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Can AT&T Uncross Its Wires?

As change sweeps across the U.S. telecommunications business, no one faces a bigger dilemma than new AT&T Chairman and CEO David Dorman. Seven years after Congress voted to let carriers reunite the local and long-distance phone businesses, AT&T (T) has been transformed from a formidable incumbent into just another challenger to Baby Bells Verizon (VZ), SBC Communications (SBC), and BellSouth (BLS) -- albeit one that in 2002 produced $3.2 billion in free cash flow. It's no wonder that Dorman joked recently at the World Economic Forum in Davos, Switzerland: "I had a bad dream that one day I woke up and was chairman of AT&T."

Indeed, charting AT&T's future is becoming a nightmare -- even for a veteran telecom exec like Dorman, who has served in top posts at long-distance carrier Sprint (FON) and at SBC. The sluggish economy and bankrupt WorldCom's (WCOEQ) willingness to slash prices for corporate data services have cast a cloud over AT&T's prospects.

Worse, new Federal Communications Commission (FCC) regulations that are due soon could overturn rules that have allowed AT&T easy and inexpensive access to the lucrative local-phone market -- a development that at the least will slow AT&T's entrance into the new world of all-distance telecom. "Dorman doesn't have a lot of options," says Patrick Comack, a telecom analyst at Miami-based Guzman & Co. "The evolution of the industry is turning AT&T into a dinosaur."

CONVENTIONAL RESPONSE. AT&T declines to comment on its strategy while the FCC decision is pending. But in a speech at the National Press Club on Jan. 30, Dorman himself described the threat AT&T faces: "The telecom industry is at a crossroads.... If the [FCC] decisions [undo the current rules], there will be an interim period where the Bells will get stronger and the competitive industry weaker."

What can Dorman do? Faced with the same challenge four years ago, former CEO Michael Armstrong set out on a $110 billion cable-TV acquisition spree that AT&T has since undone at a huge loss: It finalized the $54 billion sale of its cable assets to Comcast (CMCSA) in November. Dorman's main strategy is more conventional and less risky: Try to cut costs as fast as revenues fall -- or faster.

That's a tall order. AT&T's revenues slid 10% in 2002, to $37.8 billion, but operating income plummeted 31%, to $5.5 billion. For the short term, at least, that trend seems likely to continue. According to UBS Warburg analyst John Hodulik, voice services generate roughly 80% of AT&T's operating income. In that part of its business, it continues to face aggressive price competition from the Bells -- and it's losing market share to them and to wireless calling and e-mail.

AT&T's margins are also eroding in the business market thanks to the Bells. In the fourth quarter, AT&T said it sold 40% of its business voice minutes at wholesale prices.

WORLDCOM HANGS ON. And its vaunted data-transmission business won't be enough to offset sagging voice revenues. Though many analysts had predicted that WorldCom's Chapter 11 bankruptcy filing could create a windfall for AT&T, Ma Bell's revenues from business customers fell 3% in 2002, to $26.6 billion (see BW Online, 6/27/02, "Is WorldCom Opening the Door for AT&T" ).

That's because business customers continue to spend cautiously and demand better deals when their contracts come up for renewal. Moreover, AT&T officials noted during the Jan. 23 earnings conference call that the WorldCom effect hasn't been as pronounced as observers expected. Instead of falling apart, WorldCom has held itself together in Chapter 11 by aggressively cutting prices to retain customers. Even if WorldCom disappeared, Hodulik calculates, AT&T probably couldn't reverse its decline. He estimates that if AT&T took 100% of WorldCom's best business customers, its revenues from the corporate market would increase only 2% annually.

Faced with such prospects, AT&T now sees its salvation in the local-phone business. It still holds 40% of the residential long-distance market, and selling a combined package of long-distance and local service has proved to be a powerful customer-retention tool. At the end of 2002, AT&T had 7.3 million local lines serving residential and business customers. The majority

of those customers bought both local and long-distance service from the telecom giant.

RULE ROULETTE. Today, AT&T serves most of those customers by reselling local service it purchases at wholesale from the regional Bells. However, it could lose that right or have to pay more for such access, depending on new regulations that the FCC is scheduled to unveil on Feb. 13. AT&T has vigorously argued against changing the existing arrangement, warning that it would undermine competition and subvert the aims of the 1996 Telecommunications Act (see BW Online, 10/17/02, "When Telecom Regulation = Competition").

Right or wrong, though, the rules are likely to change. According to sources at the FCC, the commission is mulling revisions that over time would exempt densely populated, profitable markets such as New York City from the regulations that require the Bells to sell wholesale access to their networks.

Even if the rules aren't changed, the local-phone biz likely won't be AT&T's savior. Of the nine states in which it sells local service, it's profitable only in New York, where it grabbed a 17% market share, then drastically cut back marketing outlays.

"SCOPE TO SURVIVE." AT&T also faces new competition in 2003 from the Bells, which have won approval to offer long-distance service (and therefore, a competitive all-distance package) in populous states such as California and Florida. At the dawn of 2002, the Bells offered all-distance service in only 10 states. As 2003 begins, they're selling it in 35, and they hope to end the year with approvals to sell in all 50. AT&T plans to offer all-distance service in 14 to 17 states by yearend.

Of course, AT&T still has 50 million customers -- not to mention a fair number of fans. "It has the scale and scope to survive," declares Martin Hyman, an independent telecom analyst. He points out that AT&T already owns the equipment needed to offer local service in 300 U.S. cities. So if the FCC kicks it off the Bells' local networks, it can still find a way to reach local customers.

AT&T also has expertise in managing the communications networks of big companies on a contract basis, although the limp economy has dampened demand for such work for now. The managed-services market was worth just $28 billion in 2001, according to Deloitte Consulting. But over the next decade, that's expected to grow to about $80 billion.

BUY, OR BE BOUGHT? Even so, more than a few experts think the best option for AT&T (and its sister long-distance companies Sprint (FON) and MCI) ultimately may be to link up with one of the offspring from Ma Bell's 1984 breakup. Buying a Baby Bell is out of the question: AT&T's market cap is about one-third of the smallest Bell, and it has neither the cash nor the stock currency -- at around $19, ar its 52-week low -- to orchestrate a monster acquisition.

Alternatively, AT&T could sell itself. (AT&T declines to comment on that). But to whom? The Bells seem content to let AT&T bleed, since after all, they're picking up millions of long-distance customers on their own. The largest Bell, Verizon, had more than 10 million long-distance subscribers at the end of 2002. So for it, buying AT&T would mean taking on billions in debt at a time when it's whittling down its borrowings.

Behind closed doors, however, Bell strategists are taking a close look at how AT&T's scale and corporate expertise could bolster their competitive stance in telecom's new all-distance world. One possibility is a BellSouth-AT&T combination. A year ago, the two held merger discussions, and insiders say they're being revived now (see "Are BellSouth and AT&T Altar-Bound?").

"LIMITED WINDOW." The Bells, which until recently have been prohibited by FCC regulations from serving businesses outside their respective regions, are targeting this market but lack AT&T's knowhow and customer roster. Yet, to attract a suitor that's interested in this business, AT&T might have to divest its consumer voice business, analysts say. That would both eliminate antitrust concerns and lower the price of AT&T's corporate contracting business to affordable levels for the cash-strapped Bells.

"Divesting a business with billions in free cash flow is a risky move," says Blair Levin, a telecom analyst at investment firm Legg Mason. But, he adds: "AT&T only has a limited window of usefulness to the Bells. That's Dorman's dilemma."

It appears that the CEO hasn't yet chosen his path. At its fourth-quarter earnings' conference call, AT&T said it will no longer offer quarterly or annual earnings guidance, a decision some analysts interpreted as a sign that AT&T itself no longer knows just how things will pan out.

"I don't think anyone believes they'll survive as a stand-alone company," declares Susan Kalla, a telecom analyst at Freidman Billings & Ramsey in Arlington, Va. "The question is how, and how quickly, it [disappears]." And for Dorman, that's how long his nightmare lasts. By Jane Black in New York

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