollars in Millions) OTHER INCOME AND (EXPENSE), NET 2002 - 2001 Increase -------------------------------------------------------------------------------- Six Months $7.4 104.2% -------------------------------------------------------------------------------- Other income and (expense), net includes equity income (losses), interest income and other nonoperating income and expense items. As a result of the reintegration of Ventures III in the fourth quarter of 2001, we no longer recognize equity income (losses) from this investment. The increase in other income and (expense), net, was primarily attributable to the effect of equity losses recognized in 2001 from our investment in Ventures III. INTEREST EXPENSE 2002 - 2001 Increase -------------------------------------------------------------------------------- Six Months $3.0 12.4% -------------------------------------------------------------------------------- Interest expense includes costs associated with borrowing and capital leases, net of capitalized interest costs. We capitalize interest associated with the acquisition or construction of plant assets. Capitalized interest is reported as a cost of plant and a reduction in interest expense. Interest expense increased in the first six months of 2002, over the same period in 2001, primarily due to the effect of higher average levels of short-term debt with an affiliate and additional interest expense associated with the settlement of tax-related matters. EFFECTIVE INCOME TAX RATES Six Months Ended June 30, -------------------------------------------------------------------------------- 2002 37.7% -------------------------------------------------------------------------------- 2001 36.6% -------------------------------------------------------------------------------- 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 higher for the six months ended June 30, 2002, compared to the same period in 2001, primarily due to an increase in the effective income tax rate for state income taxes. This increase was partially offset by the effect of equity losses associated with our investment in Ventures III, which were recorded in 2001, for which we did not recognize income tax benefits and by a decrease in non-recurring income tax expense. 11 GTE Southwest Incorporated OTHER MATTERS ------------- Recent Accounting Pronouncements Asset Retirement Obligations In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 143, "Accounting for Asset Retirement Obligations." This standard provides the accounting for the cost of legal obligations associated with the retirement of long-lived assets. SFAS No. 143 requires that companies recognize the fair value of a liability for asset retirement obligations in the period in which the obligations are incurred and capitalize that amount as a part of the book value of the long-lived asset. That cost is then depreciated over the remaining life of the underlying long-lived asset. We are required to adopt SFAS No. 143 effective January 1, 2003. We are currently evaluating the impact this new standard will have on our future results of operations or financial position. Debt Extinguishment In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections." SFAS No. 145, among other things, eliminates the requirement that all gains and losses on the extinguishment of debt must be classified as extraordinary items on the income statement, thereby permitting the classification of such gains and losses as extraordinary items only if the criteria of APB Opinion No. 30, "Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions," are met. We are required to adopt this provision of SFAS No. 145 no later than January 1, 2003 and upon adoption we will reclassify in our statements of income previously reported extraordinary charges for the early extinguishment of debt to income from continuing operations. Exit or Disposal Activities In June 2002, the FASB issued SFAS No. 46, "Accounting for Costs Associated with Exit or Disposal Activities." This standard addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." EITF Issue No. 94-3 required accrual of liabilities related to exit and disposal activities at a plan (commitment) date. SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. The provisions of this standard are effective for exit or disposal activities that are initiated after December 31, 2002. Compensation for Internet Traffic We continue to incur expenditures related to reciprocal compensation arrangements with CLECs and other carriers to terminate calls on their network. On April 27, 2001, the FCC released an order addressing intercarrier compensation for dial-up connections for Internet-bound traffic. 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 1996 Act. Instead, the FCC established federal rates per minute for this traffic that decline from $0.0015 to $0.0007 over a three-year period. The FCC order also sets caps on the total minutes of this traffic 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. On May 3, 2002 the U.S. Court of Appeals for the D.C. Circuit remanded the April 27, 2001 FCC order for further proceedings. It did not vacate the interim pricing rules established in that order and they remain in effect. Several parties, including Pac-West Telecomm and Focal Communications Corp. have requested rehearing, asking the court to vacate the underlying order. A decision on the rehearing petitions remains pending, and the FCC's underlying order remains in effect. 12 GTE Southwest Incorporated 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 (a) Exhibits: Exhibit Number ------ 3.1 Restated Certificate of Incorporation of GTE Southwest Incorporated. 3.2 Amended and Restated Bylaws of GTE Southwest Incorporated. 12 Computation of Ratio of Earnings to Fixed Charges. (b) There were no Current Reports on Form 8-K filed during the quarter ended June 30, 2002. 13 GTE Southwest Incorporated 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. GTE Southwest Incorporated Date: August 14, 2002 By /s/ Edwin F. Hall -------------------------------- Edwin F. Hall Controller UNLESS OTHERWISE INDICATED, ALL INFORMATION IS AS OF AUGUST 7, 2002. 14 EXHIBIT INDEX

GTE SOUTHWEST INC 10-Q