Annual Report (Form 10-K), fiscal year 1994

Item 1. Business
Contel of California, Inc. (the Company) is a wholly-owned subsidiary of Contel Corporation (the Parent Company), a wholly-owned subsidiary of GTE Corporation (GTE), and provides communications services in California, Nevada and Arizona.
The Company was incorporated in California in 1954. Since its incorporation, twenty-three independent telephone companies have been merged into the Company to form the present entity.
The Company provides a wide variety of communications services ranging from local telephone service for the home and office to highly complex voice and data services for industry. The Company provides local telephone service within its franchise area and intraLATA (Local Access Transport Area) long distance service between the Company's facilities and the facilities of other telephone companies within the Company's LATAs. InterLATA service to other points in and out of the states in which the Company operates is provided through connection with interexchange (long distance) common carriers. These common carriers are charged fees (access charges) for interconnection to the Company's local facilities. End user business and residential customers are also charged access charges for access to the facilities of the long distance carriers. The Company also earns other revenues by leasing interexchange plant facilities and providing such services as billing and collection and operator services to interexchange carriers, primarily AT&T Corp. The number of access lines has grown steadily from 313,340 on January 1, 1990 to 378,362 on December 31, 1994.
The Company's principal line of business is providing telecommunication services. These services fall into five major classes: local network, network access, long distance, equipment sales and services and other. Revenues from each of these classes over the last three years are as follows:
At December 31, 1994, the Company had 1,226 employees. The Company has written agreements with the Communications Workers of America (CWA) and International Brotherhood of Electrical Workers (IBEW). The current agreements with the CWA and the IBEW units expire on September 6, 1995.
Telephone Competition and Regulatory Developments
The Company holds franchises, licenses and permits adequate for the conduct of its business in the territories which it serves.
The Company is subject to regulation by the California Public Utilities Commission (CPUC), the Public Service Commission of Nevada, and the Arizona Corporation Commission as to its intrastate business operations and by the Federal Communications Commission (FCC) as to its interstate business operations. Information regarding the Company's activities with the various regulatory agencies and revenue arrangements with other telephone companies can be found in Note 11 of the Company's consolidated financial statements included in Item 8.
During 1994, the Company began implementation of a three-year $49 million re-engineering plan that will redesign and streamline processes. In the initial year of the plan, $27 million was expended to implement this program. These expenditures were primarily associated with the consolidation of certain customer service centers, separation benefits associated with employee reductions and incremental expenditures to redesign and streamline systems and processes. The re-engineering program is expected to be completed by the end of 1996. Continued implementation of this program will position the Company to accelerate delivery of a full array of voice, video and data services and to reach its stated objective of being the easiest company to do business with in the industry.
In late 1994, the FCC began to auction new licenses for radio spectrum in 51 major markets and 492 basic trading areas across the United States to encourage the development of a new generation of wireless voice, data and messaging services which are generally referred to as broadband Personal Communications Services (PCS). PCS will compete with the Company's traditional wireline services.
In 1992, the FCC issued a "video dialtone" ruling that allows telephone companies to transmit video signals over their networks. The FCC also recommended that Congress amend the Cable Act of 1984 to permit telephone companies to supply video programming in their service areas. In 1994, GTE announced plans to build a new video network over the next ten years which will pass seven million homes in 66 key GTE markets. GTE has requested FCC approval to construct facilities in the initial three markets, including Ventura County, California, and expects to begin construction in 1995.
On January 13, 1995, the United States District Court for the Eastern District of Virginia issued an injunction declaring that GTE has the right to provide video programming to its in-franchise customers. The court's decision means
that GTE is now permitted to offer video programming over its own video dialtone networks, as well as to compete as a franchised cable operator in the Company's telephone territories.
During 1994, GTE unveiled its World Class Network in eight key markets to provide advanced communications for business customers. This program includes sophisticated high-speed, digital fiber-optic rings, a high-capacity switching network (known as SONET), and a new centralized operations center that monitors the entire network. These SONET rings are an integral part of the high-speed information network that enables GTE to provide advanced services such as high-speed data transmission and video conferencing.
Federal and state regulatory activity directed toward changing the traditional cost-based rate of return regulatory framework for intrastate and interstate telephone services has continued. Various forms of alternative regulation have been adopted, which provide economic incentives to telephone service providers to improve productivity and provide the foundation for the pricing flexibility necessary to address competitive entry into the markets the Company serves.
During 1993, the CPUC approved a New Regulatory Framework (NRF) settlement agreement allowing GTE California Incorporated (GTE California) to retain 100% of any earnings up to 15.5%, beginning in 1994. Under its prior agreement, GTE California was required to share 50% of any earnings over a 13% rate of return and refund 100% of any earnings over 16.5%. The Company has requested that it be allowed to adopt GTE California's NRF concurrent with the approval of the legal entity merger of the Company and GTE California. In September 1994, the CPUC issued a final order that authorized intraLATA toll competition (without pre-subscription) in California, effective January 1, 1995. It also provides for rate rebalancing with significant rate reductions for toll service and access charges while increasing basic local exchange rates closer to the actual cost of providing such service. The ultimate effect on revenue will depend, in part, on the extent to which rate reductions result in increased calling volumes. The decision does not permit rate increases to compensate for competitive losses of market share. GTE believes that the CPUC has over-estimated the calling volume that will be stimulated by reduced toll rates and has requested reconsideration of this aspect of the decision.
For the provision of interstate services, the Company operates under the terms of the FCC's price cap incentive plan. The "price cap" mechanism serves to limit the rates a carrier may charge, rather than just regulating the rate of return which may be achieved. Under this approach, the maximum prices that the Company may charge are increased or decreased each year by a price index based upon inflation less a predetermined productivity target. The Company may, within certain ranges, price individual services above or below the overall cap.
Under its price cap regulatory plan, the FCC also adopted a productivity sharing feature. Because of this feature, under the minimum productivity-gain option, the Company must share equally with its ratepayers any realized interstate return above 12.25% up to 16.25%, and all returns higher than 16.25%, by temporarily lowering prospective prices.
During 1992-1994, the FCC took a number of steps to increase competition for local exchange carrier (LEC) access services. These steps, known as Expanded Interconnection requirements, allow competing communications carriers to interconnect to the local exchange network for the purpose of providing switched access transport services and private line services. Expanded Interconnection requires LECs to permit competitors to connect directly to LEC central offices and the LEC network under negotiated terms and conditions. Competitors are thereby able to compete more effectively than previously to replace LEC services between large users and interexchange carriers (IXCs), or between large users and the LEC switch. The FCC accompanied its Expanded Interconnection mandate with a slight relaxation of the rigid pricing rules that govern how LECs price their access services. In 1994, the FCC also reaffirmed the switched access rate structure changes adopted in 1993 that allow LECs to better reflect the actual cost characteristics of transport services and improve the LEC's ability to compete with alternative access providers.
The GTE Consent Decree, which was issued in connection with the 1983 acquisition of GTE Sprint and GTE Spacenet (both since divested), prohibits GTE's domestic telephone operating subsidiaries from providing long distance service beyond the boundaries of the LATA. This prohibition restricts the Company's direct provision of long distance service to relatively short distances. The degree of competition allowed in the intraLATA market is subject to state regulation. However, regulatory constraints on intraLATA competition are gradually being relaxed.
These and other actions to eliminate the existing legal and regulatory barriers, together with rapid advances in technology, are facilitating a convergence of the computer, media and telecommunications industries. In addition to allowing new forms of competition, these developments are also creating new opportunities to develop interactive communications networks. The Company intends to continue to respond aggressively to regulatory and legal developments that allow for increased competition and opportunities in the marketplace. The Company expects its financial results to benefit from reduced costs and the introduction of new products and services that will result in increased usage of its networks. However, it is likely that such improvements will be offset, in part, by continued strategic pricing reductions and the effects of increased competition.
Item 2.



Item 2. Properties
The Company's property consists of network facilities (86%), company facilities (11%), customer premises equipment (1%) and other (2%). From January 1, 1990 to December 31, 1994, the Company made gross property additions of $313.5 million and property retirements of $139.9 million. Substantially all of the Company's property is subject to liens securing long-term debt. In the opinion of management, the Company's telephone plant is substantially in good repair.
Item 3.

Item 3. Legal Proceedings
There are no pending legal proceedings, either for or against the Company, which would have a material impact on the Company's financial statements.
Item 4.

Item 4. Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5.

Item 5. Market for the Registrant's Common Equity and Related Shareholder Matters
Market information is omitted since the Company's common stock is wholly-owned by Contel Corporation, which is wholly-owned by GTE Corporation.
TRANSFER AGENT AND REGISTRAR The Transfer Agent and Registrar for the Company's common stock is the First National Bank of Boston.
GTE Corporation C/O Bank of Boston P.O. Box 9191 Boston, MA 02205-9191
10-K REPORT A copy of the 1994 annual report on Form 10-K filed with the Securities and Exchange Commission may be obtained by writing to:
GTE Telephone Operations External Reporting P.O. Box 407, MC: INAAACG Westfield, IN 46074 (317) 896-6464
GTE CORPORATION ANNUAL REPORT A copy of the 1994 annual report of GTE Corporation may be obtained by writing to:
GTE Corporation Corporate Secretary's Office One Stamford Forum Stamford, CT 06904
Item 6.

Item 6. Selected Financial Data
Contel of California, Inc. and Subsidiary
(a) Per share data is omitted since the Company's common stock is 100% owned by Contel Corporation. (b) Net operating income in 1993 includes a $49.0 million pretax charge for restructuring costs which reduced net income by $30.2 million.
Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
BUSINESS OPERATIONS
Contel of California, Inc. (the Company) provides local exchange, network access and long distance telecommunications services throughout California, Nevada and Arizona. The Company serves over 375,000 access lines.
RESULTS OF OPERATIONS
Net income was $66 million for the year ended December 31, 1994 and $55 million for the year ended December 31, 1993. The 1993 results included a one-time after-tax charge of $30 million to restructure operations. Excluding this charge, net income decreased 22% or $19 million in 1994, and 9% or $9 million in 1993. The 1994 decrease is primarily a result of lower toll revenue intrastate settlements and higher depreciation and amortization and marketing, selling, general and administrative expenses. The 1993 decrease reflected higher expenses associated with the implementation of Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" effective January 1, 1993. This decrease was partially offset by lower data processing costs, and lower operating expenses as a result of the completion of a large government contract in 1992 partially offset by lower revenues related to the contract.
OPERATING REVENUES
Operating revenues were $367 million and $385 million for 1994 and 1993, respectively. This reflects a decrease of 5% or $18 million in 1994 and 7% or $29 million in 1993.
Local network service revenues are comprised mainly of fees charged to customers for providing local exchange service. Local network service revenues were $97 million and $95 million in 1994 and 1993, respectively, representing increases of 2% or $2 million in 1994 and 1% or $1 million in 1993. These increases are primarily the result of continued customer growth, as experienced through access line increases of 4% in 1994 and 2% in 1993.
Network access service revenues are fees charged to interexchange carriers that use the local telecommunication network to provide long-distance services to their customers. In addition, end users pay access fees to connect to the local network to obtain long-distance service. Network access service revenues were $137 million and $140 million in 1994 and 1993, respectively. This represents a decrease of 2% or $3 million during 1994 and virtually no change during 1993. The 1994 decrease is primarily the result of a decrease in intrastate settlements from revenue pooling arrangements.
The Company's revenues for long distance services from designated geographical areas are provided under settlement arrangements with various telephone companies. Long distance service revenues were $108 million in 1994 and $125 million in 1993, reflecting decreases of 13% or $17 million and 7% or $9 million in 1994 and 1993, respectively. The 1994 decrease is primarily the result of a decrease in intrastate settlements from revenue pooling arrangements. The 1993 decrease was due to one-time favorable adjustments made to reserves in 1992.
Equipment sales and services revenues were $13 million in both 1994 and 1993. The 1993 revenues represent a decrease of 65% or $24 million from 1992, resulting from revenues relating to a government contract completed in 1992.
Other revenues were $12 million in both 1994 and 1993. Other revenues increased 24% or $2 million in 1993. This increase was primarily a result of higher directory revenues and lower provisioning for uncollectible accounts.
OPERATING EXPENSES
Cost of sales and services was $71 million in 1994 and $72 million in 1993, reflecting decreases of 1% or $1 million in 1994 and 22% or $20 million in 1993. The 1994 decrease is primarily due to lower billing services costs. The 1993 decrease was due to expenses related to the completed government contract mentioned above. The 1993 results also included lower software fees offset by higher expenses related to the adoption of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions."
Depreciation and amortization was $65 million and $58 million in 1994 and 1993, respectively. This represents increases of 12% or $7 million in 1994 and 9% or $5 million in 1993. The 1994 increase is due to increases in the depreciation rates and higher plant balances. The 1993 increase was primarily due to higher plant investments in addition to a rate order effective July 1, 1993 that increased depreciation rates.
Marketing, selling and general and administrative expenses were $108 million and $101 million in 1994 and 1993, respectively. This reflects an increase of 7% or $7 million in 1994 and a decrease of 1% or $1 million in 1993. The 1994 increase is primarily the result of increased billing and collection costs. The 1993 decrease was due to lower data system and programming costs, lower contractor costs and lower internal telecommunication expenses. This decrease was partially offset by the higher expenses related to the adoption of SFAS No.106.
OTHER EXPENSES
Income tax expense was $46 million and $37 million for 1994 and 1993, respectively. This reflects an increase of 24% or $9 million in 1994 compared to a decrease of 38% or $23 million in 1993. The changes are primarily due to corresponding changes in pretax income.
CAPITAL RESOURCES AND LIQUIDITY
Management believes the Company has adequate internal and external resources available to meet ongoing operating requirements for construction on new plant, modernization of facilities and payment of dividends. The Company generally funds its construction program from operations, although external financing is available through the issuance of short-term or long-term debt. Short-term borrowings can be obtained through commercial paper borrowings or borrowings from GTE.
The Company's primary source of funds during 1994 was cash flow from operations of $128 million compared to $138 million for 1993. The decrease is primarily due to the decrease in net income before the restructuring reserve and unfavorable accounts payable timing differences, partially offset by favorable accounts receivable and income tax payment timing differences.
Capital expenditures represent a significant use of funds during 1994 and 1993, reflecting the Company's continued growth in access lines and modernization of current facilities and provisioning of new products and services. The Company's capital expenditures during 1994 were $55 million compared to $61 million during 1993. The Company's construction costs in 1995 are expected to be lower than 1994.
Cash used in financing activities was $71 million in 1994 compared to $79 million in 1993. This included dividend payments of $62 million in 1994 compared to $92 million in 1993. The Company borrowed $41 million from affiliates in 1993 to supplement funds from operations. The Company retired $8 million of long-term debt in 1994 compared to $28 million in 1993.
REGULATORY AND COMPETITIVE TRENDS
REGULATORY DEVELOPMENTS
Fundamental changes continue to significantly impact the telecommunications industry. During 1994, telecommunications legislation that would have changed the way the industry does business passed the House of Representatives, but was subsequently withdrawn from consideration. Telecommunications legislation has been introduced again in 1995.
Federal and state regulatory activity directed toward changing the traditional cost-based rate of return regulatory framework for intrastate and interstate telephone services has also continued. Regulatory authorities have adopted various alternative forms of regulation, which provide economic incentives to telephone service providers to improve productivity and provide the foundation for implementing pricing flexibility necessary to address competitive entry into the markets the Company serves.
During 1992-1994, the FCC took a number of steps to increase competition for local exchange carrier (LEC) access services. These steps, known as Expanded Interconnection requirements, allow competing communications carriers to interconnect to the local exchange network for the purpose of providing switched access transport services and private line services. Expanded Interconnection requires LECs to permit competitors to connect directly to LEC central offices and the LEC network under negotiated terms and conditions. Competitors are thereby able to compete more effectively than previously to replace LEC services between large users and interexchange carriers (IXCs), or between large users and the LEC switch. The FCC accompanied its Expanded Interconnection mandate with a slight relaxation of the rigid pricing rules that govern how LECs price their access services. In 1994, the FCC also reaffirmed the switched access rate structure changes adopted in 1993 that allow LECs to better reflect the actual cost characteristics of transport services and improve the LEC's ability to compete with alternative access providers.
Further information regarding the Company's activities with the various regulatory agencies is discussed in Note 11 of the Company's consolidated financial statements included in Item 8.


Item 8. Financial Statements and Supplementary Data
CONSOLIDATED STATEMENTS OF INCOME Contel of California, Inc. and Subsidiary
(a) Includes billings from affiliates of $13,929, $14,305 and $7,413 for the years 1994-1992, respectively.
CONSOLIDATED STATEMENTS OF REINVESTED EARNINGS
See Notes to Consolidated Financial Statements.
CONSOLIDATED BALANCE SHEETS Contel of California, Inc. and Subsidiary
See Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS Contel of California, Inc. and Subsidiary
See Notes to Consolidated Financial Statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Contel of California, Inc. and Subsidiary
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of Contel of California, Inc. (the Company) and its wholly-owned subsidiary, Contel Advanced Systems, Inc. All significant intercompany transactions have been eliminated. The Company is a wholly-owned subsidiary of Contel Corporation (the Parent Company), a wholly-owned subsidiary of GTE Corporation (GTE).
TRANSACTIONS WITH AFFILIATES
Certain affiliated companies supply construction and maintenance equipment and supplies to the Company. These purchases amounted to $11.5 million, $11.7 million and $15.4 million for the years 1994-1992, respectively. Such purchases are recorded in the accounts of the Company at cost which includes a normal return realized by the affiliates.
The Company is billed for data processing services and equipment rentals, and receives management, consulting, research and development and pension management services from other affiliated companies. These charges amounted to $13.9 million, $14.3 million and $7.4 million for the years 1994-1992, respectively. The amounts charged for these affiliated transactions are based on a proportional cost allocation method.
TELEPHONE PLANT
Maintenance and repairs are charged to income as incurred. Additions to, replacements and renewals of property are charged to telephone plant accounts. Property retirements are charged in total to the accumulated depreciation account. No adjustment to depreciation is made at the time properties are retired or otherwise disposed of, except in the case of significant sales of property where profit or loss is recognized.
The Company provides for depreciation on telephone plant on a straight-line basis over asset lives approved by regulators. Depreciation is based upon rates prescribed by the Federal Communications Commission (FCC) and the state regulatory commissions. The provisions for depreciation and amortization were equivalent to composite annual rates of 7.3%, 6.9% and 6.7% for the years 1994-1992, respectively.
REGULATORY ACCOUNTING
The Company follows the accounting prescribed by the Uniform System of Accounts of the FCC and the regulatory commissions in each of the Company's operating jurisdictions and Statement of Financial Accounting Standards (SFAS) No. 71, "Accounting for the Effects of Certain Types of Regulation." This accounting recognizes the economic effects of rate regulation by recording costs and a return on investment as such amounts are recovered through rates authorized by regulatory authorities. Accordingly, SFAS No. 71 requires companies to depreciate plant and equipment over lives approved by regulators.
It also requires deferral of certain costs and obligations based upon approvals received from regulators to permit recovery of such amounts in future years. The Company annually reviews the continued applicability of SFAS No. 71 based upon the current regulatory and competitive environment.
REVENUE RECOGNITION
Revenues are recognized when earned. This is generally based on usage of the Company's local exchange networks or facilities. For other products and services, revenue is recognized when services are rendered or products are delivered to customers.
MATERIALS AND SUPPLIES
Materials and supplies are stated at the lower of cost (average cost) or market value.
EMPLOYEE BENEFIT PLANS
Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The new standard requires that the expected costs of these benefits be charged to expense during the years that the employees render service. The Company elected to adopt this new accounting standard on the delayed recognition method and commencing January 1, 1993, began amortizing the estimated unrecorded accumulated postretirement benefit obligation over twenty years. Prior to the adoption of SFAS No. 106, the cost of these benefits was charged to expense as paid.
The Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits," effective January 1, 1993. SFAS No. 112 requires employers to accrue the future cost of benefits provided to former or inactive employees and their dependents after employment but before retirement. Previously, the cost of these benefits was charged to expense as paid. The impact of this change in accounting on the Company's results of operations was immaterial.
INCOME TAXES
Income tax expense is based on reported earnings before income taxes. Deferred income taxes are established for all temporary differences between the amount of assets and liabilities recognized for financial reporting purposes and for tax purposes.
As further explained in Note 7, during the fourth quarter of 1992, the Company adopted SFAS No. 109, "Accounting for Income Taxes," retroactive to January 1, 1992. SFAS No. 109 changed the method by which companies account for income taxes. Among other things, the Statement requires that deferred tax balances be adjusted to reflect new tax rates when they are enacted into law. The impact of this change in accounting on the Company's results of operations was immaterial.
Investment tax credits were repealed by the Tax Reform Act of 1986 (the Act). Those credits claimed prior to the Act were deferred and are being amortized over the lives of the properties giving rise to the credits.
FINANCIAL INSTRUMENTS
The fair values of financial instruments, other than long-term debt, closely approximate their carrying value. The estimated fair value of long-term debt at December 31, 1994 and 1993, based on either quoted market prices or an option pricing model exceeded the carrying value by approximately $4 million and $19 million, respectively.
COMPUTER SOFTWARE
The cost of computer software for internal use, except initial operating system software, is charged to expense as incurred. Initial operating system software is capitalized and amortized over the life of the related hardware.
PRIOR YEARS' FINANCIAL STATEMENTS
Reclassifications of prior year data have been made in the financial statements where appropriate to conform to the 1994 presentation.
2. RESTRUCTURING COSTS
Results for 1993 included a one-time pretax restructuring charge of $49.0 million, which reduced net income by $30.2 million, primarily for incremental costs related to implementation of the Company's three-year re-engineering plan. The re-engineering plan will redesign and streamline processes to improve customer-responsiveness and product quality, reduce the time necessary to introduce new products and services and further reduce costs. The re-engineering plan included $20.0 million to upgrade or replace existing customer service and administrative systems and enhance network software, $22.6 million for employee separation benefits associated with workforce reductions and $6.1 million primarily for the consolidation of facilities and operations and other related costs.
Implementation of the re-engineering plan began during 1994 and is expected to be completed by the end of 1996. During 1994, expenditures of $26.7 million were made in connection with the implementation of the re-engineering plan. These expenditures were primarily associated with the consolidation of customer contact, network operations and operator service centers, separation benefits from employee reductions and incremental expenditures to redesign and streamline processes.
During 1993, the Company offered various voluntary separation programs to its employees. These programs resulted in a pretax charge of $3.0 million which reduced net income by $1.8 million.
3. PREFERRED STOCK
Cumulative preferred stock, subject to mandatory redemption, is as follows:
* Thousands of Dollars
On March 1, 1994, the Company redeemed all outstanding shares of preferred stock with cash from operations.
4. COMMON STOCK
The authorized common stock of the Company at December 31, 1994 and 1993 consisted of 3,000,000 shares with a par value of $5 per share. All outstanding shares of common stock are held by the Parent Company.
There were no shares of common stock held by or for the account of the Company and no shares were reserved for officers and employees, or for options, warrants, conversions or other rights.
At December 31, 1994, $80.7 million of reinvested earnings was restricted as to the payment of cash dividends on common stock under the most restrictive terms of the Company's indentures.
5. LONG-TERM DEBT
Long-term debt outstanding, exclusive of current maturities, is as follows:
During 1994, the Company retired $2.8 million of 9.25% First Mortgage Bonds due 2001 and the $3.0 million of 8.75% Sinking Fund Debentures.
The aggregate principal amount of bonds and debentures that may be issued is subject to the restrictions and provisions of the Company's indentures.
None of the securities shown above were held in sinking or other special funds of the Company or pledged by the Company.
Maturities, installments and sinking fund requirements for the five-year period from January 1, 1995 are summarized below (in thousands of dollars):
Substantially all of the Company's telephone plant is subject to the liens of the indentures under which the bonds listed above were issued.
6. NOTES PAYABLE TO AFFILIATES
The Company finances part of its construction program through the use of short-term notes payable to affiliates which are generally refinanced at a later date by issues of long-term debt or equity. During 1994, the Company supplemented its internal generation of cash with funds borrowed from GTE. These arrangements require payment of interest based on prevailing commercial paper rates.
7. INCOME TAXES
The provision for income taxes is as follows:
The components of deferred income tax provision (benefit) are as follows:
A reconciliation between taxes computed by applying the statutory federal income tax rate to pretax income and income taxes provided in the Consolidated Statements of Income is as follows:
As a result of implementing SFAS No. 109, the Company recorded additional deferred income tax liabilities primarily related to temporary differences which had not previously been recognized in accordance with established rate-making practices. Since the manner in which income taxes are treated for rate-making has not changed, pursuant to SFAS No. 71 a corresponding regulatory asset was also established. In addition, deferred income taxes were adjusted and a regulatory liability established to give effect to the current statutory federal income tax rate and for unamortized investment tax credits. The unamortized regulatory asset and regulatory liability balances at December 31, 1994 and 1993 amounted to $39.2 million and $0.1 million and $16.6 million and $0.1 million, respectively. The regulatory assets and liabilities are reflected as other assets and other deferred credits, respectively, in the accompany Consolidated Balance Sheets. These amounts are being amortized over the lives of the related depreciable assets concurrent with recovery in rates and in conformance with the provisions of the Internal Revenue Code. The assets and liabilities established in accordance with SFAS No. 71 have been increased for the tax effect of future revenue requirements.
The tax effects of all temporary differences that give rise to the deferred tax liability and deferred tax asset at December 31 are as follows:
8. EMPLOYEE BENEFIT PLANS
RETIREMENT PLANS
The Company has trusteed, noncontributory, defined benefit pension plans covering substantially all employees. The benefits to be paid under these plans are generally based on years of credited service and average final earnings. The Company's funding policy, subject to the minimum funding requirements of U.S. employee benefit and tax laws, is to contribute such amounts as are determined on an actuarial basis to provide the plans with assets sufficient to meet the benefit obligations of the plans. The assets of the plans consist primarily of corporate equities, government securities and fixed income investments.
The components of the net pension (credit) expense for 1994-1992 were as follows (in thousands of dollars):
The expected long-term rate of return on plan assets was 8.5% for 1994 and 8.25% for 1993 and 1992.
The regulatory adjustment reflects the use of the aggregate cost method as required by the CPUC and results in $2.6 million and $4.8 million at December 31, 1994 and 1993, respectively, being reflected in other deferred credits in the accompanying Consolidated Balance Sheets.
The funded status of the plans and the prepaid pension costs at December 31, 1994 and 1993 were as follows (in thousands of dollars):
The projected benefit obligations at December 31, 1994 and 1993 include accumulated benefit obligations of $155.3 million and $128.6 million and vested benefit obligations of $143.7 million and $120.7 million, respectively.
Assumptions used to develop the projected benefit obligations at December 31, 1994 and 1993 were as follows:
POSTRETIREMENT BENEFITS OTHER THAN PENSIONS
As described in Note 1, effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions."
Substantially all of the Company's employees are covered under postretirement health care and life insurance benefit plans. The health care benefits paid under the plans are generally based on comprehensive hospital, medical and surgical benefit provisions. The Company funds amounts for postretirement benefits as deemed appropriate from time to time.
The postretirement benefit cost for 1994 and 1993 included the following components (in thousands of dollars):
During 1992, the cost of postretirement health care and life insurance benefits on a pay-as-you-go basis was $3.7 million.
The following table sets forth the plans' funded status and the accrued obligations as of December 31, 1994 and 1993 (in thousands of dollars):
The assumed discount rates used to measure the accumulated postretirement benefit obligations were 8.25% at December 31, 1994 and 7.5% at December 31, 1993. The assumed health care cost trend rates in 1994 and 1993 were 12% and 13% for pre-65 participants and 9.0% and 9.5% for post-65 retirees, each rate
declining on a graduated basis to an ultimate rate in the year 2004 of 6%. A one percentage point increase in the assumed health care cost trend rate for each future year would have increased 1993 costs by $0.5 million and the accumulated postretirement benefit obligations at December 31, 1994 by $5.9 million.
During 1993, the Company made certain changes to its postretirement health care and life insurance benefits for non-union employees retiring on or after January 1, 1995. These changes include newly established limits to the Company's annual contribution to postretirement medical costs and a revised cost sharing schedule based on a retiree's years of service. The net effect of these changes reduced the accumulated postretirement benefit obligations at December 31, 1993 by $21.2 million.
SAVINGS PLANS
The Company sponsors employee savings plans under section 401(k) of the Internal Revenue Code. The plans cover substantially all full-time employees. Under the plans, the Company provides matching contributions in GTE common stock based on qualified employee contributions. Matching contributions charged to income were $0.7 million in each of the years 1994-1992.
9. LEASE COMMITMENTS
The Company has noncancelable leases covering certain buildings, office space and equipment that contain varying renewal options for terms up to 21 years. Rental expense was $3.5 million, $3.2 million and $3.2 million in 1994-1992, respectively. Minimum rental commitments for noncancelable leases through 1999 do not exceed $0.5 million annually and aggregate $0.2 million thereafter.
10. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment, which is stated at cost, is summarized as follows at December 31:
11. REGULATORY MATTERS
The Company is subject to regulation by the FCC for its interstate business operations. Intrastate operations are regulated by the California Public Utilities Commission (CPUC), Nevada Public Service Commission (NPSC) and the Arizona Corporation Commission (ACC).
INTRASTATE SERVICES
Effective January 1, 1990 the CPUC adopted a new regulatory framework (NRF) for GTE in Phase II of the Alternative Regulatory Proceeding. The new framework replaced the traditional "rate case" process with a framework that is based on a Price Cap Index mechanism with "sharing" of earnings above a benchmark rate of return. The new plan is designed to stimulate productivity and efficiencies with a portion of those gains flowing directly to the customer. During 1993, the CPUC approved a NRF settlement agreement allowing GTE California Incorporated (GTE California) to retain 100% of any earnings up to 15.5% beginning in 1994. Under its prior agreement, GTE California was required to share 50% of any earnings over a 13% rate of return and refund 100% of any earnings over 16.5%. A policy order issued by the CPUC on July 24, 1991, urged the Company to adopt the NRF for the Company's operations to be effective no later than January 1, 1994. The Company has requested that it be allowed to adopt GTE California's NRF concurrent with the approval of the legal entity merger of the Company and GTE California.
Under the new plan, rates for services essential to basic communication would be subject to a revenue cap, set annually, based on inflation minus a productivity improvement factor. Rates for partially competitive services (e.g. Centrex and custom calling features) are subject to the flexibility within a price floor and ceiling as set by the CPUC. In addition, fully competitive services (e.g. directory advertising and inside wire installation) are not subject to pricing limits set by the CPUC. Rates are also adjusted for exogenous events that are beyond the control of management as defined in the new plan.
In September 1994, the CPUC issued a final order that authorized intraLATA toll competition (without pre-subscription) in California, effective January 1, 1995. It also provides for rate rebalancing with significant rate reductions for toll service and access charges while increasing basic local exchange rates closer to the actual cost of providing such service. The ultimate effect on revenue will depend, in part, on the extent to which rate reductions result in increased calling volumes. The decision does not permit rate increases to compensate for competitive losses of market share. GTE believes that the CPUC has over-estimated the calling volume that will be stimulated by reduced toll rates and has requested reconsideration of this aspect of the decision.
In March 1991, the merger of the Company's parent and GTE was consummated. In a decision issued on March 13, 1991, the CPUC approved a stipulation agreement which tentatively approved the merger of GTE and Contel. The decision also established a second phase of the proceeding in which GTE was directed to show that the merger meets certain California statutory requirements. GTE was also ordered to submit a plan for the merger of any of the Contel and GTE regulated California subsidiaries. On September 14, 1992, the Company and GTE California joined with GTE and Contel and filed a comprehensive plan with the CPUC to merge the Company into GTE California.
On December 23, 1993, an Administrative Law Judge issued a proposed Phase II order allowing the merger of the Company and GTE California. The proposed order added a third phase to the merger proceeding in which the issues of a start-up revenue requirement for Contel's pre-merger operations and rate integration of the respective company tariffs was considered.
On April 20, 1994, the CPUC issued a decision giving final approval to the merger of the Company into GTE California. The decision requires the merging companies to flow through to their ratepayers all of the estimated savings that will be produced from the merger. This flow through requirement is based on the CPUC's interpretation of certain statutory requirements. The CPUC, however, provided the parties with the opportunity to supplement the evidentiary record to show why the estimated merger savings should be apportioned between ratepayers and shareholders. That filing was made on April 29, 1994. By making the filing, the effective date of the decision approving the merger has been delayed. The Company and other interested parties have filed reports and comments pursuant to this proceeding.
In addition, merger applications were filed with the Arizona Corporation Commission on October 4, 1993 and the Nevada Public Service Commission on April 2, 1993. These applications were approved during 1994 but were made subject to final approval in California, which is expected in 1995.
INTERSTATE SERVICES
For the provision of interstate services, the Company operates under the terms of the FCC's price cap incentive plan. The "price cap" mechanism serves to limit the rates a carrier may charge, rather than just regulating the rate of return which may be achieved. Under this approach, the maximum price that the local exchange carrier (LEC) may charge is increased or decreased each year by a price index based upon inflation less a predetermined productivity target. LECs may, within certain ranges, price individual services above or below the overall cap.
As a safeguard under its price cap regulatory plan, the FCC adopted a productivity sharing feature. Because of this feature, under the minimum productivity-gain option, the Company must share equally with its ratepayers any realized interstate return above 12.25% up to 16.25%, and all returns higher than 16.25%, by temporarily lowering prospective prices. During 1995, the FCC is scheduled to review the LEC price cap plan to determine if it should be continued or modified.
SIGNIFICANT CUSTOMER
Revenues received from AT&T Corp. include amounts for access, billing and collection and interexchange leased facilities during the years 1994-1992 under various arrangements and amounted to $50.2 million, $33.0 million and $62.2 million, respectively.
12. SUPPLEMENTAL CASH FLOW DISCLOSURES
Set forth below is information with respect to changes in current assets and current liabilities, and cash paid for interest and income taxes:
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors of Contel of California, Inc.:
We have audited the accompanying consolidated balance sheets of Contel of California, Inc. (a California corporation) and subsidiary as of December 31, 1994 and 1993, and the related consolidated statements of income, reinvested earnings and cash flows for each of the three years in the period ended December 31, 1994. These financial statements and the schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and the schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Contel of California, Inc. and subsidiary as of December 31, 1994 and 1993, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1994, in conformity with generally accepted accounting principles.
As discussed in Note 1 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for postretirement benefits other than pensions. Also as discussed in Note 1, effective January 1, 1992, the Company changed its method of accounting for income taxes.
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supporting schedule listed under Item 14 is presented for purposes of complying with the Securities and Exchange Commission's rules and is not a required part of the basic financial statements. This supporting schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Dallas, Texas January 25, 1995.
MANAGEMENT REPORT
To Our Shareholder:
The management of the Company is responsible for the integrity and objectivity of the financial and operating information contained in this Annual Report, including the consolidated financial statements covered by the Report of Independent Public Accountants. These statements were prepared in conformity with generally accepted accounting principles and include amounts that are based on the best estimates and judgments of management.
The Company has a system of internal accounting controls which provides management with reasonable assurance that transactions are recorded and executed in accordance with its authorizations, that assets are properly safeguarded and accounted for, and that financial records are maintained so as to permit preparation of financial statements in accordance with generally accepted accounting principles. This system includes written policies and procedures, an organizational structure that segregates duties, and a comprehensive program of periodic audits by the internal auditors. The Company has also instituted policies and guidelines which require employees to maintain the highest level of ethical standards.
JAMES F. MILES President
MICHAEL W. BOLLINGER Assistant Vice President - Controller
Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
PART IV
Item 14.







Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a)(1) Financial Statements - See Contel of California Inc.'s consolidated financial statements and report of independent accountants thereon in the Financial Statements section included elsewhere herein.
(2) Financial Statement Schedules - Schedules supporting the consolidated financial statements for the years ended December 31, 1994-1992 (as required):
II - Valuation and Qualifying Accounts
Note: Schedules other than the one listed above are omitted as not applicable, not required, or the information is included in the consolidated financial statements or notes thereto.
(3) Exhibits - Included in this report or incorporated by reference.
2.1* Agreement of Merger, dated September 10, 1992 between GTE California Incorporated and Contel of California, Inc. (Exhibit 2.1 of the 1993 Form 10-K, File No. 0-1245).
3* Articles of Incorporation and Bylaws (incorporated by reference from the Registration Statement of the Company, File No. 2-52487, effective January 14, 1975).
27 Financial Data Schedule.
(b) Reports on Form 8-K - No reports on Form 8-K were filed during the fourth quarter of 1994.
* Denotes exhibits incorporated herein by reference to previous filings with the Securities and Exchange Commission as designated.
CONTEL OF CALIFORNIA, INC. AND SUBSIDIARY
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
FOR THE YEARS ENDED DECEMBER 31, 1994, 1993 AND 1992 (Thousands of Dollars)
------------------------------------------- NOTES:
(1) Charges for purpose for which reserve was created. (2) Recoveries of previously written-off amounts. (3) See Note 2 to the Consolidated Financial Statements included elsewhere herein.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
CONTEL OF CALIFORNIA, INC. -------------------------- (Registrant)
Date March 24, 1995 By JAMES F. MILES -------------- ------------------------------- JAMES F. MILES President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report is signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
JAMES F. MILES President and Director March 24, 1995 ----------------------- (Principal Executive Officer) JAMES F. MILES
MICHAEL W. BOLLINGER Assistant Vice President- March 24, 1995 ----------------------- Controller MICHAEL W. BOLLINGER (Principal Financial and Accounting Officer)
GEOFFREY C. GOULD Director March 24, 1995 ----------------------- GEOFFREY C. GOULD
MICHAEL B. ESSTMAN Director March 24, 1995 ----------------------- MICHAEL B. ESSTMAN
EXHIBIT INDEX -------------
2.1* Agreement of Merger, dated September 10, 1992 between GTE California Incorporated and Contel of California, Inc. (Exhibit 2.1 of the 1993 Form 10-K, File No. 0-1245).
3* Articles of Incorporation and Bylaws (incorporated by reference from the Registration Statement of the Company, File No. 2-52487, effective January 14, 1975).
27 Financial Data Schedule.
* Denotes exhibits incorporated herein by reference to previous filings with the Securities and Exchange Commission as designated.