In the fall of 1989, the Texas Division of Southwestern Bell Telephone Company (SWBT)

was facing considerable earnings uncertainty. Nine months had passed since the Texas Public Utilities Commission (PUC) had initiated an inquiry into SWBT's earnings in Texas.

The Company was trying to negotiate a settlement but was having difficulty reaching an agreement with the commission staff and other interested parties. One group was proposing a decrease in SWBT revenues that would result in a 76% reduction in the company's Texas revenues and adversely affect Southwestern Bell Corporation's stock price.

At the same time that the PUC was investigating alleged overeamings related to SWBT's Texas intrastate operations, company officers in Texas were trying to meet budgeted net income objectives. These targets were necessary to keep earnings growing at a conservative yet steady rate. With actual data already available for much of the year, it was apparent that the overall target for 1989 might not be met. One of the main causes of this probable shortfall was the decrease SWBT was experiencing in revenues from long distance telephone calls. This decrease was due largely to increased payments in the fom of settlements to other local exchange telephone companies in Texas. SWBT's management was searching for alternatives to the settlement process that would allow the company to retain its fair share of long distance revenues without financially ruining smaller telephone companies operating in the state.

INDUSTRY BACKGROUND In January 1984, SWBT and six other regional telephone companies were divested from American Telephone and Telegraph Company (AT&T). In addition to retaining ownership of Western Electric (manufacturing), Bell Labs (research and development), and AT&T Infomnation Systems, AT&T was allowed to retain ownership of interstate long distance sen/ices and a portion of intrastate long distance. Under the provisions of the Justice Department's Modified Final Judgment decree, each state was divided into Local Access Transport Areas (LATAs). Texas was divided into seventeen LATAs in addition to the standard metropolitan statistical area of San Angelo, which belongs solely to General Telephone (GTE).

Long distance calling between LATAs (interLATA) may be provided only by interexchange carriers (IXCs) such as AT&T, MCI, and Sprint. Local exchange carriers (LECs)

such as SWBT and GTE provide basic telephone service and long distance calling within each LATA OntraLATA). In Texas, there are 59 LECs. SWBT is by far the largest, serving approximately 6.6 million telephone lines.

Because IXCs access their customers through LEG facilities, LECs charge IXCs for using their local networks. Theoretically, these per-minute-of-use charges are based on LEC costs. However, state commissions often inflate the rates to subsidize basic telephone rates, thus keeping them priced below cost.

INTERSTATE INTRALATA LONG DISTANCE When a customer of an LEC makes an intrastate intraLATA long distance (toll) call, complefion of the call often requires the use of another LECs facilities. For example, a call from Dallas to Denton is an intraLATA toll call that originates in a Southwestern Bell area

(Dallas) but temninates in a GTE area (Denton). The originator of the call is billed by Southwestem Bell, which must reimburse GTE for costs incurred in assisting in the call. In Texas, this reimbursement is currently handled through a toll revenue pooling agreement among the LECs.

The pooling of IntraLATA toll revenues is administered by the Texas Exchange Carrier Association (TECA). Each LEC reports monthly to the TECA administrator not only its billed toll revenues but also its expenses and investment incun-ed in providing toll service.

TECA combines the revenue, expense, and investment infomriation for all 59 LECs and calculates a rate of retum equal to billed revenues less expenses (including taxes) divided by investment. Each LEC is allowed to recover its expenses plus the pool rate of retum on its investment.

In 1987 the pool rate of retum was approximately 19%. Although SWBT billed $555.3 million in toll revenues, it was allowed to retain only the total of its expenses ($285.4 million)

and retum ($147.9 million). The $122 million difference between what SWBT billed and what it was allowed to keep was paid to the pool administrator for disbursement to those companies whose costs exceeded their billed revenues.

CONCERNS WITH THE POOLING PROCESS Southwestern Bell's managers have several concerns with the current pooling process.

One of their major concerns is that few incentives exist for companies to control costs.

IntraLATA toll service is a much larger portion of the total operations of many of the smaller LECs than of SWBT. Consequently, each dollar of additional cost incuaed by the smaller companies results in approximately one dollar of additional settlements. On the other hand, Southwestern Bell's retained toll revenues (after settlement with other LECs

)

decrease by approximately $1 million for each one percent reduction in its costs. This situation is not conducive to the efficient provision of telephone service and therefore is not in the best interest of the public.

The company's managers also are concerned about the manner in which total expenses and investment related to IntraLATA toll service are calculated. Each company's accountants computes these amounts using procedures developed by the Federal Communications Commission (FCC). The very complex procedures, referred to in the industry as "separations," allocate monthly journalized expense and investment amounts to various categories of telephone service based on factors developed from studies of call traffic patterns and studies showing how telephone plant resources are utilized. The separations process was developed to provide a means of dividing expenses and investment amounts between state and interstate jurisdictions to facilitate rate setting by regulatory agencies. It never was intended to represent an accurate allocation system.

The first step in separations is to divide expense and investment amounts into trafficsensitive and non-traffic-sensitive (NTS) categories. Traffic-sensitive expenses are primarily variable and are relatively easy to trace to specific categories of service. NTS expenses are primarily fixed. These amounts (over half the total SWBT reports to the pool)

are incurred to provide and service connections between customers' premises and company's central offices. The same investment is required whether a customer makes no calls, a few calls, or hundreds of calls, and also whether those calls are intrastate or interstate.

NTS amounts are separated into three categories: interstate, intrastate toll, and intrastate local. In 1982, the FCC froze at approximately 20% the portion of Southwestem Bell's NTS expenses and investment allocated to intrastate toll operations. Thus, the initial separation of NTS amounts does not represent the current usage of the telephone networi^'s resources. However, the interi_ATA toll and IntraLATA toll components of the 20% factor are detennined monthly based on relative actual usage. Therefore, if inter-

LATA toll usage is increasing at a faster rate than IntraLATA toll usage, less will be allocated to the IntraLATA toll category. IntraLATA toll expenses and related investment could be increasing, but due to the separations process fewer dollars would be assigned to the category and thus recoverable through the pooling process. SWBT's IntraLATA toll NTS factor is approximately 8%, whereas the factors of several smaller telephone companies are in the 30% to 50% range. A third concern of Southwestern Bell managers is that revenues fronn non-jointprovided toll calls are included in the pooling process. For exannple, consider that the largest intraU^TA toll market in Texas is between Dallas and Ft. Worth. Most toll calls between the two cities use only SWBT facilities, but through the pooling process revenues from the calls are shared with the state's other LECs. Company officials believe both revenues and costs of single-company toll calls should be excluded from the pool, but currently there is no means to isolate those amounts.

A final concem relates to the telecommunications industry goal of providing adequate telephone service to all U. S. citizens at reasonable rates. All telephone companies as well as the entire nation have benefited from the subsidies that higher cost companies have received from lower-cost companies. If local telephone service, especially in rural areas were priced to cover its costs, the number of residences with service would be substantially lower. The concem at Southwestern Bell is that subsidization of high-cost companies has exceeded its historical intent; publications of the Texas PUC show that many high-cost LECs are earning well over their authorized rates of return.

After reviewing the situation. Southwestern Bell's senior managers realized they had their woric cut out for them. They know that the course of action they recommended would have to effectively address both the concerns of SWBT and the finanaal needs of the other companies.

REQUIRED:

1 Assuming toll revenue sharing will continue to be administered by the TECA, what is the most important modification that could be made to the pooling procedures to produce a more equitable distribution of revenues from the perspective of Southwestem Bell?

2 Should SWBT officials negotiate changes in the subsidization procedures directly with the other Texas LECs or take their concerns to the state Public Utilities Commission and seek mandated changes?

3. What strategy would you recommend to Southwestem Bell managers? How would your recommendation address the four concerns expressed in the case?