AT&T's Power Shake

By John Greenwald

When C. Michael Armstrong became chairman and chief executive of AT&T last fall, he inherited what looked to be one of America's last business dinosaurs: balky Baby Bells were frustrating Ma Bell's costly drive into the $110 billion local service market, a much-publicized mass layoff of 40,000 employees had failed to boost business, and worst of all, the largest U.S. telephone company (1997 revenues: $51.3 billion) was stuck on the sidelines, while upstarts such as WorldCom and MCI were teaming to deliver everything from long-distance service to high-speed Internet access. "This marvelous industry was growing in double digits globally," Armstrong explains. "The only trouble was, AT&T was not participating in that growth."

What to do? One road led through cable guy John Malone, the deal-happy boss of Tele-Communications, Inc. What better way for AT&T to provide local calling--plus a full package of communications and entertainment services--than to scoop up TCI, the second-largest U.S. cable operator after Time Warner? Never mind that the final price of $31.5 billion in AT&T stock was a lofty $8.5 billion premium over TCI's market value. Or that Malone's cable-TV wires, which run through neighborhoods with 33 million homes (about a third of all U.S. households), were mostly a year or more away from the upgrades needed to carry two-way phone traffic. Or even that Malone's record as a visionary was far from shining--witness the collapse of his dream for a 500-channel universe, or the demise of his 1993 agreement to merge with Bell Atlantic. Mike Armstrong was looking to buy.

Armstrong's vision of the new AT&T is simple enough: hooking up AT&T and TCI (1997 revenues: $7.6 billion) "will enable us to offer a full portfolio of services with one connection from one company. And this is a big deal." So big, in fact, that there was a hint of desperation about the merger, which sped to a conclusion after just eight days of talks in the Manhattan offices of Wachtell, Lipton, AT&T's legal counsel. "Time was closing in on us," says Armstrong, who at 59 remains a man in a hurry who relaxes by roaring down roads on his Harley-Davidson motorcycle. Concurs Ken McGee, a vice president for the Gartner Group consulting firm: "This merger is a matter of pure survival for AT&T. There is no other chance behind this one."

News of the deal rang bells from Wall Street to Main Street to Pennsylvania Avenue. Investors drove up the price of cable- company stocks on the hope that more buyouts would follow. But Wall Street was less than gaga about AT&T, whose stock closed Friday at $56.75, down a whopping $8.625--or 13.1%--since Armstrong unveiled the deal. "Wall Street is missing the point," says Stuart Conrad, the head of telecommunications research for Deutsche Bank Securities. "This is one of the best things that AT&T could have done."

The drubbing was partly a response to the complexity of the deal, which calls for AT&T to bundle its consumer operations and TCI's cable systems into a new subsidiary, called AT&T Consumer Services that John Zeglis, who now serves as AT&T president, will run as chairman and CEO. The unit will issue a separate "tracking stock" that will let investors place bets on the consumer-related businesses of the new AT&T. A similar tracking stock already exists for Liberty Media, TCI's cable-programming arm, whose holdings include the Discovery Channel and Black Entertainment Television. Malone, 57, who controls 86% of the Liberty stock, will continue to run that company after the merger but will leave TCI.

However Wall Street may have viewed the deal, some regulators saw it as a welcome spur to local competition--even as the Baby Bells howled. William E. Kennard, chairman of the FCC, says the merger looks "eminently thinkable." That hardly heartened US West and Bell Atlantic--which last year gobbled up neighboring NYNEX--which demanded access to long-distance markets should the deal go through. So far, Washington has barred the Bells from offering long-distance service to their own local customers on ground that they have not yet opened their "loops" to such rivals as AT&T. But to stick to that stricture after an AT&T-TCI marriage would be "like protecting the wolves from the sheep, and it's just absolutely wrong," says Jerry Brown, a spokesman for US West.

Especially when the wolf still seems hungry. For Armstrong and Malone, who is spending $1.8 billion to ready TCI cables for two-way voice and data traffic, the future is virtually here--and it looks astonishingly lucrative. Malone sees an imminent convergence of TV, telephone and computer services--long the grail of digital thinkers--that will allow customers to access all three separately or at once, simply by aiming and clicking a hand-held device at a TV set. Of course, this convergence has seemed "imminent" to Malone for the past half-decade, but new technology--most of it based on the Internet--seems likely to deliver, finally, on these rich promises. And Malone, among others, is imagining quite a future: "Would you like to order Viagra while watching your favorite entertainment show?" he quips.

If their deal is approved, Malone and Armstrong hope the merger will be a kind of business Viagra for AT&T's famously languid corporate culture. The two say their merged companies could start phasing in these hot new services swiftly. About 25% of TCI's systems will have the capacity to carry two-way traffic by the end of this year, with 95% scheduled to be ready by the end of 2000. At the same time, AT&T plans to spend some $400 per household to install the digital set-top boxes that will serve as portals to high-speed networks that will carry voice, video and data signals. So eager are the companies to get started that they plan to cross-market their cable and telephone services even as regulators review the merger--a strategy sure to bring little joy to households already swamped by come-ons.

And what will all this cost consumers? While Armstrong declines to set a price on the full package of phone, Internet and TV services, he says the savings that will flow from delivering many offerings over a few lines could hold monthly bills well below $100, depending on the services that customers choose. Says Malone: "Once this platform is in the home, the marginal cost of supplying highly desirable entertainment or communication services is very low." No one--least of all Armstrong--thinks your bill from AT&T will get smaller. The hope is that consumers, confronted with all this goodness, will sign up for everything from video conferencing to Net access.

And, of course, local phone service. The real sweet spot of the TCI deal is that it will let Armstrong outflank the Baby Bells to provide local-calling services. With AT&T's 51.4% share of the $95 billion long-distance market steadily dwindling (it was 64.9% at the start of the decade), the company had been scrambling to sign up local customers. But that meant renting phone lines from the Bells--which control the so-called last mile of the telecommunications system--to provide local service, a costly procedure that led to endless squabbles over terms. "We've got to have access to the market and not just a dialogue, a debate or a contract," Armstrong says.

That drove him straight to his pal Malone. Armstrong first suggested a deal during a visit to TCI headquarters in Englewood, Colo., last October, a week after he took the top job at AT&T. The two leaders had done business while Armstrong was at Hughes Electronics, and "his view and my view seemed pretty compatible," Armstrong recalls. But first came Armstrong's $11 billion acquisition of Teleport Communications in January. Teleport, a leading provider of local phone service to businesses, serves 66 U.S. markets through lines that circumvent the Baby Bells.

Meanwhile, Malone seemed to be preparing to sell TCI, which he had built into the dominant U.S. cable company. But his complex dealmaking had turned TCI into an unwieldy, debt-ridden giant. So, in February 1997, Malone brought in long-time cable executive Leo J. Hindery Jr. handed him the title of president and told him to clean up the mess. Hindery promptly whacked thousands of jobs and wiped $4.5 billion in debt off TCI's books by putting 3.8 million cable subscribers into joint ventures with other companies. As Colorado cable analyst Ted Henderson puts it, "They had to dress up the bride and make her attractive for AT&T."

For Malone the deal was a farewell to a company that he has dominated for 25 years. Malone recalled earning a Ph.D. (in operations research) with hefty financial help from AT&T while he worked at Bell Labs in the 1960s, and "now they are getting their dividend." Malone is not doing badly either: he leaves TCI with $1.8 billion worth of stock. "I am personally betting substantially that this will be a very successful investment," he says.

For that to be true, AT&T may have to convince TCI customers that their cable company is no longer the same one many came to hate. "Cable companies come up dead last in terms of the choice that a consumer would make for an integrated provider of communications services," says Berge Ayvazian, executive vice president of the Yankee Group, a Boston consulting firm. "And TCI, among cable operators, is not very highly rated in terms of customer satisfaction, although it has improved over the past couple of years."

Armstrong must still contend with those ornery Baby Bells. Even if all 33 million households in neighborhoods that TCI serves were to buy AT&T local service, the company would remain shut out of two-thirds of the country's homes. Armstrong hopes to make inroads with a so-called fixed wireless system that AT&T is developing to deliver household service through cellular technology. But in the end, he acknowledges, as many as 25% of U.S. homes will remain beyond AT&T's reach--unless it can strike deals with the Bells and other local phone companies.

Yet that hardly fazes this hard-charging chopper rider, who says of his quest to rebuild AT&T, "We've just begun to assemble the components." The giant that almost slept through the '90s has awakened in time to make a grab for control of the digital home.

--With reporting by David Bjerklie and Jane Van Tassel/New York, Richard Woodbury/Denver and Adam Zagorin/Washington

With reporting by David Bjerklie and Jane Van Tassel/New York, Richard Woodbury/Denver and Adam Zagorin/Washington