MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

For the Year Ended December 31, 2003

 

In the following discussion and analysis of our financial condition and results of operations, unless the context indicates or otherwise requires, references to “we,” “us,” “our” or “PLDT Group” mean the Philippine Long Distance Telephone Company and its consolidated subsidiaries, and references to “PLDT” mean the Philippine Long Distance Telephone Company, not including its consolidated subsidiaries (see Note 2 – Basis of Financial Statement Preparation to the accompanying financial statements for a list of these subsidiaries, including a description of their respective principal business activities).

 

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the accompanying financial statements and the related notes. Our financial statements, and the financial information discussed below, have been prepared in accordance with Philippine generally accepted accounting principles, or Philippine GAAP, which differs in certain significant respects from generally accepted accounting principles in the United States.

 

The financial information appearing in this report and in the accompanying financial statements is stated in Philippine pesos. All references to “pesos,” “Philippine pesos” or “Php” are to the lawful currency of the Philippines; all references to “U.S. dollars,” “US$” or “dollars” are to the lawful currency of the United States; all references to “Japanese yen,” “JP¥” or “¥” are to the lawful currency of Japan and all references to “Euro” or “€” are to the lawful currency of the European Union. Translations of Philippine peso amounts into U.S. dollars in this report and in the accompanying financial statements were made based on the exchange rate of Php55.586 to US$1.00, the volume weighted average exchange rate at December 31, 2003 quoted through the Philippine Dealing System.

 

Some information in this report may contain forward-looking statements within the meaning of Section 27A of the U.S. Securities Act of 1933 and Section 21E of the U.S. Securities Exchange Act of 1934. We have based these forward-looking statements on our current beliefs, expectations and intentions as to facts, actions and events that will or may occur in the future. Such statements generally are identified by forward-looking words such as “believe,” “plan,” “anticipate,” “continue,” “estimate,” “expect,” “may,” “will” or other similar words.

 

A forward-looking statement may include a statement of the assumptions or bases underlying the forward-looking statement. We have chosen these assumptions or bases in good faith, and we believe that they are reasonable in all material respects. However, we caution you that forward-looking statements and assumed facts or bases almost always vary from actual results, and the differences between the results implied by the forward-looking statements and assumed facts or bases and actual results can be material, depending on the circumstances. When considering forward-looking statements, you should keep in mind the description of risks and cautionary statements in this report. You should also keep in mind that any forward-looking statement made by us in this report or elsewhere speaks only as of the date on which we made it. New risks and uncertainties come up from time to time, and it is impossible for us to predict these events or how they may affect us. We have no duty to, and do not intend to, update or revise the forward-looking statements in this report after the date hereof. In light of these risks and uncertainties, any forward-looking statement made in this report or elsewhere might not occur.

Financial Highlights

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(1)  As restated to reflect the change in accounting policy on preoperating expenses, as described in Note 3 – Accounting Changes to the accompanying financial statements.

 

(2) EBIT is defined as earnings before minority interest in net (income) losses of consolidated subsidiaries, adding back interest expense and related items, taxes and deducting interest income. EBIT should not be considered in isolation or as a substitute for operating income, net income, cash flows from operating activities and other income or cash flow statement data prepared in conformity with generally accepted accounting principles, or as a measure of profitability or liquidity.

 

(3) EBITDA is defined as earnings before minority interest in net (income) losses of consolidated subsidiaries, adding back interest expense and related items, taxes, depreciation and amortization, deducting interest income and is presented because it is generally accepted as providing useful information regarding a company's ability to service and/or incur debt. EBITDA should not be considered in isolation or as a substitute for operating income, net income, cash flows from operating activities and other income or cash flow statement data prepared in conformity with generally accepted accounting principles, or as a measure of profitability or liquidity.

 

EBIT and EBITDA, on a consolidated basis for the years ended December 31, 2003 and 2002, are derived as follows:

 

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(a) See statements of income in the accompanying financial statements.

 

Overview

 

We are the largest and most diversified telecommunications company in the Philippines. We have organized our business into three main segments:

 

•               Fixed Line — fixed line telecommunications services primarily provided through PLDT. We also provide fixed line services through PLDT’s subsidiaries PLDT Clark Telecom, Inc., Subic Telecommunications Company, Inc., PLDT Maranao Telephone Company, Inc. and Bonifacio Communications Corporation, which together account for approximately 1% of our consolidated fixed lines in service, and PLDT Global Corporation;

 

•               Wireless — wireless telecommunications services provided by PLDT’s subsidiaries, Smart Communications, Inc., our cellular service provider, and Mabuhay Satellite Corporation, ACeS Philippines Cellular Satellite Corporation, and Telesat, Inc., our satellite and very small aperture terminal, or VSAT, operators; and

 

•               Information and Communications Technology — information and communications infrastructure and services for Internet applications, Internet protocol-based solutions and multimedia content delivery provided by PLDT’s subsidiary ePLDT, Inc.; Internet access services provided by ePLDT’s subsidiary Infocom Technologies, Inc.; and e-commerce, call centers and IT-related services provided by ePLDT’s other subsidiaries and associates, as described in Note 9 – Investments to the accompanying financial statements.

 

Results of Operations

 

The table below shows the contribution by each of our business segments to our consolidated operating revenues, operating expenses and net operating income (loss) for the years ended December 31, 2003 and 2002. Most of our revenues are derived from our operations within the Philippines. Our revenues derived from outside the Philippines consist primarily of revenues from incoming international calls to the Philippines.

 

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(1) Operating expenses and net operating income (loss) are computed as a percentage of operating revenues.

Consolidated Operating Revenues

 

Largely driven by the continued strong growth of our wireless business, particularly Smart’s cellular business, our consolidated operating revenues for 2003 increased by Php17,553 million, or 22%, to Php97,723 million from Php80,170 million in 2002. The revenue contribution of our wireless business accounted for 52% of our consolidated operating revenues for 2003, compared to 42% in 2002. Smart contributed Php49,876 million in revenues in 2003, an increase of 51% over its revenue contribution of Php33,021 million in 2002.

 

Fixed Line

 

Our fixed line business provides local exchange service, international and national long distance services, data and other network services, and miscellaneous services. Revenues generated from this business in 2003 totaled Php45,831 million, an increase of Php312 million, or 1%, from Php45,519 million in 2002. This increase was due to higher revenues generated from international long distance service and data and other network services, partially offset by decreased revenues from local exchange service, national long distance service, and miscellaneous services. As a percentage of our consolidated operating revenues, however, fixed line revenues decreased in 2003 to 47% from 57% in 2002 principally due to the continued strong growth of our wireless business.

 

The following table summarizes our consolidated operating revenues from our fixed line business for the years ended December 31, 2003 and 2002 by service segment:

 

 

Local Exchange Service

 

Our local exchange service revenues consist of:

 

•               flat monthly fees for our postpaid service;

 

•               installation charges and other one-time fees associated with the establishment of customer service;

 

•               fixed charges paid by other telephone companies, charges retained by PLDT for calls terminating to cellular subscribers within the local area, and local access charges paid by cellular operators for calls by cellular subscribers that terminate to our local exchange network;

 

•               revenues from usage of prepaid cards for calls within the local area and any unused peso value of expired prepaid cards;

 

•               call revenues generated from payphones and coin-operated phones; and

 

•               charges for special features, including bundled value-added services such as call waiting, call forwarding, multi-party conference calling, speed calling and Caller ID.

 

The following table summarizes key measures of our local exchange service business segment as of and for the years ended December 31, 2003 and 2002:

 

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(1) Approximately 83% and 88% were postpaid fixed line subscribers as of December 31, 2003 and 2002, respectively.

 

Revenues from our local exchange service for 2003 decreased by Php457 million, or 2%, to Php20,710 million from Php21,167 million in 2002. The decrease was primarily due to the

(1) shifting subscriber preference from postpaid to prepaid services, which generate lower average revenue per subscriber, and (2) decline in installation revenues due to a promotion in 2003 which waived installation cost of subscribers in an effort to stimulate take-up, partially offset by adjustments in our monthly local service rates. The percentage contribution of local exchange revenues to our total fixed line revenues also decreased in 2003 to 45% from 47% in 2002.

 

Gross additions to PLDT's fixed lines in service in 2003 totaled 577,530, an increase of 54,516 from the gross additions of 523,014 in 2002. On a net basis, PLDT’s fixed line additions in 2003 totaled 23,132, which was 33% higher compared to the net additions of 17,430 in 2002. While fixed line additions totaled 114,277 for PLDT’s prepaid fixed line services, PLDT’s postpaid fixed lines in service declined by 91,145 in 2003.

 

Initially intended as an affordable alternative telephone service for consumers under difficult economic conditions, our prepaid fixed line services now forms an important part of PLDT's overall churn and credit risk exposure management and subscriber retention strategy. Prepaid phone kits, each containing Php500 worth of pre-stored call credits, are sold for Php1,900 per unit. Prepaid subscribers are charged based on usage at a rate of Php1.00 per minute for local calls and at the same rates applicable to postpaid fixed line subscribers for national and international long distance calls.

 

As of December 31, 2003, PLDT’s active prepaid fixed line subscribers totaled 357,304 which accounted for approximately 17% of PLDT’s total fixed lines in service as of December 31, 2003.

 

A prepaid fixed line subscriber is recognized as an active subscriber when that subscriber activates and uses a prepaid call card. Prepaid fixed line subscribers can reload their accounts by purchasing call cards that are sold in denominations of Php500, Php300 and Php150. Reloads are valid for two months for the Php500 and Php300 card. The lower denomination of Php150 card, launched in September 2003, has an account life of 15 days. A prepaid fixed line subscriber is disconnected if that subscriber does not reload within one month for the Php500 card, four months for the Php300 card, and 15 days for the Php150 card after the expiry of the last reload. All sales of prepaid cards, whether through dealers or through PLDT's business offices, are non-refundable.

 

Pursuant to a currency exchange rate adjustment mechanism authorized by the Philippine National Telecommunications Commission, or the NTC, we adjust our monthly local service rates upward or downward by 1% for every Php0.10 change in the peso-to-dollar exchange rate relative to a base rate of Php11.00 to US$1.00. In 2003, we implemented 11 upward adjustments and three downward adjustments in our monthly local service rates, compared to 13 upward adjustments and six downward adjustments in 2002. The average peso-to-dollar rate in 2003 was Php54.215 to US$1.00, compared to the average of Php51.583 to US$1.00 in 2002. This change in the average peso-to-dollar rate translated to a peso depreciation of 5%, which resulted in an average net increase of 5% in our monthly local service rates in 2003.

 

Effective January 1, 2003, local access charges for cellular subscribers’ calls that terminate to our fixed line subscribers increased from Php2.00 per minute to Php2.50 per minute, and was further increased to Php3.00 per minute effective January 1, 2004.

 

To attract new fixed line subscribers and retain existing ones, PLDT has introduced various value-added services such as Hype in April 2003. Hype is a full two-way fixed line text messaging service, which allows subscribers to send and receive text messages to and from landline and mobile phones, and is capable of international text messaging. Hype also allows subscribers to join TV network-based and new PLDT-initiated texting services.

 

The ratio of PLDT fixed lines in service per PLDT employee improved from 172 as of December 31, 2002 to 207 as of December 31, 2003. This improvement resulted from the net decrease in PLDT’s employee headcount. During the year ended December 31, 2003, PLDT’s workforce was reduced by 16% to 10,230 employees mainly on account of PLDT’s manpower reduction program.

 

International Long Distance Service

 

Our international long distance revenues, which we generate through our international gateway facilities, consist of:

 

•               inbound call revenues representing settlements from foreign telecommunications carriers for inbound international calls, virtual transit and hubbing service and reverse charged calls such as received collect and home country direct service;

 

•               access charges paid to us by other Philippine telecommunications carriers for terminating inbound international calls to our local exchange network; and

 

•               outbound call revenues representing amounts billed to our customers (other than our cellular customers) for outbound international calls, net of amounts payable to foreign telecommunications carriers for terminating calls in their territories.

 

The following table shows information about our international long distance business for the years ended December 31, 2003 and 2002:

 

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(1) Excludes cellular call volumes.

 

Our consolidated international long distance revenues increased by Php1,903 million, or 18%, to Php12,543 million in 2003 from Php10,640 million in 2002, primarily as a result of an increase of our inbound international long distance revenues principally driven by an increase in average inbound termination rates. Likewise, the percentage contribution of international long distance revenues to our total fixed line revenues increased in 2003 to 27% from 23% in 2002.

 

Our revenues from inbound international long distance calls in 2003 increased by Php2,153 million, or 25%, to Php10,614 million from Php8,461 million in 2002 primarily due to an increase in PLDT’s average termination rates and the positive impact of the depreciation of the average value of the peso relative to the U.S. dollar, partially offset by the effect of lower inbound call volumes.

 

Our inbound international long distance call volumes in 2003 decreased by 20% to 2,128 million minutes from 2,644 million minutes in 2002, primarily due to increased competition from alternative means of long distance communications, particularly e-mail, international text messaging and Internet telephony and more inbound calls terminating directly to cellular subscribers. In addition, the increase in our average termination rates has also resulted in reduced inbound call volumes, principally those being routed through direct facilities from the U.S. to the Philippines.

 

After lengthy negotiations commencing in May 2002 with carriers around the world, PLDT increased its termination rates with carriers that account for a substantial portion of its international inbound traffic terminating on its fixed line network to US$0.12 per minute effective February 1, 2003. Prior to the increase in termination rates, a substantial portion of PLDT’s international inbound traffic terminating on its fixed line network was charged an average termination rate of approximately US$0.08 per minute.

 

On March 10, 2003, the International Bureau of the U.S. Federal Communications Commission, or U.S. FCC, issued an Order on petitions filed separately by AT&T and MCI requiring all U.S. carriers providing direct facilities-based service on the U.S.-Philippines route to suspend payments for termination services to Philippine carriers, including PLDT, Smart and Subic Telecom, until such time as the U.S. FCC issues a public notice that the affected circuits of U.S. carriers on the U.S.-Philippine route are fully restored. The Order also removed the Philippines from the list of U.S.- international routes approved for the provision of International Simple Resale. In response to the Order of the International Bureau of the U.S. FCC, the NTC issued a Memorandum Order dated March 12, 2003, directing all affected Philippine carriers

“(1) not to accept terminating traffic via direct circuits from U.S. facilities-based carriers who do not pay Philippine carriers for services rendered; and (2) to take all measures necessary to collect payments for services rendered in order to preserve the viability, efficiency, sustained growth and development and continued competitiveness of the Philippine telecommunications industry.”

 

On April 9, 2003, we filed with the U.S. FCC an application for review of the International Bureau’s March 10, 2003 Order. On April 24, 2003, AT&T and MCI filed oppositions to our application for review of the International Bureau’s March 10, 2003 Order and on May 5, 2003, we filed our reply to said oppositions. Our revenues derived from international long distance calls have not been adversely affected by the Order of the International Bureau of the U.S. FCC because most of the facilities-based traffic originating in the United States was routed through circuits of third parties not subject to the Order.

 

To resolve the long standing issue on termination rates and to allow Philippine and U.S. carriers to freely negotiate a mutually acceptable settlement of this issue, and to provide an appropriate atmosphere for commercial negotiations to prosper, on October 17, 2003, the NTC lifted its March 12, 2003 Order and ordered all Philippine carriers to immediately accept terminating traffic via direct circuits from U.S. facilities-based carriers on mutually acceptable final or interim termination rates, on terms and conditions agreed upon by the parties. Based on the negotiations between the NTC and the U.S. FCC, the NTC stated in its October 17, 2003 Order that it expects the U.S. FCC to immediately lift its March 10, 2003 Order, thereby canceling the non-payment provisions thereof and subsequently returning the Philippines to the list of U.S.-international routes approved for the provision of international simple resale. On November 12, 2003, PLDT reopened its circuits with MCI after having entered into an interim termination rate agreement with MCI. On November 14, 2003, MCI requested the U.S. FCC to lift the stop payment order on PLDT and Smart so that it may continue payment since the two local carriers have stopped blocking calls from MCI. On January 9, 2004, PLDT and AT&T finally signed an interim agreement on termination rates ending the dispute between the two carriers. AT&T notified the U.S. FCC of the unblocking of the circuits and requested that the stop payment order be lifted. Consequently, the U.S. FCC lifted the stop payment order on January 15, 2004. However, the U.S. FCC has yet to restore the Philippines to the list of U.S.-international routes approved for the provision of international simple resale. See “Other Information – Investigation by U.S. Department of Justice” below and Note 25 – Other Matters to the accompanying financial statements for further discussion.

 

The depreciation of the peso contributed to the increase in our inbound international long distance revenues in peso terms since settlement charges for inbound calls are billed in U.S. dollars or in special drawing rights, an established method of settlement among international telecommunications carriers using values based on a basket of foreign currencies, that are translated into pesos at the prevailing exchange rates at the time of billing.

 

Our revenues from outbound international long distance calls in 2003 decreased by Php250 million, or 11%, to Php1,929 million from Php2,179 million in 2002. The decline was primarily due to lower outbound call volumes and reduced IDD rates attributable to our corporate customers partly offset by the positive impact of the depreciation on the peso on outbound international long distance service revenues.

 

The depreciation of the peso contributed to the outbound international long distance revenues in peso terms because outbound calls are charged at U.S. dollar rates and billed to our subscribers in pesos at the prevailing exchange rates at the time of billing. This increase, however, was not sufficient to compensate for the reduced IDD rates attributable to our corporate customers and the decline in outbound call volumes. Our outbound international long distance call volumes declined by 8% to 158 million minutes in 2003 from 171 million minutes in 2002, primarily due to cellular substitution (subscribers opting to use cellular for international outbound calls) and the popularity of alternative means of communications such as e-mailing and text messaging.

 

National Long Distance Service

 

Our national long distance revenues consist of:

 

•               per minute charges for calls made by our fixed line customers outside of the local service areas but within the Philippines, net of interconnection charges payable for calls carried through the backbone network of, and/or terminating to the customer of, another telecommunications carrier; and

 

•               access charges received from other telecommunications carriers for calls carried through our backbone network and/or terminating to our customers.

 

The following table shows our national long distance revenues and call volumes for the years ended December 31, 2003 and 2002:

 

 

Our national long distance revenues decreased by Php1,240 million, or 16%, to Php6,429 million in 2003 from Php7,669 million in 2002 as a result of lower call volumes and changes in interconnection arrangements with certain local exchange carriers. Accordingly, the percentage contribution of national long distance revenues to our total fixed line revenues was down to 14% in 2003 from 17% in 2002.

 

Our national long distance call volumes decreased by approximately 6% to 2,049 million minutes in 2003 from 2,181 million minutes in 2002. Cellular substitution and the widespread availability and growing popularity of alternative non-voice means of communications, particularly cellular text messaging and e-mailing, have negatively affected call volumes.

 

The decrease in our national long distance revenues in 2003 compared to 2002 was, however, mitigated by the impact of the launch of various PLDT Premium Phone Services and rate adjustments.

 

PLDT Premium Phone Services allow customers to access voice-based content and information through an automated call-in facility for a certain fee. Over 30 premium phone service applications are being offered to PLDT customers ranging from appointment-booking services for selected embassies (including, among others, the U.S. and Australian embassies in the Philippines), entertainment and TV gameshow hotlines, televoting, spiritual and love counseling, celebrity chat, phone karaoke and music services. PLDT charges an average of Php10 per minute for these premium phone services.

 

In 2003, certain local exchange carriers under revenue sharing arrangements have entered into access charging agreements with PLDT. Under the revenue sharing agreements, charges are generally apportioned 30% for the originating entity, 40% for the backbone owner and another 30% for the terminating entity. Under these access charging agreements, the originating carrier generally pays access charges of (1) Php0.50 per minute for short haul traffic and Php1.25 per minute for long haul traffic to the carrier owning the backbone network, and (2) Php1.00 per minute to the terminating carrier. This change in interconnection charges resulted to a 54% decrease in average revenue per minute for calls originating from and terminating to other local exchange carriers.

 

Effective March 1, 2003, the rate for national long distance, or NDD, calls originating from PLDT subscribers and terminating to other local exchange carriers increased to Php5.00 per minute from a flat rate of Php4.50 per minute. In addition, NDD calls originating from and terminating to PLDT was also adjusted to Php5.00 per minute from a flat rate of Php4.50 per minute effective June 8, 2003. Prior to the implementation of a flat rate of Php5.00 per minute and Php4.50 per minute, NDD rates ranged from Php3.00 per minute to Php5.00 per minute for calls terminating to PLDT subscribers and from Php3.50 per minute to Php5.00 per minute on calls terminating to other networks’ subscribers depending on distance.

 

Data and Other Network Services

 

In 2003, our data and other network services posted a revenue of Php5,802 million, an increase of Php322 million, or 6%, from Php5,480 million in 2002. The revenue contribution of this service segment to our total fixed line revenues increased to 13% in 2003 from 12% in 2002, primarily attributed to an increased uptake in Domestic Frame Relay, I-Gate, digital subscriber line, or DSL, Equant and ARCSTAR bandwidth services, as well as the launch of other new network-based services. We currently expect that demand for, and therefore revenues generated from, these services will continue to grow in the foreseeable future.

 

Data and other network services we currently provide include:

 

•               traditional bandwidth services — high-speed point-to-point domestic and international digital leased line services;

 

•               broadband/packet-based/Internet-based services — frame relay, asynchronous transfer mode or ATM, Internet protocol-virtual private network or IP-VPN, DSL, Internet gateway, and wholesale digital signal level 3 or DS3; and

 

•               other packet-based switching services — Datapac and integrated services digital network, or ISDN.

 

The foregoing services are used for the following:

 

•               domestic and international communication;

 

•               broadband data transmission services that transmit data over a range of frequencies and/or bandwidth into several narrower bands;

 

•               Internet exchange services that provide Internet service providers, or ISPs, with a primary connection to the global Internet to exchange local traffic generated within the Philippines;

 

•               private networking services that use the public Internet as a backbone for private interconnection between different locations;

 

•               switch-based services, provided through a fixed bandwidth transmission facility, that allow establishment of a dedicated connection for the duration of a call; and

 

•               international packet-based services, provided through bilateral arrangements and global alliances, that integrate voice, video and data transmission.

 

Traditional bandwidth services accounted for 50% of the total revenues from PLDT’s data and other network services in 2003, broadband/IP-based services accounted for 44%, and other services accounted for the remaining 6%, compared to 57%, 38% and 5%, respectively, in 2002. These percentage changes indicate a continuing shift in data and other network revenues from traditional bandwidth services to broadband/IP-based services. We expect this trend to continue given the growing demand for broadband transmission of voice, data and video due to the continued growth of the Internet, e-commerce and other online services.

 

PLDT offers two residential Internet service packages targeting separate markets: PLDT Vibe for light to medium Internet users and DSL broadband for heavy Internet users. As of December 31, 2003, the number of PLDT’s fixed line subscribers that signed up for PLDT Vibe was 206,979, of which 129,447 were postpaid and 77,532 were prepaid subscribers, compared to 76,014 as of December 31, 2002, of which 60,878 were postpaid and 15,136 were prepaid subscribers, while the number of DSL subscribers reached 23,884 and 10,896 as of December 31, 2003 and 2002, respectively.

 

In March 2003, PLDT launched a number of data services, namely: Continuum, iView and Encompass, all under the Brains umbrella. Brains Continuum provides customers the ability to recover from service interruptions and offers network diversity, facility and hosting services in partnership with ePLDT. Brains iView enables customers to monitor the performance of their network, track bandwidth utilization patterns and identify the source of network problems. Brains Encompass provides a broad range of services for the customers’ managed networking needs, be it a wide area network or local area network.

 

In April 2003, PLDT introduced Resort Solutions, a network service that provides communication links between the head office and the remote offices of vacation resorts. It enables resort offices to access the information vital to the business and to do transactions such as real-time updating of room bookings, real-time checking of room inventory or even real-time audit of resort profitability via IP-VPN or Internet access.

 

In May 2003, Shops.work was fully launched, a network service that allows the electronic linking of retail stores providing, among other features, sales and inventory reports, up-to-date and real-time monitoring of sales and inventory, and on-line access to head offices.

 

In June 2003, Embed was introduced to the market through a soft launch. The service is a wholesale banking solution that enables a bank partner to build a community among its clients in a business to business or business to consumer arrangement through the use of IP-VPN network solution.

 

In September 2003, High Bandwidth Optical Services, or HBOS was launched, a dedicated high-speed point-to-point optical access solution that enables data mirroring, storage area network, or SAN, and local area network, or LAN, interconnectivity within the Metro. HBOS offers an option for a virtually ready alternative data center.

 

Miscellaneous

 

Miscellaneous revenues are derived mostly from directory advertising and facilities rental. In 2003, these revenues decreased by Php216 million, or 38%, to Php347 million from Php563 million in 2002, and accounted for approximately 1% of our total fixed line revenues in each of these comparable periods.

 

Wireless

 

Our wireless business segment offers cellular services as well as satellite, VSAT, and other services.

 

The following table summarizes our consolidated operating revenues from our wireless business for the years ended December 31, 2003 and 2002 by service segment:

 

 

Our wireless service revenues increased significantly by Php16,680 million, or 49%, to Php50,383 million in 2003 from Php33,703 million in 2002 mainly as a result of the continued strong growth in revenues generated from Smart’s cellular service. Accordingly, as a percentage of our consolidated operating revenues, wireless service revenues increased to 52% in 2003 from 42% in 2002.

 

Cellular Service

 

Our cellular service revenues consist of:

 

•               revenues derived from actual usage of the network by prepaid subscribers and any unused peso value of expired prepaid cards or electronic air time loads, net of discounts given to dealers;

 

•               monthly service fees from postpaid subscribers, including (1) charges for calls in excess of allocated free local calls, (2) toll charges for national and international long distance calls, (3) charges for text messages of our GSM service customers in excess of allotted free text messages and (4) charges for value-added services, net of related content provider costs;

 

•               revenues generated from incoming calls and messages to our subscribers, net of interconnection expenses; fees from reciprocal traffic from international correspondents; and revenues from inbound international roaming calls for the GSM service;

 

•               service fees charged to Pilipino Telephone Corporation, or Piltel, for using Smart's GSM network for Piltel's Talk 'N Text prepaid cellular service; and

 

•               other charges, including those for reconnection and migration.

 

Proceeds from the sale of handsets and SIM cards are not recorded as part of cellular service revenues. Gains on the sale of handsets are offset against selling and promotion expenses, while losses on the sale of handsets and SIM cards are included as part of selling and promotion expenses.

 

Our cellular service revenues in 2003 amounted to Php49,876 million, an increase of Php16,855 million, or 51%, from Php33,021 million in 2002. Cellular service revenues accounted for 51% of our consolidated operating revenues in 2003, compared to 41% in 2002. This increase was propelled by the 48% growth in Smart’s subscriber base, which increased by 3,254,426, or 48%, from 6,825,686 as of December 31, 2002 to 10,080,112 as of December 31, 2003. The strong subscriber growth offset the decline in blended monthly gross and net ARPU, which dropped by 9.3% and 3.2%, respectively.

 

Smart markets nationwide cellular communications services under the brand names Smart Buddy, Smart Gold and addict mobile. Smart Buddy is a prepaid service while Smart Gold and addict mobile are postpaid services, which are all provided through Smart's digital GSM network. Introduced in April 2003, addict mobile offers exclusive multimedia content to subscribers and features personalized means for Internet surfing, allowing subscribers to apply their allocated free credits towards their choice of data and value-added services.

 

The following table summarizes key measures of our cellular business as of and for the years ended December 31, 2003 and 2002:

 

 

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(1)  Refers to other non-subscriber-related revenues, such as facility service fees from Smart’s revenue-sharing agreement with Piltel and inbound international roaming fees.

 

(2)  Refers to all other services consisting primarily of revenues from Smart Money Holdings Corporation, Public Calling Offices and SMARTalk payphones, and a small number of leased line contracts.

 

(3)  Includes Piltel’s Talk’N Text subscribers of 2,867,085 and 1,773,620 as of December 31, 2003 and 2002, respectively. Talk’N Text is a prepaid GSM service provided by Piltel using Smart’s GSM network under a revenue-sharing agreement.

 

Voice Services

 

Smart’s revenues from voice services, which include all voice traffic and value-added services such as voice mail and international roaming, increased by Php8,758 million, or 50%, to Php26,201 million in 2003 from Php17,443 million in 2002 mainly due to the increase in subscriber base, as well as the increase in inbound international long distance revenues.

 

Prior to January 2004, Smart’s prepaid subscribers were charged a rate of Php8.00 per minute for calls made during peak hours and Php4.00 per minute for calls made during off-peak hours regardless of whether the calls were made to subscribers within the Smart network or to other mobile operators’ networks. Beginning January 2004, Smart implemented all-day flat air time rates for calls made by its prepaid subscribers. Calls terminating to other Smart and Piltel’s Talk ‘N Text subscribers are charged Php6.50 per minute, while an all-day flat rate of Php7.50 per minute is charged for calls terminating to other cellular network subscribers as well as local and NDD calls. Air time rates for postpaid subscribers vary depending on type of postpaid plan selected by subscribers.

 

Data Services

 

Smart’s revenues from cellular data services, which include all text messaging-related services as well as value-added services, increased by Php5,994 million, or 49%, to Php18,201 million in 2003 from Php12,207 million in 2002. Cellular data services accounted for 37% of Smart's GSM cellular revenues in 2003 and 2002. Text messaging-related services contributed revenues of Php16,969 million in 2003, compared to Php11,632 million in 2002, and accounted for 93% and 95% of the total cellular data revenues for 2003 and 2002, respectively. The increase in revenues from text messaging-related services resulted mainly from a 46% increase in volume of text messages to 24,085 million outbound messages in 2003 from the 16,536 million outbound messages handled in 2002. Value-added services contributed revenues of Php1,232 million in 2003, increasing by Php657 million, or 114%, from Php575 million in 2002.

 

The following table shows the breakdown of Smart’s cellular data revenues for the years ended December 31, 2003 and 2002:

 

________________

 

(1) Value-added services developed by Smart on its own platform.

 

Facility Services

 

Smart’s revenues from GSM service in 2003 and 2002 included facility service fees totaling Php4,247 million and Php2,494 million, respectively, representing Smart’s 50% share from Piltel’s Talk ‘N Text revenues, net of interconnection fees. As of December 31, 2003, Piltel had 2,867,085 Talk ‘N Text subscribers compared to 1,773,620 subscribers as of December 31, 2002 using Smart’s GSM network pursuant to a facilities service agreement between Smart and Piltel. See Note 15 – Related Party Transactions to the accompanying financial statements for a description of this agreement.

 

Subscriber Base, ARPU and Churn Rates

 

Of Smart’s 10,080,112 GSM subscribers as of December 31, 2003, prepaid subscribers accounted for approximately 98% while postpaid subscribers accounted for the remaining 2%. Smart's prepaid GSM subscriber base grew by 48% to 9,831,135 as of December 31, 2003 from 6,649,038 as of December 31, 2002, whereas Smart's postpaid GSM subscriber base increased by 41% to 248,977 as of December 31, 2003 from 176,648 as of December 31, 2002. Smart’s prepaid and postpaid net subscriber activations totaled 3,182,097 and 72,329, respectively, in 2003, or a monthly average addition of 265,175 prepaid and 6,027 postpaid subscribers.

 

Revenues attributable to Smart’s prepaid service amounted to Php40,910 million in 2003, a 47% increase over the Php27,790 million earned in 2002. Net prepaid revenues in 2003 accounted for 92% of GSM voice and data revenues, compared to 94% in 2002. Revenues attributable to Smart’s postpaid service amounted to Php3,492 million in 2003, a 88% increase over the Php1,860 million earned in 2002. Net postpaid revenues in 2003 accounted for 8% of GSM voice and data revenues, compared to 6% in 2002.

 

The following table summarizes Smart's usage-based monthly ARPUs for 2003 and 2002:

 

 

ARPU is computed for each month by dividing the revenues for the relevant services for the month by the average of the number of subscribers at the beginning and at the end of the month. Gross monthly ARPU is computed by dividing the revenues for the relevant services, gross of dealer discounts and allocated content-provided costs, including interconnection income but excluding inbound roaming revenues, by the average number of subscribers. Net monthly ARPU, on the other hand, is calculated based on revenues net of dealer discounts and allocated content-provided costs and interconnection income net of interconnection expense. ARPU for any period of more than one month is calculated as the simple average of the monthly ARPUs in that period.

 

Smart’s prepaid service revenues consist mainly of charges for subscribers' actual usage of their prepaid cards. Gross monthly ARPU for Smart’s prepaid GSM service in 2003 was Php521, compared to Php585 in 2002. The decline was attributable mainly to decreases of Php22 and Php18 in the average outbound and inbound local voice revenue per subscriber, respectively, and a Php16 decrease in the average data revenue per subscriber in 2003. On a net basis, ARPU in 2003 decreased by 5% to Php425 from Php446 in 2002. The lower rate of decrease in net ARPU compared to the decrease in gross ARPU resulted from lower average interconnection expense per subscriber due to an increasing percentage of Smart-to-Smart traffic to total voice traffic, to 61% in 2003 from 55% in 2002, as well as lower dealer discounts on Smart Load. Smart expects its prepaid ARPUs to continue to decline now that lower-denomination reloads are available and as it continues its expansion into the lower end of the market.

 

Monthly ARPU for Smart’s postpaid GSM service is calculated in a manner similar to that of prepaid service, except that the revenues consist mainly of monthly service fees and charges on usage in excess of the monthly service fees. Further, monthly postpaid ARPUs are now calculated to exclude pre-termination fees with restatement, for comparative purposes, effective from the second half of 2002 onwards. Until April 2003, pre-termination fees had been reported as part of usage revenues and included in the calculation of postpaid ARPUs. ARPU is a measure associated with a subscribers’ actual usage of the network on which pre-termination fees would have had no effect. Pre-termination fees are one-time fees charged to subscribers who terminate their postpaid service prior to the end of their respective “lock-in” periods. These “lock-in” periods are imposed in cases where a free or discounted handset has been provided to a subscriber as part of a postpaid plan which normally last for 24 months. As of December 31, 2003, 94% of Smart’s postpaid subscribers have “locked-in” contracts. This change in ARPU calculation had no material effect on our net income as reported in 2003 and in 2002. Beginning the second quarter of 2003, pre-termination fees were included, upon collection, under “Others” of “GSM Revenues” and are therefore no longer included for the purpose of calculating ARPUs.

 

Gross monthly ARPU for postpaid GSM subscribers in 2003 was Php1,756, compared to Php1,999 in 2002. On a net basis, postpaid ARPU decreased by 8% to Php1,331 in 2003 from Php1,439 in 2002. Smart's GSM monthly gross blended ARPU was Php554 in 2003, compared to Php611 in 2002. Blended net monthly ARPU decreased by 3% to Php449 in 2003 from Php464 in 2002.

 

Smart's 50% share of Piltel's revenues from Talk ‘N Text under a revenue-sharing agreement between Smart and Piltel is not included in the computations of Smart's ARPUs.

 

Churn, or the rate at which existing subscribers have their service canceled in a given period, is computed based on total disconnections in the period, net of reconnections in the case of postpaid subscribers, divided by the average of the number of subscribers at the beginning and the end of a month, all divided by the number of months in the same period.

 

A prepaid cellular subscriber is recognized as an active subscriber when that subscriber activates and uses the SIM card in the handset, which already contains Php100 worth of pre-stored air time. Subscribers can then reload by purchasing prepaid call-and-text cards that are sold in denominations of Php300, Php500 and Php1,000 or, by purchasing additional air time “over the air” via Smart Load in smaller denominations of Php30, Php60, Php115 and Php200, by receiving loads of Php2, Php5, Php10 and Php15 via Pasa Load (for prepaid subscribers only) or through their handsets using Smart Money. Reloads have validity periods ranging from one day to two months, depending on the amount reloaded. A prepaid GSM account is disconnected if the subscriber does not reload within four months after the full usage or expiry of the last reload. As a result, a subscriber would not be included in our churn rate calculation for up to 121 days to six months after the subscriber may have stopped using the service to make calls or send messages (although the subscriber may continue to receive calls and messages). These effects may cause our calculated churn rate for a period to be lower than the actual rate at which subscribers are ceasing to use Smart's services, and may contribute to more rapid growth in calculated churn following periods of rapid subscriber growth.

 

For Smart's prepaid GSM subscribers, the average monthly churn rate for 2003 was 2.9%, compared to 3.2% in 2002. In line with the various churn management initiatives implemented to address increased churn rates, Smart launched PureTxt 100 in August 2002. PureTxt 100 was originally a text-only card with a denomination of Php100 intended for Smart Buddy subscribers. In May 2003, Smart introduced Smart Load, an “over-the-air” electronic loading facility designed to make reloading of air time credits more convenient for, and accessible to consumers. These “over-the-air” reloads, which have both voice and text functions, are packaged in smaller denominations of Php30, Php60, Php115 and Php200, but have shorter validity periods of three days, six days, 12 days and 30 days, respectively. Starting with just 50,000 outlets when it was launched, Smart Load’s distribution network now encompasses over 400,000 retail agents, approximately 80% of which are micro businesses. As of December 31, 2003, 77% of Smart Buddy subscribers were using Smart Load as their reloading mechanism with daily transactions in December averaging 2.3 million. In the period since its launch, Smart Load has accounted for approximately 45% of sales derived from reloads.

 

On December 24, 2003, Smart introduced Pasa Load (the term “pasa” means “transfer” in the vernacular), a derivative service of Smart Load that allows for Php10 load transfers to other Smart Buddy and Piltel Talk ‘N Text subscribers. On January 25, 2004, denominations of Php2, Php5 and Php15 were added to the Pasa Load menu. All Pasa Load denominations have a one-day expiry period. Like PureTxt 100, we believe that Smart Load and Pasa Load will encourage subscribers to stay within our cellular network instead of churning and re-subscribing at a later time. As a result of the launch of Smart Load, we have ceased the production and sale of PureTxt 100 cards.

 

The average monthly churn rate for Smart's postpaid GSM subscribers for 2003 was 3.0%, compared to 2.3% in 2002. Smart's policy is to redirect outgoing calls to an interactive voice response system if the postpaid subscriber's account is either 45 days overdue or the subscriber has exceeded the prescribed credit limit. If the subscriber does not make a payment within 44 days of redirection, the account is disconnected. Within this 44-day period, a series of collection activities are implemented, involving the sending of a collection letter, call-out reminders and collection messages via text messaging.

 

Satellite, VSAT and Other Services

 

Our revenues from satellite, VSAT and other services consist mainly of rentals received for the lease of Mabuhay Satellite's transponders and Telesat's VSAT facilities to other companies and charges for ACeS Philippines’ satellite phone service. Total revenues from these services for 2003 amounted to Php507 million, a decrease of Php175 million, or 26%, from Php682 million for 2002.

 

Information and Communications Technology

 

Our information and communications technology business is conducted by ePLDT, a wholly-owned subsidiary of PLDT. ePLDT's principal business is its operation of an Internet data center under the brand name Vitroä. Granted pioneer status as an Internet data center by the Philippine Board of Investments, Vitroä provides co-location services, server hosting, hardware and software maintenance services, website development and maintenance services, webcasting and webhosting, shared applications, data disaster recovery and business continuity services, intrusion detection, and security services such as firewall and managed firewall.

 

ePLDT owns 99.6% of Infocom, one of the country’s leading internet service providers. Infocom offers consumer prepaid and postpaid internet access, corporate leased lines, dedicated dial-up, multi-user dial-up, broadband internet access thru DSL or NOW Cable Internet; Web consulting, development and hosting.

 

ePLDT is also engaged in the call center business through the following wholly-owned subsidiaries:

 

•               Vocativ Systems, Inc., or Vocativ, which owns and operates a 722-seat call center facility with 883 customer service representatives, or CSRs, exclusively for clients of a global provider of customer relationship management services. Vocativ commenced commercial operations in April 2002; and

 

•               Parlance Systems, Inc., or Parlance, which owns and operates a 522-seat call center facility with 619 CSRs, exclusively for one of the largest direct-to-home satellite service providers in the United States for customer support and billing requirements. Parlance commenced commercial operations in June 2002.

 

ePLDT sold its entire 51% interest in Contact World, a call center facility capable of accommodating 200 seats, on June 30, 2003 and assigned its receivables from the same to Service Zone Inc., a U.S.-based call center operator, for a total consideration of US$700,000.

 

ePLDT has also invested in a number of other e-commerce and Internet-related businesses, as described in Note 9 – Investments to the accompanying financial statements.

 

In 2003, our information and communications technology business generated total revenues of Php1,509 million, an increase of Php561 million, or 59%, from the Php948 million in 2002. These revenues accounted for 1% of our consolidated operating revenues for 2003 and 2002. ePLDT’s call center business contributed revenues of Php927 million; Infocom contributed revenues of Php380 million and Vitroä contributed revenues of Php202 million, representing 62%, 25% and 13%, respectively, of the total revenues from our information and communications technology business in 2003, compared to 32%, 37% and 31% in 2002. Going forward, we expect revenues from our call center business to continue to contribute significantly to our information and communications technology revenues with the growing demand for call center services.

 

Consolidated Operating Expenses

 

Our consolidated operating expenses in 2003 increased by Php8,157 million, or 14%, to Php67,655 million from Php59,498 million in 2002. The increase was primarily due to higher non-cash expenses, mainly depreciation and amortization and higher cash expenses, mainly compensation and benefits, maintenance and selling and promotions mostly associated with our wireless business. As a percentage of our consolidated operating revenues, however, consolidated operating expenses decreased to 69% in 2003 from 74% in 2002.

 

Fixed Line

 

Consolidated operating expenses related to our fixed line business in 2003 totaled Php33,188 million, an increase of Php1,278 million, or 4%, compared to Php31,910 million in 2002. The increase was primarily due to higher non-cash expenses, mainly provision for doubtful accounts and inventory obsolescence. As a percentage of our total fixed line operating revenues, fixed line-related operating expenses increased to 72% in 2003 as compared to 70% in 2002.

 

The following table shows the breakdown of our total consolidated fixed line-related operating expenses for the years ended December 31, 2003 and 2002 and the percentage of each expense item to the total:

 

____________

(1) Includes depreciation of capitalized foreign exchange losses from the revaluation of net dollar liabilities of Php4,329 million in 2003 and Php4,140 million in 2002.

 

Depreciation and amortization charges increased by Php128 million, or 1%, to Php13,261 million mainly due to an increase in depreciation of capitalized foreign exchange losses from the revaluation of our net dollar liabilities, which were incurred in acquiring various telecommunications equipment partially offset by a net decrease in depreciation of our regular asset base primarily resulting from asset disposals.

 

Compensation and benefits decreased by Php46 million, or approximately 1%, to Php7,089 million mainly due to a reduction in headcount due to PLDT’s manpower reduction program, partially offset by collective bargaining agreement-related increases in salaries and benefits of PLDT employees. See Note 17 – Other Income (Expenses) – Net to the accompanying financial statements for further discussion on PLDT’s manpower reduction program.

 

Provision for doubtful accounts increased by Php370 million, or 10% to Php3,926 million on account of higher provisions by PLDT for anticipated uncollectible accounts from various specifically identified domestic telecommunications carriers in 2003. PLDT’s provision for doubtful accounts in 2003 and 2002 was equivalent to 8% and 7%, respectively, of its operating revenues.

 

Maintenance expenses increased by Php7 million to Php2,856 million primarily due to higher maintenance costs of inside plant facility, computer and peripherals and submarine cable in 2003 as compared to 2002, partially offset by lower maintenance costs on outside plant facilities.

 

Selling and promotion expenses increased by Php61 million, or 5%, to Php1,353 million mainly as a result of PLDT’s promotional activities in relation to the launch of Hype, DSL and other Premium Phone Services, partially offset by reduced corporate public relations expenses.

 

Rent expenses increased by Php199 million, or 22%, to Php1,104 million mainly due to higher rentals paid by PLDT to suppliers of customer premises equipment as part of its bundled services to corporate customers partially offset by reduced number of leased transponders.

 

Professional and other service fees increased by Php40 million, or 4%, to Php1,057 million as a result of higher collection agency fees on account of higher collection of final accounts and payment of higher legal fees in 2003 for various services, partially offset by lower advisory fees due to a decrease in number of consultants in line with PLDT’s cost management efforts.

 

Insurance and security services increased by Php111 million, or 17%, to Php754 million primarily due to higher premiums on all risks insurance for properties, and directors’ and officers’ liability insurance for 2003 as compared to 2002.

 

Taxes and licenses increased by Php82 million, or 16%, to Php590 million mainly on account of higher business-related taxes paid in 2003 as compared to 2002.

 

Provision for inventory obsolescence amounting to Php239 million pertains to maintenance-related inventory items which were specifically identified as slow and non-moving stocks in 2003. There was no provision for inventory obsolescence in 2002.

 

Other operating costs increased by Php87 million, or 10%, to Php959 million mainly due to higher office supplies consumption and printing costs partially offset by lower contracted employee cost.

 

Wireless

 

Consolidated operating expenses associated with our wireless business in 2003 amounted to Php32,822 million, an increase of Php6,832 million, or 26%, from Php25,990 million in 2002. A significant portion of this increase was attributable to Smart’s non-cash charges mainly depreciation and amortization coupled with an increase in cash charges mainly compensation and benefits, maintenance, and selling and promotions. As a percentage of our wireless operating revenues, operating expenses associated with our wireless business decreased to 65% in 2003 from 77% in 2002.

 

The following table summarizes our consolidated wireless-related operating expenses for the years ended December 31, 2003 and 2002 and the percentage of each expense item to the total:

 

__________

 

(1) Includes depreciation of capitalized foreign exchange losses from the revaluation of net dollar liabilities of Php1,881 million in 2003 and Php1,855 million in 2002.

 

Depreciation and amortization charges increased by Php4,255 million, or 40%, to Php14,899 million substantially due to an increase in the depreciable asset base, a change in the estimated useful life of certain of Smart’s network assets owing to continuing network expansion and upgrade, and an increase in depreciation charges of capitalized foreign exchange losses from revaluation of net dollar liabilities.

 

Selling and promotion expenses increased by Php744 million, or 11%, to Php7,455 million mainly due to a 66% increase in Smart’s prepaid phone kit/SIM pack sales in 2003, higher product subsidies for postpaid subscribers and an increase in advertising and promotion expense on account of the launching of new services such as addict mobile, Smart Load and Pasa Load. Smart’s average subscriber acquisition cost, or SAC, for prepaid subscribers in 2003 was Php682, a decrease of 40% from Php1,139 in 2002. Commissions to dealers accounted for the highest percentage of prepaid SAC at 41% and 78% in 2003 and 2002, respectively. On the other hand, postpaid SAC in 2003 was Php15,074, an increase of 102% from Php7,460 in 2002. Handset subsidies accounted for 76% and 77% of postpaid SAC in 2003 and 2002, respectively. Blended SAC declined by 26%, to Php1,020 in 2003 from Php1,373 in 2002. Effective August 1, 2002, Smart changed its mode of payment for dealer commissions from prepaid air time cards to cash and reduced the maximum commission paid from a range of Php1,000-Php1,300 (depending on the volume purchased) to Php800 per prepaid phone kit sold. An additional 1% rebate is given on cash purchases of the prepaid phone kits. A Php50 commission is paid for each SIM pack sold.

 

Compensation and benefits increased by Php1,085 million, or 40%, to Php3,794 million primarily due to increased salaries, benefits and performance bonuses of Smart’s employees. In addition, Smart accrued for an additional share under the enhanced employee retirement fund approved by Smart’s Board of Directors in October 2003. Smart's employee headcount increased from 5,330 as of December 31, 2002 to 5,408 as of December 31, 2003.

 

Rent expenses increased by Php98 million, or 6%, to Php1,854 million on account of higher site rental cost incurred by Smart for its growing number of cell sites and base stations, in line with its network expansion and increased operational requirements for circuit facilities, coupled with higher office space rentals for the increased number of wireless centers and space requirements for increased personnel. As of December 31, 2003, Smart had 2,914 GSM cell sites and 3,904 base stations, compared with 2,110 GSM cell sites and 2,777 base stations as of December 31, 2002.

 

Maintenance expenses increased by Php786 million, or 76%, to Php1,825 million mainly due to higher site utility, repairs and other maintenance-related expenses associated with the expansion and upgrade of Smart’s cellular network equipment; increased office and telecenter utilities expenses; and increased computer hardware and software license expense.

 

Professional and other service fees increased by Php201 million, or 36%, to Php764 million mainly as a result of increased legal, audit and bill collection service fees.

 

Insurance and security services increased by Php158 million, or 27% to Php742 million mainly due to the growth in the number of Smart’s cell sites and the increase in the cost of equipment insured as a result of the continued growth and expansion of its GSM network.

 

Taxes and licenses increased by Php168 million, or 49%, to Php510 million mainly due to an increase in Smart’s business-related taxes, NTC supervision and regulation fees and disallowed input taxes.

 

Provision for inventory obsolescence decreased by Php300 million, or 77%, to Php90 million since the majority of the specifically identified slow and non-moving handsets were fully provided for in 2002.

 

Provision for doubtful accounts decreased by Php371 million, or 88%, to Php52 million mainly due to specifically identified subscriber and carrier accounts which were provided for in 2002.

 

Other operating costs increased by Php8 million, or 1%, to Php837 million mainly due to increases in Smart’s various business and operational-related expenses such as facility usage fees, training, travel, supplies, printing, and communication expenses.

 

Information and Communications Technology

 

Consolidated operating expenses associated with our information and communications technology business in 2003 totaled Php1,645 million, an increase of Php47 million, or 3%, from Php1,598 million in 2002. The increase was principally due to the full commercial operations of ePLDT and its newly formed subsidiaries. As a percentage of our information and communications technology operating revenues, operating expenses related to our information and communications technology business decreased to 109% in 2003 from 169% in 2002. The three largest expense items related to our information and communications technology business in 2003 were compensation and benefits, depreciation and amortization, and rent, representing 32%, 19% and 10%, respectively, of our total operating expenses related to this business. In 2002, the three largest expense items related to our information and communications technology business were depreciation and amortization, compensation and benefits, and rent, representing 26%, 22% and 17%, respectively, of related total operating expenses.

 

Net Operating Income

 

Our consolidated net operating income in 2003 was Php30,068 million, an increase of Php9,396 million, or 45%, from Php20,672 million in 2002. Accordingly, our consolidated operating margin (net operating income as a percentage of operating revenues) improved to 31% in 2003 from 26% in 2002.

 

Fixed Line

 

In 2003, our fixed line business segment contributed a net operating income of Php12,643 million, lower by Php966 million, or 7%, than Php13,609 million in 2002 as the 1% growth of our fixed line operating revenues was insufficient to cover the 4% increase in our fixed line-related expenses. PLDT’s net operating income contribution to this business segment in 2003 was Php12,489 million, a decrease of Php443 million, or 3%, compared to Php12,932 million in 2002.

 

Wireless

 

Our wireless business segment recorded an operating income of Php17,561 million in 2003, an increase of Php9,848 million, or 128%, over Php7,713 million registered in 2002. This significant improvement was due to a substantial increase of Php9,419 million in Smart's operating income contribution in 2003 which reached Php17,514 million from Php8,095 million in 2002 due primarily to the growth in Smart’s subscriber base.

 

Information and Communications Technology

 

In 2003, our information and communications technology business segment incurred an operating loss of Php136 million, a decrease of Php514 million, or 79%, from the Php650 million operating loss posted in 2002. These operating losses reflect the start-up nature of ePLDT’s businesses and those of its subsidiaries.

 

Interest Expense and Related Items - Net

 

Interest expense and related items – net decreased by Php1,239 million, or 10%, to Php11,425 million in 2003 from Php12,664 million in 2002 mainly due to the decrease in PLDT’s, Smart’s and Mabuhay Satellite’s interest expenses by Php798 million, Php416 million and Php62 million, respectively, due to lower debt balances and lower interest rates mainly on foreign currency-denominated loans bearing floating interest rates. These decreases were partially offset by a net increase of Php37 million in ePLDT’s interest expense resulting from an increase in its debt balances.

 

Equity Share in Net Losses (Income) of Investees Including Goodwill Amortization and Provision for Impairment in Value of Investments

 

Equity share in net losses (income) of investees including goodwill amortization and provision for impairment in value of investments decreased by Php2,506 million, or 60%, to Php1,672 million in 2003 from Php4,178 million in 2002 mainly due to the combined effects of (1) a provision for permanent decline in the value of PLDT’s investment in Piltel of Php4,110 million in 2002 and (2) impairment losses recognized in respect of ACeS Philippines’ investment in ACeS International Limited, or AIL, of Php1,614 million in 2003.

 

Interest Income

 

Interest income increased by Php275 million, or 118%, to Php509 million in 2003 from Php234 million in 2002 mainly attributable to an increase in our average cash balances.

 

Other Income (Expenses) – Net

 

In 2003, consolidated other expenses – net was Php5,963 million compared to a consolidated other income – net of Php488 million in 2002 due mainly to the combined effects of the following:

 

•         an increase in manpower reduction cost of Php1,580 million, or 488%, to Php1,904 million in 2003 from Php324 million in 2002. The increase primarily represents the costs of an enhanced separation package for 1,862 employees under PLDT’s manpower reduction program. The total cost of PLDT’s manpower reduction program of Php1,885 million in 2003 consisted of Php1,443 million of payments made over and above the normal separation benefits under the PLDT employees’ benefit plan and Php442 million loss on settlement; unrecognized past service costs which are normally amortized over the estimated remaining working lives of employees, in respect of employees who availed of the manpower reduction program are recognized as loss on settlement. See Note 17 – Other Income (Expenses) – Net to the accompanying financial statements for further discussion. The remaining balance in manpower reduction cost was attributable to SubicTel and ePLDT in the amount of Php14 million and Php5 million, respectively;

 

•         provision for unrealizable assets of Php1,408 million;

 

•         an increase in hedging cost of Php939 million (of which Php717 million was attributable to PLDT) as PLDT increased the hedged portion of its debt to 38% as of December 31, 2003 from 21% as of December 31, 2002 and an increase in Smart’s hedging cost of Php222 million in 2003; Smart did not have any hedging costs in 2002;

 

•         net gains aggregating Php906 million relating to certain financial instruments terminated in 2002;

 

•         impairment losses recognized in respect of certain equipment of ACeS Philippines related to the business of AIL amounting to Php974 million; and

 

•         impairment losses of Php387 million recognized by ePLDT in respect of certain equipment related to an investee company.

 

Income Before Income Tax and Minority Interest

 

Our income before income tax and minority interest in net income (losses) of consolidated subsidiaries in 2003 was Php11,517 million, representing an increase of Php6,965 million, or 153%, from Php4,552 million in 2002. On a non-consolidated basis, however, income before income tax and equity share in net income of our subsidiaries decreased by Php5,472 million, or 181%, to a loss of Php2,441 million in 2003 as against an income of Php3,031 million in 2002.

 

Our consolidated provision for income tax in 2003 decreased by 85%, to Php242 million in 2003 from Php1,592 million in 2002. On a non-consolidated basis, our tax benefit was Php587 million in 2003 as against a provision of Php854 million in 2002. These are reflective of PLDT’s tax loss position for 2003 owing to foreign exchange losses realized during the year from the repayment and refinancing of debt.

 

In 2003, our effective corporate tax rates were lower than the 32% statutory corporate tax rate due to differences between our consolidated and non-consolidated income as shown in our financial statements and our taxable income. These differences arose from the following:

 

•               the effect of a three-year income tax holiday granted to Smart by the Philippine Board of Investments in connection with the pioneer status it awarded to Smart's GSM network expansion project;

 

•               income already subjected to final tax; and

 

•               equity in net income of our associates, which has already been subjected to tax and therefore, as income to PLDT, is no longer subject to income tax.

 

Smart's three-year income tax holiday, which will expire in May 2004, applies to the incremental income generated from its GSM network expansion. The income tax holiday is computed by applying the exemption rate against the income tax due on GSM operations. The exemption rate is computed by dividing the incremental GSM revenues by eligible GSM revenues (both gross of interconnection revenues) where the incremental GSM revenues are derived by deducting the BOI-prescribed base figure (Smart’s gross GSM revenue in 2000) from the total GSM revenues. After adjusting for non-deductible items and unrealized and realized foreign exchange losses, Smart’s net taxable income is multiplied by the statutory corporate income tax rate of 32% and the exemption rate. The resulting figure is the income tax holiday that will be deducted from the income tax due on GSM revenues with the difference being the income tax due for the period. We expect our consolidated effective tax rate to increase following the expiration of Smart’s tax holiday.

 

Net Income

 

As a result of the factors discussed above and after taking into account our equity in net income of investees amounting to Php13,036 million, our consolidated net income for 2003 was Php11,182 million, representing an increase of Php8,179 million, or 272%, over our restated consolidated net income of Php3,003 million in 2002. This increase was largely due to Smart’s net income contribution of Php16,123 million for 2003, a significant improvement of 161% over its net income contribution in 2002, partially offset by non-recurring provisions, net of tax aggregating Php4,258 million and manpower reduction cost of Php1,436 million in 2003.

 

PLDT's net loss in 2003, before taking into account its equity share in net income of investees, was Php1,854 million as against an income of Php2,177 million in 2002. This was attributable to the after-tax effects of the following: (1) increase in manpower reduction cost of Php1,203 million, (2) non-recurring charges of Php1,236 million, (3) increase in hedging cost of Php488 million as PLDT increased the hedged portion of its debt to 38% in 2003 from 21% in 2002 and (4) net gains of Php616 million relating to certain financial instruments terminated in 2002.

 

Smart’s net income in 2003 was Php16,123 million, a 161% increase over its net income of Php6,166 million in 2002, on account of the sustained growth of its cellular operations.

 

ACeS Philippines registered a net loss of Php2,818 million in 2003, compared to a net loss of Php300 million in 2002 largely due to impairment charges in respect of its investment in AIL of Php1,614 million and of certain equipment related to the business of AIL of Php974 million.

 

Basic and diluted earnings per share, or EPS, of common stock increased to Php55.74 and Php53.73, respectively, in 2003 from basic and diluted EPS of Php8.03 in 2002 , after giving retroactive effect to common stock equivalents. See Note 19 – Earnings Per Common Share to the accompanying financial statements for further discussion.

 

Liquidity and Capital Resources

 

The following table shows our consolidated and non-consolidated cash flows for the years ended December 31, 2003 and 2002 as well as consolidated and non-consolidated capitalization and other selected financial data as of December 31, 2003 and 2002:

 

_______________

_

(1) Total debt less cash and cash equivalents.

(2) As restated to reflect the change in accounting policy on preoperating expenses, as described in Note 3 – Accounting Changes to the accompanying financial statements.

 

Since 2002, PLDT has pursued a number of liability management initiatives with the objectives of further improving the balance between its cash flows and debt service requirements and reducing its overall indebtedness.

 

Through these initiatives, PLDT was able to successfully raise the necessary external financing to fund its operating, investing and debt service requirements for 2002. On January 25, 2002, PLDT signed two loan agreements with Kreditanstalt fur Wiederaufbau, or KfW, which provided PLDT with a refinancing facility of US$149 million. On May 2, 2002, PLDT completed a global offering of notes in the aggregate amount of US$350 million with a simultaneous tender offer for its 8.5% Notes due 2003 and 10.625% Notes due 2004, which closed on May 15, 2002. On July 26, 2002, PLDT signed a loan agreement with Japan Bank for International Cooperation, or JBIC, for a JP¥9,760 million credit facility under JBIC’s Overseas Investment Loan, or OIL, Program. On September 4, 2002, PLDT signed a US$145 million syndicated multicurrency term loan facility, the first tranche of which was drawn on June 18, 2003 to refinance a portion of a Japanese yen syndicated term loan which matured on the same date, and the second tranche was drawn on December 22, 2003 to refinance a portion of a U.S. dollar term loan which fell due on the same date.

 

As of December 31, 2003, non-consolidated cash and cash equivalents amounted to Php5,278 million, while our consolidated cash and cash equivalents totaled Php19,263 million. Principal sources of consolidated cash and cash equivalents in 2003 were cash flows from operations amounting to Php56,006 million, drawings from short and long-term credit facilities aggregating Php18,496 million, and net equity funds raised through PLDT's subscriber investment plan totaling Php96 million. These funds were used principally for capital outlays of Php17,784 million, including capitalized interest of Php887 million; debt principal payments of Php31,017 million; and interest payments of Php11,659 million charged to operations.

 

Operating Activities

 

On a consolidated basis, net cash flows from operating activities in 2003 increased by Php3,061 million, or 6%, to Php56,006 million from Php52,945 million in 2002.

 

A growing portion of our consolidated cash flow is generated by our wireless business, which accounted for 52% of our consolidated operating revenues in 2003, compared to 42% in 2002. Revenues from our local exchange and national long distance services accounted for 21% and 7%, respectively, of our consolidated operating revenues in 2003, down from 26% and 10%, respectively, in 2002. Our international long distance service accounted for 13% of our consolidated operating revenues in 2003 and 2002, while data and other network services accounted for 6% and 7% of our consolidated operating revenues in 2003 and 2002, respectively.

 

PLDT's contribution to our consolidated cash flows from operations in 2003 was Php24,874 million, representing a decrease of Php3,211 million, or 11%, from Php28,085 million in 2002. The decrease was due to a higher level of cash operating and other expenses, including the cost for the manpower reduction program during 2003, compared to 2002.

 

Our subsidiaries, particularly Smart, made significant contributions to our cash from operations. In 2003, Smart generated cash from operations of Php29,727 million, or 53% of our consolidated cash flows from operations. Smart’s strong cash flows reflect the continuing strong performance of its cellular business. However, Smart is subject to loan covenants that restrict its ability to pay dividends, redeem preferred shares, make distributions to PLDT or otherwise provide funds to PLDT or any associate without the consent of its lenders. After receiving approvals from Finnvera and certain lenders for the payment of dividends to PLDT in an amount not to exceed 40% of Smart’s net income in 2001, Smart made its first dividend payment of Php1,540 million to PLDT in December 2002. In June 2003, Smart paid dividends in the amount of Php4,300 million to PLDT, representing 70% of Smart’s 2002 net income, and in November 2003, Smart paid additional dividends in the amount of Php1,866 million to PLDT equivalent to the remaining 30% of its 2002 net income, Smart will be required to obtain further waivers from Finnvera and certain lenders to pay additional dividends in future periods. We cannot assure you that Smart will be able to obtain such waivers in the future, or what amount, if any, Smart would be permitted or financially able to distribute. We expect that we will have difficulty meeting our debt payment obligations if we do not continue to receive cash dividends from Smart.

 

As of December 31, 2003, related party liabilities included (1) PLDT’s payables to Smart amounting to Php3,450 million, representing interconnection fees; (2) Smart’s liabilities to Piltel totaling Php2,199 million, relating mostly to prepaid air time reloads for Talk ‘N Text subscribers through Smart Load, and (3) Piltel’s liabilities to PLDT amounting to Php985 million, representing interconnection charges. See “Related Party Transactions” in this report and Note 15 – Related Party Transactions to the accompanying financial statements for further discussion.

 

Investing Activities

 

On a consolidated basis, net cash used in investing activities in 2003 of Php19,508 million was higher by Php2,698 million, or 16%, compared to Php16,810 million in 2002. This increase was primarily the result of higher aggregate capital spending. On a non-consolidated basis, net cash used in investing activities was Php919 million in 2003 compared to Php3,953 million in 2002 largely due to dividends received from Smart.

 

Our consolidated capital expenditures in 2003 totaled Php17,784 million, an increase of Php2,227 million, or 14%, from Php15,557 million in 2002 primarily due to Smart’s increased capital spending, partially offset by PLDT’s lower capital spending. Smart's capital spending of Php11,305 million in 2003 was used to further expand and upgrade its GSM and transmission network facilities to increase capacity and coverage in respect of basic and advanced cellular services. PLDT's capital spending of Php6,100 million was principally used to finance the expansion of its fixed line data and network services. PLDT Global’s capital spending of Php266 million was used to acquire additional transmission equipment for its subsidiaries. ePLDT and its subsidiaries’ capital spending of Php53 million was used to primarily fund its VitroTM, Infocom and call center business operations. The balance represented other subsidiaries’ capital spending. Consolidated capital expenditures in 2002 amounted to Php15,557 million, of which Php6,932 million, Php7,131 million, Php653 million and Php391 million were attributable to PLDT, Smart, ePLDT and PLDT Global, respectively.

 

Under the terms of Piltel’s debt restructuring plan, PLDT issued a Letter of Support for the benefit of Piltel and its creditors under which PLDT has agreed to cover any funding shortfalls of Piltel up to a maximum amount of US$150 million. Under the Letter of Support, PLDT provided to Piltel Php2,317 million (US$48 million) in 2000, Php2,039 million (US$41 million) in 2001, and Php571 million (US$11 million) in 2002. There was no drawdown under the Letter of Support in 2003. Drawings under the PLDT Letter of Support are converted into U.S. dollars at the prevailing exchange rates at the time of drawdown. As of December 31, 2003, the remaining undrawn balance under the Letter of Support was US$50 million (approximately Php2,793 million). If, among other things, Piltel's financial and operating performance were to deteriorate or any amounts were required to be paid to Piltel's unrestructured creditors in cash to settle their claims (aggregate principal of US$1 million as of December 31, 2003), additional drawings under the Letter of Support would likely be required to provide all or a portion of the funds needed by Piltel. We cannot assure that additional amounts will not have to be drawn under the Letter of Support nor can we predict when the remaining undrawn balance under the Letter of Support will be exhausted. See Note 9 – Investments to the accompanying financial statements for further discussion.

 

Financing Activities

 

On a consolidated basis, we used net cash of Php28,083 million for financing activities in 2003, compared to Php29,479 million in 2002. On a non-consolidated basis, net cash used in financing activities in 2003 was Php22,894 million, compared to Php22,405 million in 2002. The net cash used in financing activities in 2003 was mainly attributable to debt repayments by PLDT in line with its ongoing debt reduction program.

 

Debt Financing

 

Additions to our consolidated long-term debt in 2003 totaled Php15,361 million, consisting of PLDT's drawings totaling Php11,797 million, primarily from loan facilities extended and/or guaranteed by various export credit agencies and refinancing facilities used to repay maturing debts, and Smart's drawings of Php3,564 million, under its loan facilities with HypoVereinsbank, Credit Lyonnais and Nippon Export and Investment Insurance of Japan, or NEXI.

 

On a consolidated basis, net additions to short-term borrowings amounted to Php3,135 million in 2003 as compared to net payments of Php8,058 million in 2002. This was primarily due to the issuance by PLDT of One-Year Peso Notes in April and May 2003, generating an aggregate of Php1,803 million in net proceeds.

 

Our consolidated indebtedness as of December 31, 2003 was Php159,814 million, representing a decrease of Php8,709 million, or 5%, compared to Php168,523 million as of December 31, 2002. This decrease was mainly due to the reductions of Php5,869 million and Php2,305 million in PLDT’s and Smart’s indebtedness, respectively. PLDT’s indebtedness decreased by 4% to Php134,175 million as of December 31, 2003 from Php140,044 million as of December 31, 2002, due to PLDT’s debt payments in line with the thrust to reduce PLDT’s overall indebtedness. Smart's indebtedness as of December 31, 2003 was Php20,586 million, a decrease of 10% from Php22,891 million as of December 31, 2002.

 

As of December 31, 2003, PLDT had undrawn committed dollar-denominated long-term credit facilities in the aggregate amount of US$120 million, inclusive of the remaining US$50 million undrawn portion of the US$149 million KfW refinancing facility, US$8 million undrawn portion of the US$12 million term loan facility extended by DEG-Deutsche Investitions-und Entwicklungsgesellschaft mbH, or DEG, under an agreement dated May 29, 2003 and the undrawn JP¥5,615 million syndicated term loan facility supported by Nippon Export and Investment Insurance of Japan under an agreement dated June 11, 2003. Smart also had undrawn committed dollar-denominated long-term credit facilities in the aggregate amount of US$40 million under the US$100 million NEXI loan facility signed by Smart in November 2002 which is scheduled to be drawn by the end of the first half of 2004. In addition, Smart still has available facilities under its €50 million Framework Agreement with HypoVereinsbank up to a maximum aggregate amount of €44 million.

 

After giving effect to the anticipated application of existing refinancing facilities, the scheduled maturities of our outstanding long-term debt as of December 31, 2003 are as follows:

 

 

Approximately Php114,869 million principal amount of our consolidated outstanding long-term debt as of December 31, 2003 is scheduled to mature over the period from 2004 to 2008. Of this amount, approximately Php89,430 million is attributable to PLDT, Php20,586 million to Smart, and the remainder to Mabuhay Satellite, MaraTel and ePLDT.

 

Covenants

 

Our debt instruments contain restrictive covenants and require us to comply with specified financial ratios and other financial tests, calculated in conformity with accounting principles generally accepted in the Philippines, at relevant measurement dates, principally at the end of each quarterly period.

 

The financial tests under our debt instruments, as amended, include maintaining a positive tangible net worth and compliance with the following ratios:

 

•               interest coverage ratio, calculated on a non-consolidated basis and excluding PLDT’s equity share in net earnings or lossses of investees, of not less than 180% or 200%;

 

•               total debt to EBITDA on a non-consolidated basis of not more than 5.5:1 on December 31, 2003, not more than 5.0:1 from March 2004 to June 2004, not more than 4.5:1 from September 2004 to December 2004 and not more than 4.0:1 from March 2005 and thereafter;

 

•               long-term indebtedness to appraised value of equity/tangible net worth on a non-consolidated basis, ranging from not more than 1.1:1 to not more than 3.0:1;

 

•               current ratio on a non-consolidated basis, ranging from not less than 0.9:1 to not less than 1.2:1;

 

•               debt service coverage ratio on a non-consolidated basis of at least 1.1:1; and

 

•               debt to free cash flow ratio on a non-consolidated basis of not more than 5.5:1 from December 31, 2003 to June 30, 2004, not more than 5.0:1 from September 30, 2004 to June 30, 2005, not more than 4.5:1 from September 30, 2005 to June 30, 2006, and not more than 4.0:1 from September 30, 2006 onwards.

 

In addition, some of PLDT's debt instruments contain covenants requiring PLDT to comply with specified financial tests on a consolidated basis. These include:

 

•               long-term debt to appraised value of equity/tangible net worth of not more than 2.33:1;

 

•               total debt to EBITDA of not more than 4.5:1 in 2003 and 2004, and not more than 4.0:1 in 2005 and thereafter;

 

•               current ratio of not less than 0.75:1 to 0.9:1; and

 

•               interest coverage ratio of not less than 200%.

 

For purposes of deriving appraised value of equity/tangible net worth, we determined the revaluation surplus in respect of PLDT’s properties. PLDT’s properties in service as of December 31, 1997 were reappraised by an independent firm of appraisers to reflect their sound value, as part of NTC’s financial reporting requirements, based on the December 29, 1997 exchange rate of Php40.116 to US$1.00. As of December 31, 1997, the sound value was Php225,966 million and the revaluation surplus was Php82,723 million. This reappraisal was approved by the NTC on January 28, 2000 under NTC Case No. 98-183. As of December 31, 2003 and 2002, the revaluation surplus on PLDT’s 1997 appraised properties still in service, net of a 5% disallowance factor, amounted to Php38,441 million and Php44,984 million, respectively.

 

The principal factors that can negatively affect our ability to comply with these financial ratios and other financial tests are depreciation of the peso relative to the U.S. dollar, poor operating performance of PLDT and its consolidated subsidiaries, impairment or similar charges in respect of investments or other assets that may be recognized by PLDT and its consolidated subsidiaries, and increases in our interest expense. Interest expense may increase as a result of various factors, including issuance of new debt, the refinancing of lower cost indebtedness by higher cost indebtedness, depreciation of the peso, the lowering of PLDT's credit ratings or the credit ratings of the Philippines, increases in reference interest rates, and general market conditions. Since approximately 96% of PLDT's total debt is denominated in foreign currencies, principally in U.S. dollars, many of these financial ratios and other tests are negatively affected by any weakening of the peso. As of December 31, 2003, the peso depreciated by 4% to Php55.586 to US$1.00, from Php53.254 to US$1.00 as of December 31, 2002. The peso has been subjected to significant fluctuations. In 2003, the peso depreciated to Php55.075 to US$1.00 on March 12, 2003 then recovered to a high of Php52.021 to US$1.00 on May 8, 2003 only to depreciate again to a low of Php55.767 to US$1.00 on November 27, 2003.

 

PLDT's ability to maintain compliance with financial covenant requirements measured on a non-consolidated basis is principally affected by the performance of PLDT’s fixed line business. PLDT cannot be assured of the benefit of net revenues and cash flows generated by Smart and PLDT’s other investees in assisting in complying with non-consolidated covenants.

 

We have maintained compliance with all of our financial ratios and covenants as measured under our loan agreements. However, if negative factors adversely affect our financial ratios, we may be unable to maintain compliance with these ratios and covenants or be unable to incur new debt. Under some of our loan agreements, certain of our financial ratios have become more restrictive at the end of the second and fourth quarters of 2003 and will continue to become more restrictive in increments thereafter, which will make it more difficult for PLDT to maintain compliance with this ratio in the future. Inability to comply with our financial ratios and covenants or raise new financing could result in a declaration of default and acceleration of some or all of our indebtedness. The terms of some of our debt instruments have no minimum amount for cross-default.

 

Under PLDT's loan agreements that require maintenance of an interest coverage ratio of at least 180%, interest coverage ratio is the ratio of (x) our after-tax net income for the 12 months immediately preceding the calculation date after (1) adding back interest charges, depreciation, amortization and other non-cash charges (including equity share in net earnings or losses of investees but excluding provision for doubtful accounts) and provision for income taxes, and (2) deducting capitalized subscriber acquisition costs, to (y) the estimated aggregate interest charges payable during the 365-day period following the calculation date on all of PLDT's indebtedness outstanding on such calculation date.

 

Under PLDT's loan agreements that require maintenance of an interest coverage ratio of at least 200%, interest coverage ratio is the ratio of (x) our after-tax net income after adding back reserves for higher plant replacement costs, income taxes, interest charges, depreciation and non-cash charges (including equity share in net earnings or losses of investees and provision for doubtful accounts) during 12 consecutive months within the 15 calendar months immediately preceding the calculation date, to (y) the sum of (1) the estimated aggregate interest charges on all indebtedness, net of interest capitalized to construction, plus (2) dividends on mandatorily redeemable preferred stock, in each case scheduled to be paid during the 12 months following the calculation date.

 

Non-consolidated total debt to EBITDA is the ratio of (x) PLDT's total indebtedness (not including amounts payable by PLDT to Piltel under the Letter of Support) to (y) net income for the preceding 12 months, after adding back interest accrued on all indebtedness, depreciation, amortization and other non-cash charges (including equity share in net earnings or losses of investees, but excluding provision for doubtful accounts) and provision for income taxes and deducting any capitalized subscriber acquisition costs.

 

Non-consolidated long-term indebtedness to appraised value of equity (or under some covenants, to tangible net worth) is the ratio of (x) PLDT's aggregate indebtedness (or portion of such indebtedness) due more than one year following the calculation date and par value of all mandatorily redeemable preferred stock to (y) the sum of the aggregate par value of all of PLDT's outstanding common and convertible preferred stock (other than preferred stock subject to mandatory redemption), paid-in capital in excess of the par value of such stock, PLDT's retained earnings, reserve for higher plant replacement costs and revaluation increment arising from independent certified appraisals of PLDT's telephone plant approved by the NTC.

 

Non-consolidated current ratio is the ratio of (x) non-consolidated current assets to

(y) non-consolidated current liabilities, excluding from current liabilities 50% of the portion of long-term indebtedness due within one year of the calculation date.

 

Debt service coverage ratio is the ratio of (x) PLDT’s cash flow from operations after adding back interest charges (to the extent previously deducted) plus (1) dividends received from investees, cash received upon any redemption of redeemable preferred shares issued by Smart, any cash received under PLDT’s subscriber investment plan and interest income received less

(2) capital expenditures (excluding capitalized interest) and investments in investees for the 12 months immediately preceding the calculation date plus (3) PLDT’s closing cash balance of the last day of the calculation date to (y) the sum of the projected interest charges and principal debt repayments (excluding debt to be repaid with a refinancing facility) during the 12 months following the calculation date.

 

Debt to free cash flow ratio is the ratio of (x) PLDT’s debt less PLDT’s closing cash balance of the last day of the calculation period to (y) PLDT’s cash flow from operations after adding back interest charges (to the extent previously deducted) plus (1) dividends received from investees, cash received upon any redemption of redeemable preferred shares issued by Smart, any cash received under PLDT’s subscriber investment plan and interest income received less

(2) capital expenditures (excluding capitalized interest) and investments in investees for the 12 months immediately preceding the calculation date.

 

PLDT's debt instruments contain a number of other negative covenants that, subject to certain exceptions and qualifications, restrict PLDT's ability to take certain actions without lenders' approval, including:

 

•               incurring additional indebtedness;

 

•               prepaying other debt;

 

•               making investments;

 

•               extending loans;

 

•               extending guarantees or assuming the obligations of other persons;

 

•               paying dividends or other distributions or redeeming, repurchasing or otherwise acquiring shares of PLDT’s capital stock;

 

•               disposing of all or substantially all of its assets or of assets in excess of specified thresholds of its tangible net worth;

 

•               entering into management contracts providing for the management of its business or operations by a third party;

 

•               creating any lien or security interest;

 

•               permitting set-off against amounts owed to PLDT;

 

•               merging or consolidating with any other company;

 

•               entering into transactions with shareholders and affiliates; and

 

•               entering into sale and leaseback transactions.

 

Under the indenture of PLDT's 10.625% Notes due 2007 and 11.375% Notes due 2012, PLDT is required to comply with a number of additional covenants, including covenants that, subject to certain exceptions, restrict PLDT's ability to (1) incur debt unless its ratio of debt to EBITDA (calculated on a non-consolidated basis based on definitions provided in the same indenture, except under certain circumstances), after giving effect to the incurrence of such debt, would be less than 5.5 to 1 on or prior to December 31, 2003, 5.0 to 1 from January 1, 2004 to December 31, 2004 and 4.5 to 1 thereafter and (2) pay dividends, repurchase or redeem its capital stock, make investments and prepay subordinated debt, among other things. Subject to certain exceptions, these covenants also restrict our ability to sell assets and to use the proceeds of these asset sales.

 

Under the terms of the US$149 million facility with KfW, PLDT is prohibited from paying any dividends on common stock until after December 31, 2004. In addition, under the terms of PLDT's US$145 million multicurrency term facility agreement and JP¥5,615 million loan agreement, PLDT is restricted from distributing dividends to common stockholders unless

(i) no default has occurred which is continuing, and (ii) its debt to free cash flow ratio, after giving effect to the distribution of such dividends and, under certain circumstances, other adjustments to PLDT’s closing cash balance, would be less than 4.0 to 1.0. Under other loan agreements, PLDT may not declare or pay dividends on any of its capital stock without the prior written consent of the lenders (i) if PLDT is in default in the payment of any amounts due and payable under such loan agreement or after the occurrence and during the continuance of any other event of default or potential event of default under such agreements, (ii) if after giving effect to such action the current ratio would be less than 1.2 to 1.0 or (iii) in an amount greater than PLDT’s net income after taxes during the fiscal year to which such payment or distribution relates.

 

In case of a change in control of PLDT, PLDT may be required to repurchase or prepay certain indebtedness. Under the terms of the 10.625% Notes due 2007 and 11.375% Notes due 2012, we are required to offer to purchase all outstanding notes due 2007 and notes due 2012 for cash at a price of 101% of their principal amounts plus accrued interest in the event that (1) the aggregate of NTT Communications' and First Pacific's direct and indirect voting interest in PLDT's outstanding capital stock having voting rights falls below 35% of such capital stock,

(2) any person or, in certain instances, group of persons, which is not controlled directly or indirectly by First Pacific or NTT Communications acquires a direct or indirect voting interest in PLDT's outstanding capital stock having voting rights which equals or exceeds 35% of such capital stock and (3) if a rating agency at such time maintains a rating on either series of notes, the rating agency downgrades its credit rating on the series within 90 days (or more, in certain circumstances) following notice of the occurrence of the events specified in (1) and (2) above.

 

Under the terms of PLDT’s JP¥9,760 million loan from JBIC, in the event of any proposed sale or transfer of PLDT's stock that would result in NTT Communications holding less than 14.95% of PLDT's voting stock, we will be required to prepay, immediately upon effectiveness of such sale or transfer, all principal outstanding under the loan, together with accrued interest. However, prepayment will not be required if, following such sale or transfer,
(1) NTT Communications continues to have prior approval rights with respect to all matters as to which NTT Communications has approval rights under the stock purchase agreement pursuant to which it acquired its shares in PLDT or (2) JBIC, in its sole discretion, determines that NTT Communications’ participation in the expansion of Smart's GSM network capacity to extend PLDT’s cellular business in Smart would not be reduced below its level of participation as of the date of the loan agreement.

 

Under the terms of both PLDT’s US$145 million multicurrency term facility agreement and JP¥5,615 million loan agreement, if any lender so requests in writing, PLDT shall prepay in full such lender’s participation in the loan within 45 days from notification of the change in control and no later than the date on which PLDT is required to repurchase its 10.625% Notes due 2007 and 11.375% Notes due 2012 (“Bonds”) from bondholders accepting the change in control offer. A change in control is deemed to occur when (1) the aggregate of NTT Communications’ and First Pacific’s direct and indirect voting interest in PLDT’s outstanding capital stock having voting rights falls below 35% of such capital stock, (2) any person or, in certain instances, group of persons, which is not controlled directly or indirectly by First Pacific or NTT Communications acquires a direct or indirect voting interest in PLDT’s outstanding capital stock having voting rights which equals or exceeds 35% of such capital stock and (3) if a rating agency at such time maintains a rating on the Bonds, the rating agency downgrades its credit rating on the Bonds within 90 days (or more, in certain circumstances) following notice of the occurrence of the events specified in (1) and (2) above.

 

PLDT’s debt instruments contain customary and other default provisions that permit the lender to accelerate amounts due or terminate their commitments to extend additional funds under the debt instruments. These default provisions include:

 

•               cross-defaults and cross-accelerations that permit a lender to declare a default if PLDT is in default under another debt instrument; in some cases, the cross-default provision is triggered upon a payment or other default permitting the acceleration of PLDT’s debt, whether or not the defaulted debt is accelerated. In other cases, the cross-default provision requires the defaulted loan to be accelerated. In some debt instruments, the cross-default provision will be triggered only if the principal amount of the defaulted indebtedness exceeds a threshold amount specified in these debt instruments;

 

•               failure by PLDT to meet certain financial ratio covenants referred to above;

 

•               the occurrence of any material adverse change in circumstances that a lender reasonably believes materially impairs PLDT’s ability to perform its obligations under its debt instrument with the lender;

 

•               the revocation, termination or amendment of any of the permits or franchises of PLDT in any manner unacceptable to the lender;

 

•               the abandonment, termination or amendment of the project financed by a loan in a manner unacceptable to the lender;

 

•               the nationalization or sustained discontinuance of all or a substantial portion of PLDT’s business; and

 

•               other typical events of default, including the commencement of bankruptcy, insolvency, liquidation or winding up proceedings by PLDT.

 

Financing Requirements

 

We believe that our available cash, including cash flow from operations and drawings from existing and anticipated credit facilities, will provide sufficient liquidity to fund our projected operating, investment, capital expenditures and debt service requirements for the next 12 months. Further, as described above, we completed a number of initiatives under our liability management program to meet our debt service requirements in the short and medium term.

 

We continue to pursue various initiatives and financing transactions with the objective of further improving the balance between our cash flows and debt service requirements and reducing our overall indebtedness. In addition, PLDT has reduced its capital expenditures and investments, suspended dividend payments to common shareholders and increased its application of available cash to reduce its indebtedness. Further, we expect to benefit from increasing revenue and cash flow contributions from our subsidiaries, particularly Smart. After receiving approvals from Finnvera and certain lenders for the payment of dividends to PLDT in an amount not to exceed 40% of Smart’s net income in 2001, Smart made its first dividend payment of Php1,540 million to PLDT in December 2002. In June 2003, Smart paid dividends in the amount of Php4,300 million to PLDT, representing 70% of Smart’s 2002 net income, and in November 2003, Smart paid additional dividends to PLDT equivalent to the remaining 30% of its 2002 net income or Php1,866 million, after receiving the necessary approvals from Finnvera and certain lenders. Smart will be required to obtain further waivers to pay additional dividends in future periods. We cannot assure you that Smart will be able to obtain such waivers in the future, or what amount, if any, Smart would be permitted or financially able to distribute. We expect that we will have difficulty meeting our debt payment obligations if we do not continue to receive cash dividends from Smart.

 

Credit Ratings

 

Our credit ratings may significantly affect the terms of our prospective financings, particularly financing costs. None of our existing indebtedness contains provisions under which credit rating downgrades would trigger a default, changes in applicable interest rates or other similar terms and conditions. On January 27, 2004, PLDT’s foreign currency senior unsecured debt rating was upgraded by Moody’s Investors Service to “Ba2” from a recent “Ba3” as of July 29, 2003 and preferred stock rating moved up to “B1” from “B2.” The rating reflects continued improvements in the operating performance of Smart and the expectation of on-going free cash flow to help repay debt maturities in the coming years. The negative outlook on PLDT's rating is constrained, reflecting Moody's decision to downgrade the Philippine Government's long-term foreign currency bond rating to “Ba2” with a negative outlook also on January 27, 2004.

 

On May 30, 2003, Fitch Ratings also changed its outlook on PLDT to stable with a credit rating of “BB-”. On April 22, 2003, Standard & Poor's Ratings Group affirmed its “BB” rating and stable outlook on PLDT.

 

On October 29, 2002, Philippine Rating Services Corporation, or PhilRatings, a credit rating agency in the Philippines, announced its “PRS1” rating for PLDT’s Php2.0 billion One-Year Peso Notes for which the registration was rendered effective by the Philippine Securities and Exchange Commission on April 9, 2003. On December 10, 2003, PhilRatings affirmed its rating of “PRS1” for PLDT’s One-Year Peso Notes. PRS 1 is the highest rating possible on PhilRatings’ scale for short-term securities and is based on the issuer’s “strongest capability for timely payment of debt on both principal and interest.”

 

Off-Balance Sheet Arrangement

 

On October 10, 2002, PLDT entered into a Receivables Purchase Deed with a foreign institution, or the Purchaser, under which PLDT agreed (1) to sell its receivables from certain eligible foreign carriers for an advance payment of US$50 million and (2) to service, administer and collect the receivables on behalf of the Purchaser. The Purchaser will have no recourse to PLDT should the eligible carrier fail or refuse to settle the assigned/purchased receivables, except if PLDT commits a breach of its representations and warranties under the Receivables Purchase Deed. For the year ended December 31, 2003, receivables sold under the Receivables Purchase Deed amounted to US$11 million (Php608 million).

Equity Financing

 

Through our subscriber investment plan, or SIP, which provides postpaid fixed line subscribers the opportunity to buy shares of our 10% Cumulative Convertible Preferred Stock as part of the upfront payments collected from subscribers, PLDT was able to raise Php96 million in 2003 and Php464 million in 2002. As approved by the NTC, the SIP was made optional in 2003 from being required in earlier years.

 

Cash dividend payments in 2003 amounted to Php1,603 million, compared to Php1,582 million in 2002, all of which were paid solely to preferred shareholders of PLDT. The most recent cash dividend paid by PLDT to its common shareholders was in April 2001, and no dividends were paid to common shareholders in 2003.

 

Contractual Obligations and Commercial Commitments

 

Contractual Obligations

 

The following table discloses our contractual obligations outstanding as of December 31, 2003:

 

_____________

 

(1)  The amounts disclosed in the table above are based on the original Air Time Purchase Agreement with AIL. In 2003, a Standstill Agreement was executed to cover, among other matters, the amended minimum and supplemental air time payment provisions for the year 2003. The parties are currently in negotiations to reach an agreement in respect of a revised Air Time Purchase Agreement.

 

Long-term Debt Obligations

 

For a discussion of our long-term debt obligations, see Note 12 – Long-term Debt to the accompanying financial statements.

 

Long-term Lease Obligations

 

Transponder Lease Agreement. On December 28, 1995, PLDT and Mabuhay Satellite entered into a Transponder Lease Agreement, which was amended on May 10, 2000. This agreement has a term of ten years commencing on December 18, 1997, unless terminated earlier in accordance with the terms thereof. The annual basic rent for the transponders is US$14 million in 2003. As of December 31, 2003, PLDT’s aggregate remaining obligation under this agreement was approximately Php2,802 million.

 

Municipal Telephone Projects. In 1993, PLDT entered into two lease agreements with the Philippine Department of Transportation and Communications, or DOTC, covering telecommunications facilities established under the Municipal Telephone Act. Under these agreements, PLDT was granted the exclusive right to perform telecommunications management services, to expand services, and to promote the use of the DOTC-contracted facilities in certain covered areas for a period of 15 years. Title to the properties shall be transferred to PLDT upon expiration of the lease term. As of December 31, 2003, PLDT’s aggregate remaining obligation under these agreements amounted to approximately Php885 million. In case of cancellation, PLDT is liable to pay Php100 million under each of the two contracts as liquidated damages.

 

Domestic Fiber Optic Network Submerged Plant Agreement. On July 4, 2000, PLDT entered into an agreement with NTT World Engineering Marine Corporation for submarine cable repair and related services for the maintenance of PLDT's domestic fiber optic network submerged plant for a period of five years up to July 4, 2005. Under this agreement, PLDT is required to pay NTT World Engineering Marine Corporation a fixed annual standing charge of US$2 million, excluding cost for the use of a remotely-operated submersible vehicle at US$5,000 for every day of use and repair cost computed at US$19,000 per day of actual repair. As of December 31, 2003, the aggregate remaining obligation under this agreement was approximately Php185 million.

 

Digital Passage Service Contracts. PLDT has existing Digital Passage Service Contracts with foreign telecommunication administrations for several dedicated circuits to various destinations for ten to 25 years expiring at various dates. As of December 31, 2003, PLDT’s aggregate remaining obligation under these contracts amounted to approximately Php41 million.

 

License Agreement with Mobius Management Systems (Australia) Pty Ltd., or Mobius. PLDT entered into a license agreement with Mobius pursuant to which Mobius has granted PLDT a non-exclusive, non-assignable and non-transferable license for the use of computer software components. Under this agreement, Mobius is also required to provide maintenance services for a period of one year at no additional maintenance charge. PLDT may purchase maintenance services upon expiration of the first year for a fee of 15% of the current published license fee. As of December 31, 2003, PLDT’s aggregate obligation under this agreement was approximately Php65 million.

 

Other Long-term Lease Obligations. We have various long-term lease contracts for periods ranging from two to ten years covering certain offices, warehouses, cell sites, telecommunication equipment locations and various office equipment. In particular, Smart has lease obligations aggregating Php2,309 million in respect of office and cell site rentals with over 2,000 lessors nationwide.

 

Unconditional Purchase Obligations

 

Air Time Purchase Agreement with ACeS International Limited. PLDT is a party to a Founder NSP, or National Service Provider, Air Time Purchase Agreement with AIL, which was amended in December 1998, under which PLDT is granted the exclusive right to sell ACeS services in the Philippines. In exchange, the Air Time Purchase Agreement states that PLDT has to purchase from AIL a minimum of US$5 million worth of air time annually over ten years commencing on the date of commercial operations of the Garuda I satellite. In the event AIL’s aggregate billing revenue is less than US$45 million in any given year, the Air Time Purchase Agreement also states that PLDT has to make supplemental air time purchase payments not to exceed US$15 million per year during the ten-year term.

 

PLDT and the other founder NSPs are endeavoring to amend the Air Time Purchase Agreement due to the occurrence of partial satellite loss, changes in the primary business of ACeS and other events affecting the business.

 

In March 2003, PLDT, together with the other founder NSPs, entered into a Standstill Agreement with AIL suspending the application and enforcement of the minimum and supplemental air time payments under the original Air Time Purchase Agreement. In lieu of these payments, the parties agreed that AIL shall provide PLDT and the other founder shareholders with unlimited use of air time for the year 2003 in exchange for a fixed fee in the amount of US$3.8 million for PLDT. Moreover, PLDT is obliged to purchase from AIL 13,750 satellite phone units for the year 2003 at US$395 F.O.B. per unit, subject to quarterly price adjustments. The parties to the Standstill Agreement also agreed to negotiate in good faith and use their best efforts to reach an agreement on a revised Air Time Purchase Agreement before November 15, 2003 that will cover, among others, the amended minimum and supplemental air time payment provisions subject to the approval of AIL’s creditors. See Note 3 – Accounting Changes and Note 21 – Provisions and Contingencies to the accompanying financial statements for further discussion.

 

As of December 31, 2003, PLDT’s aggregate remaining minimum obligation under the original Air Time Purchase Agreement was approximately Php10,081 million.

 

International Affiliate Agreement with VeriSign, Inc., or VeriSign. On September 15, 2000, ePLDT entered into an agreement with VeriSign for the non-exclusive, non-transferable right and license to use the VeriSign software, brand and Certification Practice Statement for the purpose of approving, issuing, suspending or revoking digital certificates for users of the Internet or similar open systems in the Philippines for a period of seven years. Under this agreement, ePLDT is required to pay VeriSign a certain percentage of the revenue derived from the services subject to minimum annual royalty payments aggregating to US$11 million, which was subsequently reduced to US$1 million, for the seven-year contract period. In addition, ePLDT was required to pay an annual support fee totaling US$0.5 million during the first year and US$0.3 million in each year thereafter.

 

Effective July 1, 2003, VeriSign has agreed to amend the agreement and issued Addendum 6 to write-off all past due invoices and payments owed to VeriSign, which were invoiced or scheduled to be invoiced under the agreement prior to this Addendum 6. All royalty payments and annual support fees due through June 2003 will be part of the write-off in the amount of US$0.8 million. For contract year 4 (September 2003-August 2004), the annual support fee will be reduced from US$0.3 million to US$ 40,000 and for contract years 5-7 (September 2003-August 2007) from US$0.3 million to US$0.16 million. In addition, VeriSign agreed to reduce the affiliate revenue sharing rates from 50% of suggested retail price to 25% of suggested retail price for both enterprise and Internet products for 12 months starting July 2003 and negotiable thereafter. As of December 31, 2003, ePLDT’s aggregate remaining minimum obligation under this agreement was approximately Php26 million pertaining to annual support fee.

 

License Purchase Agreement with I-Contact Solutions Pte. Ltd. On April 2, 2003, iPlus Intelligent Network Inc., or iPlus, entered into an Application Services Provider, or ASP, and Reseller Contract with I-Contact Solutions Pte. Ltd., or I-Contact, of Singapore. Under the agreement, iPlus will purchase licenses of the CosmoCall Universe ™ IP-based contact center solution. CosmoCall Universe supports multi-channel customer interactions including telephone, web chat, web voice, web video, web collaboration, email and voicemail in one high capacity, high availability, multi-tenant platform. CosmoCall Universe is a complete, unified contact center suite that includes ACD, IVR, CTI, predictive dialing, multimedia recording and a complement of powerful management applications. The aggregate value of these licenses is US$2.1 million and these will be delivered quarterly over a two-year period. Further to the agreement, I-Contact will appoint iPlus as the exclusive reseller and ASP for the Philippine market and will provide iPlus with all the necessary support in terms of sales, marketing, and technical services. As of December 31, 2003, iPlus’ aggregate remaining obligation under this agreement was approximately Php83 million.

 

Other Unconditional Purchase Obligations. PLDT has various purchase contracts for periods ranging from two to three years covering the use of fraud management system and satellite hub and remote VSAT network systems.

 

Other Long-term Obligations

 

Mandatory Conversion and Purchase of Shares. As of December 31, 2003, PLDT had issued a total of 3 million shares of Series V Convertible Preferred Stock, 5 million shares of Series VI Convertible Preferred Stock and 4 million shares of Series VII Convertible Preferred Stock in exchange for a total of 58 million shares of Piltel’s Series K, Class I Convertible Preferred Stock pursuant to the debt restructuring of Piltel. Of these PLDT issued preferred shares, 99% of Series V, close to 100% of Series VI and 100% of Series VII Convertible Preferred Stock were issued on June 4, 2001. In 2002, PLDT issued additional 30,100 shares of Series V Convertible Preferred Stock and 14,087 shares of Series VI Convertible Preferred Stock in exchange for a total of 220,935 shares of Series K, Class I Convertible Preferred Stock of Piltel. In 2003, PLDT issued 110,908 more shares of Series VI Convertible Preferred Stock in exchange for 554,540 shares of Piltel’s Series K, Class I Convertible Preferred Stock. Each share of Series V, VI and VII Convertible Preferred Stock is convertible at any time at the option of the holder into one PLDT common share. On the date immediately following the seventh anniversary of the issue date of the Series V and Series VI Convertible Preferred Stock and on the eighth anniversary of the issue date of the Series VII Convertible Preferred Stock, the remaining outstanding shares under these series will be mandatorily converted to PLDT common shares. Under a put option exercisable for 30 days, holders of common shares received on mandatory conversion will be able to require PLDT to purchase such PLDT common shares for Php1,700 or US$36.132 or JP¥4,071.89 per share, depending on the series.

 

As of December 31, 2003, 145,320 shares of Series V Convertible Preferred Stock and 531,251 shares of Series VI Convertible Preferred Stock had been converted to PLDT common shares. The aggregate value of the put option based on outstanding shares as of December 31, 2003 was Php21,898 million, of which Php13,774 million is payable on June 4, 2008 and Php8,124 million on June 4, 2009 if all of the outstanding shares of Series V, VI and VII Convertible Preferred Stock were mandatorily converted and all the underlying common shares were put to PLDT. The market value of the underlying common shares was Php10,763 million, based on the market price of PLDT’s common stock of Php970 per share as of December 31, 2003.

 

Commercial Commitments

 

As of December 31, 2003, our outstanding commercial commitments, in the form of letters of credit, amounted to Php2,640 million. These commitments will expire within one year.

 

In October 1998, Smart entered into a Frame Supply Contract with Nokia Telecommunications OY for the supply of hardware, software and documentation for its GSM cellular network. In the same month, Smart and Nokia (Philippines), Inc., or Nokia, signed a Frame Services Contract that covers the design, planning, installation, commissioning, integration, acceptance testing, training and handling over of the GSM network. In August 2001, Smart issued a Master Purchase Order, or MPO, in the amount of US$200 million in favor of Nokia for the purchase of additional equipment to expand its GSM cellular network. The US$200 million MPO was completed in November 2003. On May 30, 2003, Smart entered into a Technical Support Services Order, or TSSO, with Nokia (Philippines), Inc., in the amount of US$8 million. This TSSO has been fully served as of December 31, 2003.

 

In January 2004, Smart signed a new MPO in favor of Nokia amounting to US$117 million (Phase 7 under the Frame Supply Contract between Smart and Nokia). Smart is, however, under no legal obligation to incur these expenditures.

 

As of December 31, 2003, Smart had no guarantee obligations, standby repurchase obligations or other commercial commitments.

 

Quantitative and Qualitative Disclosures about Market Risks

 

Our operations are exposed to various risks, including liquidity risk, foreign exchange risk and interest rate risk. The importance of managing these risks has significantly increased in light of considerable change and continuing volatility in the Philippine and international financial markets. With a view to managing these risks, we have incorporated financial risk management functions in our organization, particularly in our treasury operations.

 

Liquidity Risk Management

 

We seek to manage our liquidity profile to be able to finance our capital expenditures and service our maturing debts. To cover our financing requirements, we intend to use internally generated funds and proceeds from debt and equity issues and sales of certain assets.

 

As part of our liquidity risk management program, we regularly evaluate our projected and actual cash flow information and continuously assess conditions in the financial markets for opportunities to pursue fund-raising initiatives. These initiatives may include bank loans, export credit agency-guaranteed facilities, and debt capital and equity market issues.

 

Foreign Exchange Risk Management

 

As of December 31, 2003, the Philippine peso depreciated against the U.S. dollar to Php55.586 to US$1.00 from Php53.254 to US$1 as of December 31, 2002, which in turn depreciated against the U.S. dollar from Php51.690 to US$1.00 at December 31, 2001. In 2003, PLDT capitalized net foreign exchange losses of Php4,629 million, as compared to Php3,876 million in 2002. Of these capitalized net foreign exchange losses, Php4,549 million in 2003 and Php3,961 million in 2002, were attributable to foreign currency-denominated liabilities used to finance our capital investments and were therefore recorded as additions to the carrying value of the related property accounts.

 

The following table shows our consolidated and non-consolidated foreign currency-denominated monetary assets and liabilities and their peso equivalents as of December 31, 2003 and 2002:

 

________________

 

(1)  The exchange rate used was Php55.586 to US$1.00.

(2)  The exchange rate used was Php53.254 to US$1.00.

 

While a certain percentage of our revenues is either linked to or denominated in U.S. dollars, substantially all of our indebtedness, a substantial portion of our capital expenditures and a portion of our operating expenses are denominated in foreign currencies, mostly in U.S. dollars.

 

As of December 31, 2003, approximately 96% of both our total consolidated and non-consolidated debts were denominated in foreign currencies. Of our foreign currency-denominated debts, 7% and 8% are in Japanese yen, on a consolidated and non-consolidated basis, respectively, and the balance in U.S. dollars. Thus, a weakening of the peso against the U.S. dollar or Japanese yen will increase both the principal amount of our unhedged foreign currency-denominated debts (representing 63% and 58% of our consolidated and non-consolidated debts, respectively), and interest expense on our debt in peso terms. In addition, many of our financial ratios and other financial tests will be negatively affected. If, among other things, the value of the peso against the U.S. dollar drops from its current level, we may be unable to maintain compliance with these ratios, which could result in acceleration of some or all of our indebtedness. For further information on our loan covenants, see “Liquidity and Capital Resources — Financing Activities — Covenants” above and Note 12 – Long-term Debt to the accompanying financial statements.

 

To manage our foreign exchange risks, stabilize cash flows, and improve investment and cash flow planning, we enter into forward foreign exchange contracts, foreign currency swap contracts, currency options and other hedging products aimed at reducing and/or managing the adverse impact of changes in foreign exchange rates on our operating results and cash flows. However, these hedges do not cover all of our exposure to foreign exchange risks, and hedges to cover all of our exposure are not currently nor readily available.

 

Specifically, we use forward foreign exchange contracts, foreign currency swap contracts and currency option contracts to manage the foreign exchange risk associated with our foreign currency-denominated loans. As of December 31, 2003, PLDT’s outstanding forward foreign exchange contracts, principal-only long-term cross-currency swap contracts and currency option contracts amounted to US$125 million, US$725 million and US$79 million, respectively.

 

Smart’s outstanding forward foreign exchange contracts amounted to US$72 million as of December 31, 2003. Also, Smart had a long-term cross-currency swap contract which matured on April 30, 2003. The final exchange has been made and the contract has been terminated.

 

For further discussions of these contracts, see Note 12 – Long-term Debt to the accompanying financial statements.

 

Interest Rate Risk Management

 

From time to time and on a limited basis, we enter into interest rate swap agreements in order to manage our exposure to interest rate fluctuations.

 

We make use of hedging instruments and structures solely for reducing or eliminating financial risks associated with our liabilities and not for trading or speculative purposes.

 

Effect of Peso Depreciation

 

In 2003 and 2002, our operating revenues, which have been received in U.S. dollars or in respect of which we have been able to adjust our service fees to reflect changes in the peso-to-dollar exchange rate exceeded our U.S. dollar-linked operating expenses. As a result, the depreciation of the peso against the dollar over this period had a positive net impact on our operating profit. However, since substantially all of our indebtedness is denominated in U.S. dollars, such depreciation has also increased our interest expense in peso terms and increased the peso amounts of our U.S. dollar-denominated indebtedness. PLDT has capitalized its foreign exchange losses in respect of its U.S. dollar-denominated indebtedness, and net income in future periods is expected to be negatively affected as a result of higher depreciation expense resulting from such capitalization. Our cash flows are negatively affected by the higher peso cost of repaying U.S. dollar-denominated debts, and our ability to comply with financial covenants and ratios is negatively affected by the increase in the amount of our debts and our interest expenses in peso terms.

 

Impact of Inflation and Changing Prices

 

Inflation can be a significant factor in the Philippine economy, and we are continually seeking ways to minimize its impact. In recent periods, while decreases in the relative value of the peso have had a significant effect on us, we do not believe inflation has had a material impact on our operations. The average inflation rate in the Philippines in 2003 was 3.1%, the same level as in 2002.

 

OTHER INFORMATION

 

PLDT Named as Best Managed Company in the Philippines for 2003 by Asiamoney

 

PLDT has been named as the Philippines’ Overall Best Managed Company in 2003 by Asiamoney, one of the most influential and trusted financial magazines in Asia. PLDT was top picked in a survey that ranked Asia’s leading listed companies in 2003 by more than 200 investors from over 180 institutions worldwide. PLDT also placed first in the following categories:

 

•               Best in Corporate Strategy

 

•               Best in Financial Management

 

•               Best in Operational Efficiency

 

•               Best in Investor Relations

 

•               Best Focus on Shareholder Value

 

•               Most Improved in Corporate Governance

 

Smart Acquires Wolfpac

 

In October 2003, Smart acquired an 80% equity interest in Wolfpac Communications, Inc., a leading content and applications provider in the Philippines nominated twice as “best wireless applications developer” in the international GSM Association Awards. The acquisition provides Smart with the opportunity to have a direct link to the content development community, a key differentiator in cellular service.

 

PLDT CBA Negotiations Concluded with a MOA

 

The negotiations on the Collective Bargaining Agreement for the years 2003-2006 for PLDT’s rank-and-file employees were concluded with the signing of a Memorandum of Agreement between the bargaining parties, the Manggagawa ng Komunikasyon sa Pilipinas Union and the PLDT Management panel, on February 13, 2004.

 

Investigation by U.S. Department of Justice

 

In January 2004, PLDT and a PLDT employee received a grand jury subpoena in connection with a criminal investigation being conducted by the U.S. Department of Justice with respect to alleged antitrust violations relating to the provision of international termination services in the Philippines. At this time, PLDT cannot predict the outcome of the investigation.

 

Related Party Transactions

 

In the ordinary course of business, companies belonging to the PLDT Group are engaged in arm’s-length intercompany transactions. We believe that the terms of these transactions are comparable with those available from unrelated parties.

 

•               Telecommunications services provided within the PLDT Group — interconnection agreements among/between PLDT, Smart, Piltel, Clark Telecom, Subic Telecom, MaraTel and PLDT Global under terms similar with those agreed with other telecommunications providers outside the PLDT Group.

 

•               Transponder Lease Agreement between PLDT and Mabuhay Satellite — an agreement pursuant to which Mabuhay Satellite leases to PLDT C-band transponders on board the Agila II satellite, in consideration of a basic rent. Total fees under this agreement totaled Php747 million and Php925 million for 2003 and 2002, respectively. PLDT’s outstanding obligations under this agreement amounted to Php26 million as of December 31, 2003 and Php270 million as of December 31, 2002.

 

•               Facilities Management Agreement between PLDT and Piltel — an agreement under which PLDT undertakes the management, operation and maintenance of Piltel’s regional telecommunications facilities as well as Executive Order No. 109, network operations and services, including E.O. 109 fixed line build-out installations, public calling offices, payphone facilities, and the systems required to support these services. Management fees under this agreement totaled Php52 million for 2003 and 2002, respectively. PLDT’s outstanding receivables under this agreement amounted to Php329 million and Php258 million as of December 31, 2003 and 2002, respectively.

 

•               Facilities Management Agreement between Subic Telecom and Piltel — an agreement under which Subic Telecom manages the regional telephone network, customer operations, network operations and payphones of Piltel in Subic and Olongapo City. Management fees under this agreement totaled Php21 million and Php22 million for 2003 and 2002, respectively. Subic Telecom’s outstanding receivables under this agreement amounted to Php11 million as of December 31, 2003 and Php2 million as of December 31, 2002.

 

•               Agreements between Smart and Piltel — agreements relating to the integration of Smart’s and Piltel’s operations under which Smart undertakes to manage Piltel’s facilities, customer services, administrative support and management services and billing services. In addition, Smart also entered into a facilities service agreement with Piltel under which Piltel accesses Smart's existing GSM network and facilities to enable Piltel to offer prepaid cellular service using GSM technology in exchange for approximately 50% of Piltel's revenues, net of interconnection expenses. Total fees under these service agreements totaled Php4,974 million and Php3,159 million for 2003 and 2002, respectively. Smart’s outstanding receivables under these agreements amounted to Php1,539 million and Php816 million as of December 31, 2003 and 2002, respectively.

 

•               Air Time Purchase Agreement between PLDT and AIL and Related Agreements — an agreement under which PLDT has been granted the exclusive right to sell ACeS services in the Philippines. In March 2003, PLDT, together with the founder shareholders, entered into a Standstill Agreement in respect of the Air Time Purchase Agreement. See Note 15 – Related Party Transactions and Note 20 – Contractual Obligations and Commercial Commitments to the accompanying financial statements for further discussion.

 

•               Agreements between Smart and ACeS Philippines — agreements under which Smart (1) provides ACeS Global Mobile Personal Communications by Satellite, or GMPCS, services, in the Philippines under a revenue-sharing agreement,

(2) undertakes the management, maintenance and operations of GMPCS, and

(3) provides certain administrative support and services in certain aspects of ACeS Philippines’ business operations. Fees under these agreements, net of Smart’s share, totaled Php12 million for 2003 and 2002. Under these agreements, Smart had no outstanding obligation as of December 31, 2003 and 2002.

 

In addition, transactions to which PLDT or its subsidiary is a party, in which a director or key officer or owner of more than 10% of the common shares of PLDT, or any member of the immediate family of a director or key officer or owner of more than 10% of the common shares of PLDT had a direct or indirect material interest as of December 31, 2003 and 2002 are as follows:

 

•               Agreements with NTT Communications and/or its Affiliates — agreements under which (1) NTT Communications provides advisory services for various business areas of PLDT; (2) NTT World Engineering Marine Corporation provides maintenance services to PLDT’s domestic fiber optic network; (3) PLDT is licensed to market managed data and other services using NTT Communications’ Arcstar brand; and (4) PLDT and NTT Communications agreed to cooperative arrangements for international telecommunication services. Fees under these agreements totaled Php288 million and Php289 million for 2003 and 2002, respectively. PLDT’s outstanding obligations under these agreements amounted to Php40 million and Php36 million as of December 31, 2003 and 2002, respectively.

 

•               Agreements between Smart and Asia Link B.V. — agreements under which Asia Link undertakes to provide technical support services for the operations and maintenance of Smart’s CMTS. Fees under these agreements totaled Php429 million for 2003 and 2002. Under these agreements, Smart had outstanding payables of Php228 million as of December 31, 2003 and Php31 million as of December 31, 2002. Asia Link is a subsidiary of First Pacific.

 

•               Agreements relating to insurance companies — Gotuaco del Rosario and Associates, or Gotuaco, acts as the broker for certain insurance companies to cover certain insurable properties of the PLDT Group. Insurance premiums are remitted to Gotuaco and the broker’s fees are settled between Gotuaco and the insurance companies. In addition, PLDT has signed an insurance policy with Malayan Insurance Co. Inc., or Malayan, wherein premiums are paid directly to Malayan. Premium payments to Gotuaco and Malayan covering the twelve-month period ending July 31, 2004 totaled Php439 million. Two directors of PLDT have a direct/indirect interest in or serve as director/officer of Gotuaco and Malayan.

 

For a more detailed discussion of the related party transactions enumerated above, see Note 15 Related Party Transactions to the accompanying financial statements.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

PHILIPPINE LONG DISTANCE TELEPHONE COMPANY

 

FINANCIAL STATEMENTS

 

AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001

 

AND

 

REPORT OF INDEPENDENT AUDITORS

 

 

 

Report of Independent Auditors

 

 

 

The Stockholders and the Board of Directors

Philippine Long Distance Telephone Company

Ramon Cojuangco Building

Makati Avenue, Makati City

 

 

We have audited the accompanying consolidated and non-consolidated balance sheets of Philippine Long Distance Telephone Company and Subsidiaries and of Philippine Long Distance Telephone Company as of December 31, 2003 and 2002, and the related consolidated and non-consolidated statements of income, changes in stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2003. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the Philippines. 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 consolidated and non-consolidated financial statements referred to above present fairly, in all material respects, the financial position of Philippine Long Distance Telephone Company and Subsidiaries and of Philippine Long Distance Telephone Company as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the Philippines.

 

 

 

/s/SyCip Gorres Velayo & Co.

SYCIP GORRES VELAYO & CO.

B. C. SIY-YAP

Partner

CPA Certificate No. 57794

SEC Accreditation No. 0098-A

Tax Identification No. 102-100-627

PTR No. 7012898

January 5, 2004

Makati City

 

 

February 19, 2004

 

PHILIPPINE LONG DISTANCE TELEPHONE COMPANY

 

BALANCE SHEETS

December 31, 2003 and 2002

(in million pesos, except par value amounts)

 

 

See accompanying Notes to Financial Statements.

PHILIPPINE LONG DISTANCE TELEPHONE COMPANY

 

STATEMENTS OF INCOME

For the Years Ended December 31, 2003, 2002 and 2001

(in million pesos, except per share amounts)

 

 

See accompanying Notes to Financial Statements.

PHILIPPINE LONG DISTANCE TELEPHONE COMPANY

 

STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

For the Years Ended December 31, 2003, 2002 and 2001

(in million pesos)

 

 

See accompanying Notes to Financial Statements.

 

PHILIPPINE LONG DISTANCE TELEPHONE COMPANY

 

STATEMENTS OF CASH FLOWS

For the Years Ended December 31, 2003, 2002 and 2001

(in million pesos)

 

 

PHILIPPINE LONG DISTANCE TELEPHONE COMPANY

 

STATEMENTS OF CASH FLOWS (continued)

For the Years Ended December 31, 2003, 2002 and 2001

(in million pesos)

 

 

See accompanying Notes to Financial Statements.