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

Item 1. Business
GTE Southwest Incorporated (the Company) was incorporated in Delaware in 1926. The Company is a wholly-owned subsidiary of GTE Corporation (GTE) and provides communications services in the states of Arkansas, New Mexico, Oklahoma and Texas.
On May 1, 1994, the Company sold a portion of its telephone plant-in-service, materials and supplies and customers (representing 12,798 access lines) in the state of Oklahoma to Eaglenet, Inc. On November 30, 1994, the Company sold a portion of its telephone plant-in-service, materials and supplies and customers (representing 8,898 access lines) in the state of Oklahoma to Pioneer Telephone Cooperative, Inc.
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 carrier. 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 served has grown steadily from 1,365,164 on January 1, 1990 to 1,734,364 on December 31, 1994.
The number of access lines in the states in which the Company operates as of December 31, 1994 was as follows:
The Company's principal line of business is providing telecommunication services. These services fall into five major classes including 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 6,433 employees. The Company has written agreements with the Communications Workers of America (CWA). During 1995, two contracts with the CWA will expire.
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 regulatory bodies of the states of Arkansas, New Mexico, Oklahoma and Texas 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 12 of the Company's financial statements included in Item 8.
During 1994, the Company began implementation of a three-year $172 million re-engineering plan. In the initial year of the plan, $37 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. During 1995, the level of re-engineering activities and related expenditures are expected to accelerate as pilot programs are rolled out and other major initiatives are completed. The overall re-engineering plan remains on schedule and 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. 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, including Dallas, Texas, 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. Regulatory authorities have adopted various forms of alternative 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.
Many states are currently investigating whether to authorize local and toll competition. Several have concluded that competition is in the public interest and five states, none within the Company's operating jurisdictions, have authorized plans that would allow customers to pre-subscribe to a specific carrier to handle intraLATA toll calls. GTE is challenging these orders primarily based on the lack of equality since the Company is prohibited from providing interLATA toll service.
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 (81%), company facilities (15%), customer premises equipment (1%) and other (3%). From January 1, 1990 to December 31, 1994, the Company made gross property additions of $1.5 billion and property retirements of $1.0 billion. 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
See Note 12 to the Company's financial statements included in Item 8.
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 GTE Corporation.
TRANSFER AGENT AND REGISTRAR
The Transfer Agent and Registrar for the Company's common stock, preferred stock and no par preferred 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
PARENT COMPANY ANNUAL REPORT
A copy of the 1994 annual report of our parent company 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
GTE Southwest Incorporated
(a) Per share data is omitted since the Company's common stock is 100% owned by GTE Corporation.
(b) Net operating income in 1993 included a $172.0 million pretax charge for restructuring costs which reduced net income by $105.9 million.
Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
BUSINESS OPERATIONS
GTE Southwest Incorporated (the Company), a wholly-owned subsidiary of GTE Corporation (GTE), provides local exchange, network access and long distance telecommunications services in Arkansas, New Mexico, Oklahoma and Texas. The Company also markets telecommunications systems and equipment. The Company serves over 1.7 million access lines in its operating territory, with 87% of these lines in Texas.
RESULTS OF OPERATIONS
Net income was $123 million for 1994 including a $15 million gain, net of tax, associated with the sale of certain non-strategic properties in Oklahoma. In 1993 a net loss of $19 million was recorded, including one-time after-tax charges totaling $143 million to restructure operations, complete enhanced early retirement and voluntary separation programs and for the early retirement of high-coupon debt.
Excluding these special items, net income decreased 13% or $16 million in 1994 and 16% or $23 million in 1993. The 1994 decrease is primarily the result of voluntary network access rate reductions during 1993 and 1994 in an ongoing effort to price services more competitively and an increase in cost of sales and services and depreciation and amortization expenses, partially offset by a decrease in interest expense. The 1993 decrease reflected lower operating revenues due to voluntary rate reductions and the impact of the adoption of Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" effective January 1, 1993.
OPERATING REVENUES
Operating revenues were $1.21 billion and $1.16 billion for 1994 and 1993, respectively. This reflects an increase of 4% or $48 million in 1994 compared to a decrease of 2% or $19 million in 1993.
Local network service revenues are comprised mainly of fees charged to customers for providing local exchange service. In 1994 local network service revenues were $451 million compared to $421 million in 1993. This represents increases of 7% or $30 million in 1994 and 8% or $29 million in 1993. These increases are primarily the result of expansion of local calling zones and an increase in access lines.
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. Revenues derived from network access services were $447 million in 1994 and $438 million in 1993. This represents an increase of 2% or $9 million during 1994 and a decrease of 9% or $45 million in 1993. The 1994 increase is primarily the result of an increase in minutes of use and increased revenue related to the Texas Pooling Alternative Settlement Plan (PASP) which the Company elected to begin participating in effective January 1, 1994. The increased revenue from PASP does not increase operating income as there is a corresponding increase in
operating expenses. These increases are partially offset by revenue decreases resulting from the Company's exit from old pooling arrangements and an access charge restructuring plan which was approved by the Public Utility Commission of Texas (PUC) on April 1, 1992. The implementation of this plan resulted in a $41 million annual reduction, effective September 1, 1992, a $29 million annual reduction, effective September 1, 1993, and a final annual reduction of $33 million which became effective September 1, 1994. The 1993 decrease was primarily the result of the access charge restructuring plan previously mentioned and lower interstate rates. The Company's annual interstate rates were voluntarily reduced by $1 million effective July 1, 1992, $4 million effective July 17, 1992, $9 million effective October 2, 1992 and $11 million effective December 15, 1992. These reductions were partially offset by an increase in minutes of use in 1993.
The Company's revenues for long distance services are provided under bill and keep arrangements or settlement arrangements with various telephone companies. Long distance service revenues for 1994 were $198 million and $190 million in 1993, representing a 4% or $8 million increase in 1994, and a decrease of 7% or $15 million in 1993. The 1994 increase is primarily the result of an increase in the volume of toll calls and an increase in directory assistance revenues. The 1993 decrease was primarily the result of lower settlements.
Revenues derived from equipment sales and services were $82 million in 1994 and $72 million in 1993. This represents increases of 13% or $10 million in 1994 and 8% or $5 million in 1993. These increases are due to higher sales of nonregulated equipment, such as single-line telephones, large private branch equipment, voice messaging services and maintenance agreements.
Other operating revenues were $32 million and $41 million in 1994 and 1993, respectively. This represents a decrease of 22% or $9 million in 1994 compared to an increase of 14% or $5 million in 1993. The 1994 decrease is primarily due to higher provisions for uncollectible accounts and lower regulated rental revenues. The 1993 increase was primarily due to lower provisioning for the Texas rate case reserve in 1993 compared to 1992, partially offset by increased operator service and regulated rental revenues. The Texas rate case reserve represents the results of the Texas Court of Appeals' decision concerning the 1989 Texas rate order (see Note 12 to the financial statements included in Item 8).
OPERATING EXPENSES
Cost of sales and services were $342 million and $281 million for 1994 and 1993, respectively. This represents increases of 22% or $61 million in 1994 and 11% or $27 million in 1993. The 1994 increase is primarily the result of costs associated with the previously mentioned Texas PASP, increased installation and maintenance expenses and an increase in materials expense. The 1993 increase reflected costs associated with the adoption of SFAS No. 106 effective January 1, 1993. As a result of the adoption of the new standard, expenses increased $24 million in 1993.
Depreciation and amortization expense was $272 million in 1994 compared to $254 million in 1993, reflecting increases of 7% or $18 million in 1994 and 1% or $4 million in 1993. The 1994 increase is primarily the result of an increase in the composite annual depreciation rate. The 1993 increase was primarily due to higher depreciation rates in several jurisdictions as well as increased plant balances.
Expenses for marketing, selling, general and administrative costs were $382 million in 1994 and $398 million in 1993. The 1993 expense included a one-time charge of $9 million associated with the enhanced early retirement and voluntary separation programs offered to eligible employees. Excluding this charge, marketing, selling, general and administrative costs decreased 2% or $7 million in 1994 compared to an increase of 3% or $10 million in 1993. The 1994 decrease is primarily the result of a decrease in data processing costs. The 1993 increase reflected costs of $15 million associated with the adoption of SFAS No. 106 in addition to higher data processing costs due to system conversions. These increases were partially offset by lower advertising expenses and lower franchise taxes.
OTHER (INCOME) DEDUCTIONS
Interest expense was $56 million in 1994 and $74 million in 1993, reflecting decreases of 24% or $18 million in 1994 and 3% or $2 million in 1993. These decreases are primarily the result of lower average interest rates obtained through the high-coupon debt refinancing in November 1993.
The $22 million pretax gain on disposition of assets represents the combined excess of cash proceeds over book value of assets and liabilities sold to Eaglenet, Inc. on May 1, 1994 and to Pioneer Telephone Cooperative, Inc. on November 30, 1994 (see Note 3 to the financial statements included in Item 8).
Income tax expense was $60 million in 1994, compared to an income tax benefit of $31 million for 1993. This represents an increase of $91 million in 1994 compared to a decrease of $103 million in 1993. The increase in 1994 is primarily due to increases in pretax income and favorable adjustments made in 1993 to prior years' tax liabilities. The decrease in 1993 was primarily due to decreases in pretax income and adjustments to prior years' tax liabilities.
CAPITAL RESOURCES AND LIQUIDITY
Management believes the Company has adequate internal and external resources available to meet ongoing operating requirements for construction of 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 the parent, GTE. In addition, a $2.8 billion line of credit is available to the Company through shared lines of credit with GTE and other affiliates to support short-term financing needs.
The Company's primary source of funds during 1994 and 1993 was cash flows from operations of $350 million and $469 million, respectively. The decrease is primarily the result of an increase in customer receivables and unfavorable timing of tax payments, partially offset by an increase in customer and affiliate payables.
Capital expenditures represent the largest use of funds during 1994, 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 $302 million compared to $301 million during 1993. These expenditures are partially offset in 1994 by the $68 million received in the sale of certain non-strategic properties (see Note 3 to the Financial Statements). The Company's anticipated construction
costs for 1995 are expected to increase slightly from the 1994 level, reflecting continued modernization of facilities and anticipated growth.
Cash used in financing activities was $112 million in 1994 compared to $173 million in 1993. This included dividend payments of $93 million in 1994 compared to $157 million in 1993. The decrease reflects timing differences in the payment of dividends in 1994 compared to 1993. External financing included net short-term borrowings of $19 million in 1994, compared to $22 million in 1993. The Company retired $38 million of long-term debt and preferred stock in 1994 compared to $13 million in 1993.
In November 1993, the Company called $501 million of high-coupon first mortgage bonds with varying maturities. These bonds had coupons ranging from 7.875% to 11.75%. In December 1993, the Company issued $250 million of 5.82% debentures due 1999 and $250 million of 6.54% debentures due 2005 to refinance these bonds. The expense of calling these bonds is reflected as an extraordinary after-tax charge of $31 million in the Statements of Income.
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 12 of the Company's financial statements included in Item 8.


Item 8. Financial Statements and Supplementary Data
STATEMENTS OF INCOME GTE Southwest Incorporated
(a) Includes billings to affiliates of $35,658, $37,803 and $47,492 for the years 1994-1992, respectively.
(b) Includes billings from affiliates of $78,423, $71,165 and $59,233 for the years 1994-1992, respectively.
STATEMENTS OF REINVESTED EARNINGS
See Notes to Financial Statements.
BALANCE SHEETS GTE Southwest Incorporated
See Notes to Financial Statements.
STATEMENTS OF CASH FLOWS GTE Southwest Incorporated
See Notes to Financial Statements.
NOTES TO FINANCIAL STATEMENTS GTE Southwest Incorporated
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
GTE Southwest Incorporated (the Company) is 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 $80.3 million, $108.0 million and $122.1 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 certain printing and other costs associated with telephone directories, 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 $78.4 million, $71.2 million and $59.2 million for the years 1994-1992, respectively. The amounts charged for these affiliated transactions are based on a proportional cost allocation method.
The Company has an agreement with GTE Directories Corporation (Directories) (100% owned by GTE), whereby the Company provides its subscriber lists, billing and collection and other services to Directories. Revenues from these activities amounted to $35.7 million, $37.8 million and $47.5 million for the years 1994-1992, respectively.
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 6.8%, 6.4% and 6.6% 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 postretirement 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 8, 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. As of December 31, 1994, the estimated fair value of long-term debt based on either quoted market prices or an option pricing model was lower than the carrying value by approximately $67 million. The estimated fair value of long-term debt as of December 31, 1993, exceeded the carrying value by approximately $17 million.
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 $172.0 million, which reduced net income by $105.9 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 $68.8 million to upgrade or replace existing customer service and administrative systems and enhance network software, $77.8 million for employee separation benefits associated with workforce reductions and $21.0 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 $37.4 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. The level of re-engineering activities and related expenditures are expected to accelerate in 1995.
During 1993, the Company offered various voluntary separation programs to its employees. These programs resulted in a pretax charge of $9.2 million which reduced net income by $6.4 million.
3. PROPERTY REPOSITIONING
On May 1, 1994, the Company sold a portion of its telephone plant-in-service, materials and supplies and customers (representing 12,798 access lines) in the state of Oklahoma to Eaglenet, Inc. for $41.0 million in cash. This represents less than 1% of the Company's access lines. A pretax gain of $9.3 million was recorded on the sale. The proceeds from this transaction were used primarily to pay down long-term debt.
On November 30, 1994 the Company sold a portion of its telephone plant-in-service, materials and supplies and customers (representing 8,898 access lines) in the state of Oklahoma to Pioneer Telephone Cooperative, Inc. for $26.8 million in cash. The property sold represents less than 1% of the Company's access lines. A pretax gain of $12.6 million was recorded on the sale. The proceeds from this transaction were used primarily to pay down short-term commercial paper borrowings.
4. PREFERRED STOCK
The authorized cumulative preferred stock, not subject to mandatory redemption, consists of 2,060,758 shares. Shares outstanding at December 31, 1994 and 1993 are as follows:
Cumulative preferred stock, subject to mandatory redemption, is as follows:
* Thousands of Dollars
The 4.60% Series sinking fund provisions require the Company to redeem 7,000 shares at $20 per share on April 1 of each year. This requirement was met in 1994 and 1993 with the purchase of 7,000 shares per year.
The $8.10 Series sinking fund provisions require the redemption of 9,000 shares at $100 per share on November 1 of each year. The Company redeemed 18,000 shares in each of the years 1993 and 1994 to meet this requirement.
The preferred shareholders are entitled to voting rights (on an equal basis with the common shareholder) in the event dividends in arrears equal or exceed the annual dividends on all preferred stock. Otherwise, the preferred shareholders have no voting rights. The Company is not in arrears in its dividend payments at December 31, 1994.
The aggregate redemption requirements of preferred stock subject to mandatory redemption are $1 million in each of the years 1995-1999.
No shares of preferred stock were 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.
5. COMMON STOCK
The authorized common stock of the Company consists of 6,450,000 shares with a stated value of $100 per share. All outstanding shares of common stock are held by GTE.
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, $1.6 million of reinvested earnings was restricted as to the payment of cash dividends on common stock under the terms of the Company's Certificate of Incorporation.
6. LONG-TERM DEBT
Long-term debt outstanding, exclusive of current maturities, is as follows:
In November 1993, the Company called $501 million of high-coupon first mortgage bonds with proceeds from commercial paper borrowings. These bonds had coupons ranging from 7.875% to 11.75%. In December 1993, the Company issued $250 million of 5.82% Debentures, due 1999 and $250 million of 6.54% Debentures, due 2005 to refinance these bonds. The cost of calling these bonds is reflected as an extraordinary after-tax charge of $31.3 million in the Statements of Income.
During 1994, the Company called $30 million of 7 3/4% First Mortgage Bonds with proceeds from the sale of non-strategic properties.
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.
Debt discount on the Company's outstanding long-term debt is amortized over the lives of the respective issues.
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.
7. SHORT-TERM DEBT
The Company finances part of its construction program through the use of interim short-term loans, primarily commercial paper, which are generally refinanced at a later date by issues of long-term debt or equity. Information relating to short-term borrowings is as follows:
A $2.8 billion credit line is available to the Company through shared lines of credit with GTE and other affiliates. Most of these arrangements require payment of annual commitment fees of .1% of the unused lines of credit.
8. INCOME TAXES
The provision (benefit) 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 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 amounted to $0.7 million and $41.9 million, respectively, and the unamortized regulatory asset and regulatory liability balances at December 31, 1993 amounted to $1.1 million and $45.5 million, respectively. The regulatory assets and liabilities are reflected as other assets and other deferred credits, respectively, in the accompanying 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:
9. 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 corporate debt securities.
The components of the net pension credit 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 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 $349.6 million and $375.0 million and vested benefit obligations of $300.6 million and $331.2 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 $5.2 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 1994 costs by $4.7 million and the accumulated postretirement benefit obligations at December 31, 1994 by $39.9 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, among others, 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 $44.7 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 $4.9 million, $4.8 million and $4.8 million in 1994-1992, respectively.
10. LEASE COMMITMENTS
The Company has noncancelable leases covering certain buildings, office space and equipment that contain renewal options for terms up to 42 years. Rental expense was $12.9 million, $13.0 million and $14.3 million in 1994-1992, respectively. Minimum rental commitments under noncancelable leases through 1999 do not exceed $1.5 million annually and aggregate $3.0 million thereafter.
11. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment, which is stated at cost, is summarized as follows at December 31:
12. REGULATORY MATTERS
The Company is subject to regulation by the FCC for interstate business and is regulated by the state regulatory commissions in Arkansas, New Mexico, Oklahoma and Texas for intrastate business.
INTRASTATE SERVICES
The Company provides long distance services within designated geographic areas called Local Access and Transport Areas (LATAs) in conformity with state commission orders. The Company also provides long distance access services directly to interexchange carriers and other customers who provide services between LATAs. The Public Utility Commission of Texas (PUC) approved a rulemaking procedure on December 17, 1991, with an effective date of January 1, 1991, allowing the Company and other local exchange carriers (LECs) to exit the intraLATA toll pool with transition payments from Southwestern Bell Telephone Company to be received through 1997.
After exiting the toll pool, the Company began participating in the Texas Pooling Alternative Settlement Plan (PASP) effective January 1, 1994. The PASP is also known as an Originating Responsibility Plan. Under this plan, the toll rates billed to end users for intraLATA toll calls originating in the Company's service area are retained by the Company. The Company, in turn, pays access charges to the telephone company hauling and terminating the call based on that company's approved access charge tariff. Likewise, the Company will receive access charges for terminating any intraLATA toll call that originates outside of its service area based on its approved access charge tariff.
An access charge restructuring plan was approved by the PUC on April 1, 1992. The implementation of this plan resulted in a $40.6 million annual rate reduction, effective September 1, 1992. Effective September 1, 1993, the Company implemented an additional rate reduction of $29.0 million representing the second step of a three year phase-out of certain access charges under the access charge restructuring plan. The final phase became effective September 1, 1994 with an additional rate reduction of $33.0 million.
The Oklahoma Corporation Commission approved a Joint Stipulation and Settlement Agreement in the consolidated docket to end the Toll Surcharge Pool in Oklahoma. This will allow the Company to exit the toll pool while receiving transition payments during a three year (1994-1996) conversion period to an access charge arrangement. The order approving the stipulation was issued April 19, 1994 for implementation July 1, 1994. The industry has until July 1995 to agree on an IntraLATA Access Charge Plan or submit individual plans to the Commission.
The Company is currently involved in a New Mexico rate proceeding, filed on September 1, 1994, that will result in a revenue reduction in mid-year 1995. The revenue reduction proposed by the Company was approximately $1.9 million. The New Mexico Staff and Attorney General have recommended revenue reductions of $9.5 million and $9.2 million, respectively. The proceeding has been bifurcated into two phases. The first phase will consider the appropriate revenue requirement. Following completion of the revenue requirement phase, a second phase will consider rate design. Hearings were held in January 1995. An order on the revenue requirement phase of this proceeding is expected by March 31, 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 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 the prospective prices. During 1995, the FCC is scheduled to review the LEC price cap plan to determine whether it should be continued or modified.
In 1992, the Company's network access rates were voluntarily reduced by $0.9 million effective July 1, 1992, $3.5 million effective July 17, 1992, $9.0 million effective October 2, 1992, and $10.9 million effective December 15, 1992.
OTHER RATE MATTERS
On June 19, 1991 the Texas Third District Court of Appeals (Court of Appeals) affirmed in part and reversed in part a decision by the District Court of Travis County (District Court) regarding the Company's rate proceeding - Docket No. 5610. The Court of Appeals affirmed the portion of the District Court's order which determined that the PUC had no authority to retroactively adjust the Company's rates. That portion of the PUC's order would have resulted in customer refunds of approximately $140.0 million. The Court of Appeals also affirmed the District Court's determination relating to the manner in which the PUC had calculated the Company's rate of return in setting its rates. The Court of Appeals, however, reversed the District Court's determination that the PUC had made appropriate findings related to payments made by the Company to two of its affiliates. In addition, the Court of Appeals reversed the District Court's determination related to the PUC's treatment of the Company's federal income tax expense. The Court of Appeals remanded the case to the PUC for proceedings consistent with the court's decision.
On April 15, 1992, the Company filed a Motion for Rehearing with the Court of Appeals which was denied without comment on August 26, 1992. On October 2, 1992, the Company filed an application for Writ of Error with the Texas Supreme Court. The Supreme Court denied all Writs of Error on December 31, 1992.
On January 15, 1993, the Company filed a Motion for Rehearing with the Texas Supreme Court. On June 9, 1993, the Supreme Court granted all Motions for Rehearing and the Company's Application for Writ of Error. On September 13, 1993, the Supreme Court heard oral arguments of the issues. The Company filed additional briefs in October 1993 and February 1994 with the Supreme Court. The Court will review the issues and a decision is expected to be reached sometime in 1995.
The Company, as a result of the Court of Appeals' decision, established in June 1991 an initial reserve of $33.3 million (including interest), a portion of which related to the period prior to 1991. In July 1991, the Company began recording a monthly pretax reserve of approximately $1.3 million. In December 1992, as a result of the Texas Supreme Court's initial denial of the Company's Writ of Error, the Company recorded an additional pretax reserve of $14.3 million (including interest). This reserve, combined with the monthly reserves, resulted in a total of $30.7 million (including interest) in reserves established during 1992. Of this amount, a portion related to the period prior to 1992. An additional $21.8 million was reserved in 1993 and $23.6 million in 1994 (including interest). The Texas rate case reserve at December 31, 1994 is $117.2 million.
Management is of the opinion that the reserves that have been established for this issue are reasonable and prudent and it is unlikely that this issue will have any further material adverse effect on the Company's financial position or results of operations.
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 $171.6 million, $172.9 million and $197.6 million, respectively.
13. 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:
14. QUARTERLY FINANCIAL DATA (UNAUDITED)
Summarized 1994 and 1993 quarterly financial data is as follows:
(a) Net income includes a $31.3 million extraordinary charge for the early retirement of debt. Income before extraordinary charge was $34.9 million.
(b) Net operating income includes a $172.0 million pretax charge for restructuring costs which reduced net income by $105.9 million.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Shareholders of GTE Southwest Incorporated:
We have audited the accompanying balance sheets of GTE Southwest Incorporated (a Delaware corporation and wholly-owned subsidiary of GTE Corporation) as of December 31, 1994 and 1993, and the related 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 GTE Southwest Incorporated as of December 31, 1994 and 1993, and the results of its operations and its 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 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 Shareholders:
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 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.
KATHERINE J. HARLESS President
GERALD K. DINSMORE Senior Vice President - Finance and Planning
Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
PART III
Item 10.



Item 10. Directors and Executive Officers of the Registrant
a. Identification of Directors
The names, ages and positions of the directors of the Company as of March 27, 1995 are listed below along with their business experience during the past five years.
Directors are elected annually. The term of each director expires on the date of the next annual meeting of shareholders, which is to be held on the fourth Wednesday in March.
There are no family relationships between any of the directors or executive officers of the Company.
b. Identification of Executive Officers
The Company's policies are established not only by the Company's executive officers, but also by the executive officers of GTE Telephone Operations (Telops). Accordingly, the list below contains the names, ages and positions of the executive officers of both the Company and GTE Telephone Operations as of March 27, 1995.
Each of these executive officers has been an employee of the Company or an affiliated company for the last five years.
Except for duly elected officers and directors, no other employees had a significant role in decision making.
All officers are appointed for a term of one year.
NOTES:
(1) Mary Beth Bardin was elected Vice President - Public Affairs of GTE Telephone Operations replacing G. Bruce Redditt who was appointed Vice President - Public Affairs and Communications, GTE Corporation.
(2) Katherine J. Harless was elected President replacing John C. Appel who was elected Senior Vice President - Regional Operations of GTE Telephone Operations and the Company.
During 1994, the organizational structure of GTE Telephone Operations was restructured to include 11 regions, eliminating the previous Area management structure.
Item 11.

Item 11. Executive Compensation
Executive Compensation Tables
The following tables provide information about executive compensation.
SUMMARY COMPENSATION TABLE
The following table sets forth information about the compensation of the 1994 Chief Executive Officer and each of the other four most highly compensated executive officers (the named executive officers) of the Company in 1994 for services in all capacities to the Company.
(1) Annual Compensation represents the Company's pro rata share of salaries, bonuses and other annual compensation. Total annual cash compensation for Messrs. Appel, Cole, Myers, Gomez and Mundy, for whom allocated amounts are shown above, is $375,423; $210,781; $200,342; $189,423 and $175,700 for 1994, respectively.
(2) 1994 Long-Term Incentive Plan (LTIP) Payouts include transition awards for the 1994 period, which were established by the Committee as a special grant to allow for the smooth transitioning from a single long-term performance measure (return on equity) to a combined measure (return on equity and operating cash flow margin).
(3) All other compensation includes Company contributions to defined contribution plans.
(4) Mr. Appel served as President until February 15, 1995. In May 1994, he was also elected Senior Vice President - Regional Operations, GTE Telephone Operations. Ms. Harless was elected President of the Company on February 15, 1995.
(5) Mr. Cole served as State Vice President - Sales until February 1995. In November 1994, he was also appointed Project Director - Carrier Markets - Quality, GTE Telephone Operations.
(6) Mr. Myers served as State Vice President - Operations until February 1995. In August 1994, he was also appointed Regional President - South Region, GTE Telephone Operations.
(7) Mr. Gomez served as State Vice President - External Affairs until February 1995. In August 1994, he was also appointed Assistant Vice President - Regional Regulatory and Governmental Affairs - Central Regions, GTE Telephone Operations.
(8) Mr. Mundy served as State Vice President - General Counsel until February 1995. In October 1994, he was also appointed Associate General Counsel - Texas and New Mexico, GTE Telephone Operations.
OPTION/SAR GRANTS IN LAST FISCAL YEAR
The following table shows all grants of options and tandem stock appreciation rights (SARs) to the named executive officers of the Company in 1994, whether or not specifically allocated to the Company. The options and SARs were granted under the LTIP. Pursuant to Securities and Exchange Commission rules, the table also shows the value of the options granted at the end of the option terms (ten years) if the stock price were to appreciate annually by 5% and 10%, respectively. There is no assurance that the stock price will appreciate at the rates shown in the table. The table also indicates that if the stock price does not appreciate, there will be no increase in the potential realizable value of the options granted.
(1) Each option was granted in tandem with a SAR, which will expire upon exercise of the option. Under the LTIP, one-third of these grants vest annually commencing one year after the date of grant.
AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FY-END OPTION/SAR VALUES
The following table provides information as to options and SARs exercised by each of the named executive officers of the Company during 1994. The table sets forth the value of options and SARs held by such officers at year-end measured in terms of the closing price of GTE Corporation (GTE) common stock on December 30, 1994.
Long-Term Incentive Plan - Awards in Last Fiscal Year
The GTE 1991 LTIP provides for awards, currently in the form of stock options with tandem SARs and cash bonuses, to participating employees. The primary purpose of the LTIP is to offer participants an incentive to cause GTE to achieve superior financial performance, thereby helping to assure superior performance for the shareholders. The stock options and tandem SARs awarded under the LTIP to the named executive officers in 1994 are shown in the table on page 39.
The named executive officers are eligible to receive annual grants of performance bonuses which are earned during a 36-month performance cycle. The performance bonuses are paid in cash. Awards for the three-year performance cycle ending in 1994 are based on GTE's financial performance during the relevant cycle as measured by GTE's average return on equity (ROE) against pre-established target levels. In 1994, the Executive Compensation and Organizational Structure Committee of the Board of Directors of GTE (the Committee) established an additional measure of corporate performance - operating cash flow margin (OCFM). The Committee views OCFM as an excellent complement to ROE due to its capacity to accurately measure profitable revenue growth, a key determinant of financial strength, especially for high growth businesses. To transition from awards based solely on performance against ROE targets to awards based on a combination of ROE and OCFM performance, the Committee established two performance periods - a one-year period to run concurrently with the final year of the three-year ROE performance cycle ending in 1994 and a two-year period to run concurrently with the final two years of the three-year ROE performance cycle ending in 1995. The awards for the two award periods will be based on GTE's performance against ROE and OCFM performance for the one- and two-year periods. Awards for the three-year performance cycle ending in 1996 will be based on GTE's performance against the ROE and OCFM targets established for the full three-year cycle. Seventy-five percent of the award is determined based on ROE performance and 25% of the award is determined based on OCFM performance.
At the time performance targets for the current LTIP cycles are established, a Common Stock Unit account is set up for each participant in the LTIP. An initial dollar amount for each account (target award) is determined based on the competitive performance bonus grant practices of other major companies in the telecommunications industry and with practices of other major corporations not involved in the telecommunications industry that have a reputation for excellence, are comparable to GTE in terms of such quantitative measures as revenues, market value and total shareholder return and are viewed as direct competitors for executive talent in the overall labor market as well as GTE's past and projected financial performance. That amount is then divided by the average market price of GTE common stock for the calendar week preceding the day the account is established to determine the number of Common Stock Units in the account. The value of the account increases or decreases based on the market price of the GTE common stock. An amount equal to the dividends paid on an equivalent number of shares of GTE common stock is added on each dividend payment date. This amount is then converted into the number of Common Stock Units obtained by dividing the amount of the dividend by the average price of the GTE common stock on the composite tape of the New York Stock Exchange on the dividend payment date and added to the Common Stock Unit account. Mr. Appel is the only individual of the named executive officers eligible to receive a cash award under the LTIP. The number of Common Stock
Units initially allocated in 1994 to the named executive officers' accounts and estimated future payouts under the LTIP are shown in the following table:
(1) It is not possible to predict future dividends and, accordingly, estimated Common Stock Unit accruals in this table are calculated for illustrative purposes only and are based upon the dividend rate and price of GTE common stock at the close of business on December 30, 1994. The target award is the dollar amount derived by multiplying the Common Stock Unit balance at the end of the award cycle by the price of GTE common stock.
(2) The Threshold is the level of the average ROE and the average OCFM during the relevant cycle which represents the minimum acceptable performance level for both the ROE and OCFM performance measures. If the Threshold is attained with respect to both performance measures, the award will be equal to 20% of the combined target award for ROE and OCFM. Because ROE and OCFM are separate performance measures, it is possible to receive an award if the Threshold is achieved with respect to only one of the performance measures. If the actual results for one, but not both, performance measures is at the Threshold level, the portion of the award determined by the measure performing at the Threshold level will be at 20% of the target award for that performance measure, and no award will be made for the portion of the award determined by the measure performing at less than the Threshold level. However, if the actual results for both performance measures are below the minimum acceptable performance level, no award will be earned.
(3) The Target is the level of the average ROE and the average OCFM during the cycle which represents outstanding performance for both the ROE and OCFM performance measures. If the Target is attained with respect to both performance measures, the award will be equal to 100% of the target award for ROE and OCFM. If the actual results for one, but not both, performance measures is at the Target level, the portion of the award determined by the measure performing at the Target level will be at 100% of the target award for that performance measure, and the portion of the award determined by the measure performing at less than 100% will be determined accordingly.
(4) This column has intentionally been left blank because it is not possible to determine the maximum award until the award cycle has been completed. The maximum amount of the award is limited by the amount the actual ROE and the actual OCFM exceed the targeted ROE and the targeted OCFM. If GTE's average ROE and OCFM during the cycle exceed their performance
targets, additional bonuses may be earned according to the following schedule:
For example, if average ROE and OCFM performance each exceed the ROE and OCFM targets by 0.5%, respectively, the performance bonus will equal 114% of the combined target award.
Executive Agreements
GTE has entered into an agreement (the Agreement) with Mr. Appel regarding benefits to be paid in the event of a change in control of GTE (a Change in Control).
A Change in Control is deemed to have occurred if a majority of the members of the Board do not consist of members of the incumbent Board (as defined in the Agreement) or if, in any 12-month period, three or more directors are elected without the approval of the incumbent Board. An individual whose initial assumption of office occurred pursuant to an agreement to avoid or settle a proxy or other election contest is not considered a member of the incumbent Board. In addition, a director who is elected pursuant to such a settlement agreement will not be deemed a director who is elected or nominated by the incumbent Board for purposes of determining whether a Change in Control has occurred. A Change in Control will not occur in the following situations: (1) certain merger transactions in which there is at least 50% GTE shareholder continuity in the surviving corporation, at least a majority of the members of the board of directors of the surviving corporation consists of members of the Board of GTE and no person owns more than 20% (or under certain circumstances, a lower percentage, not less than 10%) of the voting power of the surviving corporation following the transaction, and (2) transactions in which GTE's securities are acquired directly from GTE.
The Agreement provides for benefits to be paid in the event this individual separates from service and has a "good reason" for leaving or is terminated without "cause" within two years after a Change in Control.
Good reason for leaving includes but is not limited to the following events: demotion, relocation or a reduction in total compensation or benefits, or the new entity's failure to expressly assume obligations under the Agreement. Termination for cause includes certain unlawful acts on the part of the executive or a material violation of his or her responsibilities to the Corporation resulting in material injury to the Corporation.
An executive who experiences a qualifying separation from service will be entitled to receive up to two times the sum of (i) base salary and (ii) the average of his or her other percentage awards under the EIP for the previous three years. The executive will also continue to receive medical and life insurance coverage for up to two years and will be provided with financial and outplacement counseling.
In addition, the Agreement with Mr. Appel provides that in the event of a separation from service, he will receive service credit in the following amounts: two times years of service otherwise credited if the executive has five or fewer years of credited service; ten years if credited service is more than five and not more than ten years; and, if the executive's credited service exceeds ten years, the actual number of credited years of service. These additional years of service will apply towards vesting, retirement eligibility, benefit accrual and all other purposes under the Supplemental Executive Retirement Plan (SERP) and the Executive Retired Life Insurance Plan. In addition, each executive will be considered to have not less than 76 points and 15 years of accredited service for the purpose of determining his or her eligibility for early retirement benefits. However, there will be no duplication of benefits.
The Agreement remains in effect until the earlier of July 1 of each successive year or the date on which the executive reaches age 65, unless the Agreement is terminated earlier pursuant to its terms. The Agreement will be automatically renewed on each successive July 1 unless, not later than December 31 of the preceding year, one of the parties notifies the other that he does not wish to extend the Agreement. If a Change in Control occurs, the Agreement will remain in effect until the obligations of GTE (or its successor) under the Agreement has been satisfied.
Retirement Programs
Pension Plans
The estimated annual benefits payable, calculated on a single life annuity basis, under GTE's defined benefit pension plans at normal retirement at age 65, based upon final average earnings and years of employment, are illustrated in the table below:
PENSION PLAN TABLE
GTE Service Corporation, a wholly-owned subsidiary of GTE, maintains the GTE Service Corporation Plan for Employees' Pensions (the Service Corporation Plan), a noncontributory pension plan for the benefit of GTE employees based on years of service. Pension benefits to be paid from the Service Corporation Plan and contributions to this plan are related to basic salary exclusive of overtime, differentials, incentive compensation (except as otherwise described) and other similar types of payment. Under the Service Corporation Plan, pensions are computed on a two-rate formula basis of 1.15% and 1.45% for each year of service, with the 1.15% service credit being applied to that portion of the average annual salary for the five highest consecutive years that does not exceed the Social Security Integration Level (the portion of salary subject to the Federal Security Act), and the 1.45% service credit
being applied to that portion of the average annual salary that exceeds said level. As of February 15, 1995, the credited years of service under the plan for Messrs. Appel, Cole, Myers, Gomez and Mundy are 23, 30, 33, 20, and 14, respectively.
Under Federal law, an employee's benefits under a qualified pension plan such as the Service Corporation Plan are limited to certain maximum amounts. GTE maintains a SERP, which supplements, on an unfunded basis, the benefits of any participant in the Service Corporation Plan in an amount by which any participant's benefits under the Service Corporation Plan are limited by law. In addition, the SERP includes a provision permitting the payment of additional retirement benefits determined in a similar manner as under the Service Corporation Plan on remuneration accrued under management incentive plans as determined by the Committee. SERP benefits are payable in a lump sum or an annuity.
Executive Retired Life Insurance Plan
The Executive Retired Life Insurance Plan (ERLIP) provides Mr. Appel a postretirement life insurance benefit of three times final base salary, Messrs. Cole and Myers a postretirement life insurance benefit of one and one-half times final base salary and Messrs. Gomez and Mundy a postretirement life insurance benefit of one times final base salary. Upon retirement, ERLIP benefits may be paid as life insurance, or optionally, an equivalent amount equal to the present value of the life insurance amount (based on actuarial factors and the interest rate then in effect), as a lump sum payment, as an annuity or as installment payments.
Directors' Compensation
The current directors, all of whom are employees of GTE, are not paid any fees or remuneration, as such, for services on the Board.
Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management
(a) Security Ownership of Certain Beneficial Owners as of February 28, 1995:
(b) Security Ownership of Management as of December 31, 1994:
(1) Includes shares acquired through participation in GTE's Consolidated Employee Stock Ownership Plan and/or the GTE Savings Plan.
(2) Included in the number of shares beneficially owned by Messrs. Foster, Cahill, Dinsmore, Esstman, White, Appel, Cole, Myers, Gomez and Mundy and all directors and executive officers as a group are 214,539; 32,616; 39,499; 46,466; 109,299; 10,532; 17,099; 3,133; 10,533; 10,066 and 923,660 shares, respectively, which such persons have the right to acquire within 60 days pursuant to stock options.
(c) There were no changes in control of the Company during 1994.
The Federal securities laws require the Company's directors and executive officers, and persons who own more than 10% of a registered class of the Company's equity securities, to file with the Securities and Exchange Commission initial reports of ownership and reports of changes in ownership of any equity securities of the Company.
To the Company's knowledge, based solely on review of the copies of such reports furnished to the Company and representations that no other reports were required, all persons subject to these reporting requirements filed the required reports on a timely basis. All of the Company's common stock is owned by GTE and, to the Company's knowledge, none of such directors or executive officers currently owns, or has ever owned, any shares of the Company's registered preferred stock (which is the only registered class of the Company's equity securities).
Item 13.

Item 13. Certain Relationships and Related Transactions
The Company's executive officers or directors were not materially indebted to the Company or involved in any material transaction in which they had a direct or indirect material interest. None of the Company's directors were involved in any business relationships with the Company.
PART IV
Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) (1) Financial Statements - See GTE Southwest Incorporated's financial statements and report of independent accountants thereon in the Financial Statements section included elsewhere herein.
(2) Financial Statement Schedules - Schedules supporting the 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 financial statements or notes thereto.
(3) Exhibits - Included in this report or incorporated by reference.
3* Articles of Incorporation and amended By-Laws (Exhibit 3 of the 1993 Form 10-K, File No. 1-7077).
4* Indenture dated as of November 15, 1993 between GTE Southwest Incorporated and Nations Bank of Georgia, National Association, as Trustee (Exhibit 4.1 of the Company's Registration Statement on Form S-3, File No. 33-50939).
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.
GTE SOUTHWEST INCORPORATED
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 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.
GTE SOUTHWEST INCORPORATED ------------------------------ (Registrant)
Date March 27, 1995 By KATHERINE J. HARLESS -------------- ---------------------------- KATHERINE J. HARLESS 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.
Exhibit Index
Exhibit No. -----------
3* Articles of Incorporation and amended By-Laws (Exhibit 3 of the 1993 Form 10-K, File No. 1-7077).
4* Indenture dated as of November 15, 1993 between GTE Southwest Incorporated and NationsBank of Georgia, National Association, as Trustee (Exhibit 4.1 of the Company's Registration Statement on Form S-3, File No. 33-50939).
27 Financial Data Schedule.
* Denotes exhibits incorporated herein by reference to previous filings with the Securities and Exchange Commission as designated.