It's an unlikely spot to find what could be the future of the telephone industry. The dingy Art Deco structure is like so many other old Bell System buildings dotting American downtowns. But step inside the Chesapeake & Potomac Telephone Co. office in Arlington, Va., and take a tour. Past the equipment that switches phone calls for the Washington suburb lies a sealed-off room housing shiny new IBM computers. They're no ordinary machines--they hold dozens of movies, TV shows, and educational programs that have been turned into computer code. By punching in a few numbers on their phones, some Arlington residents can have these shows zapped across the phone lines and into their TV sets. Here's where the information superhighway--or at least a small stretch of it--is being laid.

What the Bell Atlantic Corp. subsidiary is up to is unusual, but it's hardly unique. Its experiment, which tests new technology to pump digital video over copper phone wires rather than over costly fiber-optic cabling, is just one of dozens of video projects under way at the nation's phone companies. Indeed, while the cable-TV industry has hogged the spotlight in the information-superhighway derby--with shrewdly timed announcements, lobbying campaigns, and huge deals--such as cable operator Viacom International Inc.'s proposed takeover of Paramount Communications Inc., the race is only just beginning. And the phone companies are now making their moves. The result: The information superhighway could pull up to U.S. homes sooner than many experts expected.

Like Bell Atlantic, companies ranging from Nynex to American Telephone & Telegraph have been quietly working on ways to deliver interactive video and reams of other information to PCs and TV sets in homes and offices (table, page 132). These companies may be new to video and don't know their way around Hollywood yet, but they have some big advantages. A century of switching signals to millions of phone lines and keeping track of whom to bill for what gives them a leg up on cable companies when it comes to managing interactive TV. And the phone companies are already ahead of cable operators in upgrading backbone networks with the fiber lines needed for advanced video services. Finally, strong balance sheets will allow them to raise billions to complete their rebuilding programs.

Of course, phone companies have disadvantages, too, including more stringent regulations than those cable companies face. But now some of the biggest regulatory barriers--the ones that have kept the seven Baby Bell regional companies out of video--are falling. In what many industry-watchers call a watershed decision, on Aug. 24, a federal court struck down as unconstitutional the section of the 1984 Cable Act that bars the Baby Bells from creating, owning, or even packaging video programming distributed inside their telephone service regions. (In Bell Atlantic's Arlington experiment, the programming suppliers control how the shows are presented.)

LEGAL AMMO. "This decision clearly heats up the race," says Thomas E. Gage, a vice-president at Gemini Consulting, a high-tech advisory firm in Morristown, N.J. Although the ruling applies only to Bell Atlantic, which filed the lawsuit, if the decision is upheld, the reasoning behind it should provide legal ammunition for other phone companies to get their video restrictions removed as well. The federal judge found that barring phone companies from video service violates their First Amendment rights. The other Baby Bells, along with GTE Corp. and Rochester Telephone Corp., have asked the judge to rule that the decision applies nationwide.

For years, the local phone companies have argued that unless they can profit from the creation and sale of programming--rather than just transmitting the "content" for others--it would not be worthwhile for them to invest heavily in upgrading their networks to handle digital video and other data. Neither the 1991 ruling allowing Baby Bells to participate in information services nor last year's "video dial tone" ruling, which permits local phone companies to construct video pipelines to homes, was enough to induce the local phone companies to pump money into video. The Federal Communications Commission's video dial tone decision carried big restrictions, including a rule that kept Baby Bells from owning more than a 5% stake in the programming.

Now, with the liberating August ruling in hand, Bell Atlantic plans to turn itself into a programming powerhouse that could challenge such giants as Home Box Office Inc. and Nickelodeon. The Philadelphia-based company is betting that it can be first with such interactive services as home-education programs in which viewers answer questions and receive a grade at the end. "We are going to be a very good competitor for the cable companies," boasts Bell Atlantic's chairman and CEO, Raymond W. Smith.

Other Baby Bells seem intent on becoming very good allies with cable companies. In May, U S West Inc. announced a $2.5 billion investment in cable and programming giant Time Warner Inc. Under it, the two will rebuild Time Warner's cable systems so they can offer video-on-demand services. The huge deal, orchestrated by U S West CEO Richard D. McCormick, could clear the way for more such megadeals. Even now, industry executives say Viacom is courting several Baby Bells to join in the $8.2 billion alliance with Paramount.

Meanwhile, Southwestern Bell Corp. has agreed to buy two Washington-area cable systems outright. If approved by regulators, the $650 million deal with Hauser Communications Inc. will be the first in which a U.S. phone company has taken over a domestic cable operator. These deals follow by several years Baby Bell investments in video services overseas. Ameritech Corp. is part-owner of a New Zealand cable system while Nynex, Southwestern Bell, and U S West, along with partners that include U.S. cable companies, have built advanced networks that bring telephone and cable-TV service into British homes over a single line. That experience could be a big edge if they get a clear go-ahead to create such hybrid networks in the U.S.

In addition to the local phone companies, the U.S. long-distance giants have video schemes of their own. AT&T, for instance, wants to build a system of computers and advanced switches that would store and send digitized video programs, acting as the national link for the local phone and cable systems that reach consumers' homes. Sprint Corp. recently announced that it has built the first nationwide system that uses new phone-switching technology called asynchronous transfer mode, or ATM, that its backers say can send video signals as easily as voice calls. MCI Communications Corp. also is eyeing video services, though it has announced no firm plans.

ROBOSHOPPER. What this all points to is an accelerating race to deliver the long-promised services of the superhighway: movies on demand, interactive video town meetings, long-distance medical diagnosis, and more sophisticated forms of TV shopping, to name a few. If the phone companies get final clearance, the race to beat cable giants to market could move up completion of a national information superhighway long before the 2015 target established by federal policymakers, says Joseph S. Kraemer, a telecom consultant at Deloitte & Touche.

Certainly, the financial clout of the phone companies could be a decisive factor, since the superhighway network could cost hundreds of billions to build. "Phone companies have access to huge amounts of capital," says Kidder, Peabody & Co. analyst Steven R. Yanis. Phone companies have higher credit ratings on average than cable companies, allowing them to raise funds more cheaply on the debt market. They also enjoy huge cash flows from their phone businesses. And two-thirds of the states have modified their regulations to make it easier for the phone companies to justify the big investments needed to upgrade their networks, Yanis says.

The local phone companies have other big advantages, too. Even now, just 60% of U.S. households get cable, while phone wires reach nearly everyone. And phone company computers are geared to account for the millions of transactions that would cross an interactive TV network. Phone companies also have a less tangible advantage: far better customer relations. Indeed, the reputation for bad service by cable companies was a big factor when Congress voted to reregulate the industry last year.

FREE-FOR-ALL. The phone companies may be more inclined to team up than fight. Analysts expect more deals like the U S West-Time Warner alliance, giving phone companies a shortcut into programming or a way to reach beyond their home regions. Other combinations could pair weak cable operators with local phone companies to jointly build a video network, though such alliances could raise antitrust concerns. Still others could be marriages between titans. The industry grapevine is still abuzz about AT&T joining forces with Tele-Communications Inc., the largest cable operator. This mix-and-match alliance-building could produce several wild years as the industries sort things out. "Some places you'll cooperate, some places you'll compete," says Brian L. Roberts, president of cable operator Comcast Corp.

Splicing cable and phone companies together remains a tricky undertaking. "There are so many restrictions to us working together," says Lee G. Camp, CEO of Pacific Telesis Group's Pacific Bell Information Services, that he gave up looking for a partner. For example, the ban keeping Bell companies out of long-distance phone service also prevents them from carrying video beyond local calling areas, limiting their appeal to cable partners.

With recent developments such as the Bell Atlantic ruling, however, industry-watchers and Wall Street are beginning to anticipate the end of the old restrictions. And they're viewing the phone giants in a far more optimistic light. Just a few months ago, it seemed (on Wall Street at least) that the cable companies had the information superhighway sewn up and were ready to sweep into local phone service, too. A lot of investors believed that "the phone companies are dinosaurs," says Kidder Peabody's Yanis. Following the August court decision, shares of the Baby Bells have risen. But cable stocks climbed, too--apparently on the belief that they will benefit from alliances with the phone companies.

Now, Wall Street, cable executives, and other phone companies are watching Bell Atlantic closely as it wires 60,000 homes in Alexandria, Va., next door to Arlington, with fiber-optic lines. The system, which could take up to 18 months to construct, will provide direct competition with the city's incumbent cable system, operated by Jones Intercable Inc.

INTERIM STEP. In particular, the observers want to see just how the phone company surmounts technical hurdles--and at what cost. For the Arlington experiment, which has only Bell Atlantic employees as customers, the company is using existing lines instead of stringing fiber-optic cable all the way to homes, which would cost $1,000 to $1,500 per line. Instead, Bell Atlantic is relying on a technique called asymmetric digital subscriber line, or ADSL, that can shoot the digital bits that make up a movie or TV show from Bell Atlantic's computers over copper phone lines into living rooms. And customers can still make calls while watching a movie.

Cable companies dismiss the ADSL technology, which was developed by Bellcore, the research arm of the Baby Bells. One prominent cable executive calls the Bell Atlantic ADSL trial "a PR stunt," noting its location near the homes of many members of Congress and employees of federal regulatory agencies. Indeed, the current state-of-the-art ADSL system is limited in that it can feed only one program at a time to a home, although a new version capable of sending four different programs to four sets is in the works. And ADSL's picture quality, while acceptable, is only about as good as that of videotape. Finally, ADSL can't provide some advanced features such as video phone calls. In fact, Bell Atlantic says ADSL is largely an interim technology that it will use while it establishes a market for on-demand programming--and to keep cable operators at bay. Later, the company plans to rewire most areas with fiber.

Still, no U.S. cable system can yet do what the Bell Atlantic ADSL service can today: allow a viewer to order a movie or other show and have it appear on the TV set in a minute or two. Most cable company pay-per-view setups offer only a few hit movies and only at set times. For the phone companies, "technology is not really the obstacle here, in terms of getting [video] services to homes and businesses. It's regulatory barriers," says Gary R. Edson, vice-president of business development at Ameritech.

Indeed, the regulatory arena is where the most violent clashes between cable-TV and phone companies are occurring. As renewed rate regulation limits their ability to invest, the cable companies are crying foul at the possibility that the Bells will use profits from their local phone-service monopolies to fund the replacement of copper wires with fiber or coaxial cable. They contend that phone companies should not be allowed to offer video services until there is vigorous competition in local phone service, including by cable players.

The debate may come to a head this fall when Congress is scheduled to discuss several bills to loosen regulations. The Bell Atlantic video ruling is a wake-up call to legislators and regulators that if they don't reshape communications policy, the courts will. Already, the ruling opens up the possibility that Baby Bells can simply buy local cable companies to get into video, though Bell Atlantic says it has no plans to do so. Such a move could replace two monopolies in each community with one huge one--a development sure to raise public apprehension.

But the momentum appears to be on the local phone companies' side. AT&T's $12.6 billion deal last month to buy McCaw Cellular Communications Inc. gives the Baby Bells more leverage in their push for deregulation. Through the new alliance, they say, AT&T can reenter local phone service through wireless connections. And if AT&T can get into local service, the Baby Bells say they should be allowed into long distance.

Clearly, there will be winners and losers in both the cable and phone industries. It is as risky to be too early to the interactive video market--with products that don't quite work--as it is to be too late. But with the right mix of technology, services, and partners, the phone industry could take a leading role in building the information superhighway. And it could speed up the construction, ending years of hype and bringing the Information Age into American living rooms sooner than anyone expected.



Phone companies want to build information highways that will send interactive video and other digitized data to your living room as readily as phone calls.

AMERITECH Building fiber-optic lines close to major customers. Testing several interactive video services. Part owner of a New Zealand cable system.

AT&T Wants to build a national network of computers to store and forward movies and other "content" to local distributors, such as cable companies and Baby Bells.

BELL ATLANTIC Testing new video-delivery technology and plans to rebuild much of its system for interactive services. Also entering the video-programming business.

BELL SOUTH Has rebuilt much of its network with fiber lines, though not to homes. Installing advanced ATM switching technology that could send video to homes.

GTE Few concrete plans, but has named a vice-president of video services. Testing an interactive network in Cerritos, Calif.

MCI Hasn't talked much about interactive services. But has $4.3 billion in cash from sale of 20% to British Telecommunications.

NYNEX Major player in the British market for cable-phone systems, but says little about U.S. plans. Will test interactive video services in New York City.

PACIFIC TELESIS Held inconclusive talks with cable companies to cooperate. Plans to rewire California for information highway by 2015. Plans to test video on demand.

SOUTHWESTERN BELL Buying two Washington (D.C.)-area cable TV systems for $650 million. Says little about its video plans in home region. Also in British market.

SPRINT Claims it's first phone company to offer a national network of advanced ATM switches for video traffic to big customers. Few disclosed video plans.

U S WEST Its $2.5 billion investment in cable giant Time Warner Inc. transformed phone-cable competition. Plans to rewire its phone territory for two-way video services. Owns half of a British cable-phone system.

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